24 July 2018

Impact of China Removal of Restrictions in Auto Sector

This article was written by Mark Schaub (Partner) , Atticus Zhao (Senior Associate).

The automotive sector is facing the twin disruptions of new energy and autonomous cars.

It is eye-catching that one of the major initiatives to further open up China’s economy announced by President Xi Jinping at the Boao Forum on 10 April 2018 was large scale relaxation of foreign investment restrictions in the auto sector. Shortly after President Xi’s announcement the National Development and Reform Commission (NDRC) revealed on 17 April 2018 that foreign ownership limits on automakers would be phased out over a 5-year transition period.

According to NDRC, foreign ownership restrictions on special-purpose vehicles and new energy vehicles (NEVs) will be removed in 2018. The liberalization will be followed by commercial vehicles in 2020 and passenger cars in 2022. The rule that currently prohibits foreign automakers from setting up more than two joint ventures in China will also be lifted in 2022. After the 5-year transition period, all restrictions on foreign investment in auto sector will be removed.

These policies were swiftly followed by regulatory action and on 28 June 2018, NDRC and the Ministry of Commerce (MOFCOM) jointly issued the Special Administrative Measures for Admittance of Foreign Investment (Negative List) (2018) (“2018 Negative List”)[1] which is due to take effect from 28 July 2018.[2]

The 2018 Negative List confirmed the pledge to fully remove foreign investment ownership limits on auto industry over a 5-year transition period.

In addition to making it easier for international companies to manufacture cars in sell more cars to China the government has also significantly lowered import tariffs for vehicles. Starting 1 July 2018 import tariffs on autos were reduced to 15% from 25% and auto parts will be subjected to 6% tariffs.

The relaxation on foreign ownership restrictions should open up China’s auto industry and for this reason it may have a major impact on domestic and international OEMs alike.

Background

China’s first Sino-foreign auto joint venture predated China even having an official auto industrial policy. Back in May 1983, Beijing Jeep was established with a shareholding of 68.65% held by Beijing Automotive Manufacturing Plant and 31.35% by the American Motors Corporation. 

It was only in 1994, when the China Planning Commission (the predecessor of the NDRC) issued the Policy for the Automotive Industry (“1994 Auto Policy”) that China embarked on a policy heavy regime for the auto industry. A key policy was to restrict foreign automakers to owning no more than 50 percent in any Sino-foreign joint venture but also limit the foreign automakers to no more than 2 joint ventures for any single type of vehicle in China.

The 1994 Auto Policy was the first to establishing this so called “50% + 2” rule – a bane of existence for many foreign automakers. Despite the 1994 Auto Policy being overhauled in 2004 and 2009 the “50% + 2” rule remained largely unchanged.

In 1995, China issued Foreign Investment Industry Catalogue (“Foreign Investment Catalogue”) which echoed the shareholding limitation on foreign automakers in auto sector. The Foreign Investment Catalogue has been amended 8 times[3] since 1995 and reflects China’s evolving views on foreign investment’s role in industrial policy.

Both China’s policies in relation to automotive industry and foreign investment have tended to reduce restrictions on foreign investment over the last 20 years. Despite this the “50% + 2” rules have largely remained intact under the Foreign Investment Catalogue except that in 2017 the “2 joint ventures” limitation was removed for purely electric vehicles.   

For years, the “50% + 2” rules were considered as a necessary policy to buy local automakers time to gain the skills, master the technology and build the brands to allow them to compete before international automakers would be unfettered access to the China market.

China’s policy in respect of cars has been spectacularly successful. China has become world largest auto market since 2009. By the end of 2017, China has more than 200 million private owned cars.[4] In 2017, China manufactured and sold 29 million and has been No. 1 global manufacturer for nine consecutive years.[5] In contrast, back in 2000, China manufactured and sold only 2 million vehicles.

Relaxing restrictions on foreign ownership in the China auto industry have long been sought by both international OEMs and also foreign governments.

The first indication of relaxation by the Chinese government dates back to 2016 when the minister of Ministry of Industry and Information Technology (MIIT), Mr. Miao Wei, revealed in an auto summit that China intended to remove foreign ownership restrictions within 3-5 years or at latest within 8 years. In April 2017, China issued the Mid and Long Term Planning of Auto Industry which clearly stated that China intended to move towards a removal of foreign ownership restrictions in an orderly manner.

Although China’s relaxation of foreign ownership restrictions in auto sector seems to be a longer term concept and does not seem to have been driven by recent actions by the Trump Administration,  such policy is likely to ease recent tensions in Sino-US trade.

Impact

The removal of the foreign ownership restrictions will have a major impact on both Chinese and international automakers.

1. Chinese OEMs

The share price of many local automakers slumped on 18 April 2018 after NDRC’s announcement that foreign ownership restrictions will be relaxed. This share movement may to some extent reflect Chinese consumers’ concerns over the competitiveness of local automakers.

It is unlikely that many Chinese automakers applaud the change of direction in policy. The policy will mean more competitors – many of these with powerful and deep R&D capability, access to leading technologies and global footprints.

In respect of Chinese automotive joint ventures it may, at least theoretically, that the Chinese partner may lose some leverage within such joint ventures.  

However, the Chinese automakers may be underplaying their abilities to compete. After 30 years of working with international OEMs, many local automakers have established their own brands that are well recognized in China and, in some cases, beyond.

It is probable that the relaxation of foreign ownership restrictions signals the Chinese government increased confidence in their home-grown automakers.

Chinese automakers will likely face fierce competition from international automakers during and after the 5-year transition period. Local automakers engaged in manufacturing NEVs will very likely feel the pressure already this year. Nevertheless, the relaxation will be a stimulus to urge Chinese automakers to improve their products and strengthen their brands.  

2. New Players and NEVs

The 5-year relaxation plan of NDRC and the 2018 Negative List provides that China will remove foreign ownership restrictions for NEVs from 28 July 2018.

It is likely that international manufacturers focused on NEVs, such as Tesla, will be the main beneficiaries of eliminating the restrictions at least in the short term.

However, in the longer term it needs to be noted that China has ambitious plans to become a global leader in the next generation of autos and is promoting domestic manufacturing of NEVs including offering incentives. By 2020, China aims to be capable of manufacturing 2 million purely electric vehicles and hybrid vehicles annually and 5 million totally. [6]China is already the world’s largest NEV market, selling 777,000 NEVs in 2017. The market is also fast growing in that this represents 53 percent year-on-year growth. By 2025, China aims for NEVs to constitute 20 percent of all vehicle manufacturing and sales within the country.[7]

In addition to offering the carrot of incentives to encourage manufacturing of NEVs China also has a stick. The stick is the introduction of a dual-credit scheme for gasoline cars' fuel consumption and new energy vehicle production (“Dual-credit Scheme”). Under the Dual-credit Scheme, carmakers in China will be assessed against China's fuel consumption requirements. Companies that manufacture or import more than 30,000 passenger cars a year will be examined in terms of NEV production and those failing to meet such requirements will need to buy credits from other automakers or be fined.

Under the Dual-credit Scheme, NEVs' credits are required to account for 10% in 2019 and 12% in 2020, with one NEV calculated as two to five units depending on the mileage achieved on one charge. The Chinese government has given a one year grace period and will implement the scheme in 2019 rather than the originally planned 2018. This grace period was primarily to give international automakers more time to prepare for compliance. NEVs are likely to be the main battlefield for local automakers and international automakers in China in the longer term.

One major issue is that China’s loosening of foreign investment restrictions for NEVs does not mean that international automakers are being waved in to set up NEV manufacturing in China. Existing market entry and project investment requirements, administrative rules on manufacturers and products still remain in place. In addition to the need to comply with China’s various requirements and regulatory hoops the international NEV OEM will also need to deal with the current suspension of approvals for investments for manufacturing NEVs due to concerns of excess production. The NDRC has for this reason also raised the thresholds to be met to invest in electric vehicles in the draft Administrative Rules on Auto Industry Investment that was circulated for public comment in July 2018 (“Draft Auto Investment Rules”).

3. Existing Joint Ventures

The removal of the foreign investment restrictions on auto industry theoretically gives foreign automakers the option to separate their China operations from their Chinese joint venture partners.

The international OEMs will have the following options:

(1) Buy-out the Chinese partner

As the shareholding restrictions will be removed in the next 5 years it will be legally possible for the foreign automakers to wholly own the manufacturing entity and therefore the joint venture would be converted into a wholly foreign owned enterprise (WFOE).

However, although such restructurings are legally possible we assume they will be unlikely in practice as such restructuring cannot be decided unilaterally by the foreign partner. Any restructuring will require the Chinese partner’s agreement and co-operation. In most cases Chinese partners in such joint ventures are large companies and therefore absent special circumstances are unlikely to engage in a 100% sell off.  

In addition, according to statistics, of the 23 main Sino-foreign auto joint ventures the average remaining term of the joint venture contracts is 19 years.[8]Accordingly most joint ventures are intended to go far beyond 2022 – this again underscores how important it is to have the agreement and cooperation of the Chinese partner for any restructuring.

In addition to being large enterprises most Chinese partners in Sino-foreign JVs are state-owned enterprises. Accordingly in addition to negotiating with the Chinese partners the foreign partners will also need to negotiate with the relevant Chinese government authorities.

(2) Go Solo

Another theoretical option is for a foreign automaker to exit its joint venture and set up its own manufacturing WFOE. However, this is unlikely to be a practical option due to the following reasons:

Fossil-fuelled car investment is strictly controlled. The Catalogue of Investment Projects Approved by Government issued by the State Council on 12 December 2016 and the Opinion on Improving Auto Investment Projects issued by NDRC and MIIT on 12 December 2017, clearly indicate that China government will strictly control any increase in production capacity of traditional fossil-fuelled cars. The overriding principle is that no new fossil-fuelled car investment projects will be approved.

In addition the NDRC’s Draft Auto Investment Rules expressly prohibit the establishment of any new separate fossil-fuelled car manufacturing project. Although not in force the draft rules clearly show the government’s intent.

The above rules make it clear that foreign automaker will not be able to set up any new fossil-fuelled car manufacturing entities in China. Currently most joint ventures are manufacturing and selling fossil-fuelled cars. As such, it will be very unlikely that a foreign carmaker will be able to establish a WFOE to manufacture fossil-fuelled cars in China. Accordingly they may well be stuck in their current JVs or with the option of buying out the Chinese partner in whole or in part (subject to the practical restraints outlined above).

NEVs possible but higher requirements. Under the 2018 Negative List, foreign investment restrictions on NEVs will be removed as of 28 July 2018. This means that a foreign automaker will be able to set up a WFOE to manufacture NEVs. However, according to NDRC’s Draft Auto Investment Rules, while NEVs (specifically electric vehicles) remain strongly encouraged by Chinese government, the threshold to invest in an electric vehicle project has been substantially raised; for example, the construction scale for an electric vehicle investment project must have at a minimum of 100,000 electric passenger vehicles or 5,000 electric commercial vehicles.

We understand that since July 2015, approximately 15 electric vehicle manufacturing companies have obtained manufacturing approvals from NDRC. Although 15 sounds like a lot it should be noted that more than 200 companies are queuing for such manufacturing approvals. Based on our research it appears that as of June 2017 NDRC has not issued any additional approvals for an electric vehicle manufacturer. [9]

It is likely that the pause in issuing new production licenses for electric vehicles is due to the work on the Draft Auto Investment Rules. However, although the production license issue is likely to be resolved the raised bar for electric vehicle manufacturing companies will likely be a major barrier for many newcomers to this market.

Difficult to set up sales channel and after-sale network on its own. One issue that may cause issues is that many car manufacturers need much more than just an auto manufacturing plant. They require an eco-system to build and sell cars. Accordingly it may also be a major hurdle for a foreign automaker to build its own sales channels, car financing and after-sales network throughout China without a Chinese partner’s involvement. Building such infrastructure need more than just investment – it will also require specific market know how and relationships.

(3) Maintain Status Quo or Something Similar

Another option for foreign automakers is to maintain the status quo of the joint ventures for the next 5-10 years. This will be the most likely outcome as buying out will be complicated and possibly economically fraught.

This can also be seen from the reaction of most of the major international carmakers after NDRC’s announcement of the relaxation of foreign investment restrictions - they welcomed the relaxation but they also stated that they will continue to work with their Chinese partners.[10]

It may be that the foreign automakers use the relaxation of foreign investment restrictions will use this to seek a larger share of the JV and therefore greater responsibility.   

However, the attraction of remaining in the JV may apply equally to the Chinese partners. Maintaining the status quo for the next few years may be a practical approach for the Chinese partners as well.

Summary

China’s relaxation of foreign investment restrictions in auto industry (including lowering import tariffs on vehicles) will provide better access for international automakers to the world's biggest car market and provide a more level playing field for international automakers to compete with Chinese automakers. It is anticipated that most foreign investment seek to enter the NEV segment as NEVs are likely to be the main type of autos China promotes going forward.  

Although the relaxations may provide opportunities for international OEMs, they are unlikely to take advantage in establishing NEV manufacturing entities in China due to NEV investment requirements mentioned above. For Chinese automakers the main opportunity will be to improve their ability to compete by requiring more adoption of innovation and improvement of competitiveness in a global context.

Initial media reports very much concentrated on international automakers with joint ventures with Chinese automakers. However, the complexity of the situation (i.e. dealing with Chinese partners but also in many cases Chinese authorities and the need to build an eco-system) will mean it is less likely that they part company with their Chinese partners over the next 5-10 years.

Indeed the opening up the market and the entry of new aspirants may lead to a circling of the wagons and may even lead to these partners of circumstance deepening their cooperation in order to compete in the dynamic market.


[1]http://www.mofcom.gov.cn/article/b/f/201806/20180602760432.shtml

[2]On 30 June 2018, NDRC and MOFCOM further jointly issued Special Administrative Measures for Admittance of Foreign Investment in Pilot Free Trade Zones (Negative List) (2018), which has the same rules as the 2018 Negative List on China auto industry.

[3] The amendments to Foreign Investment Industry Catalogue have been made in 1997, 2002, 2004, 2007, 2011, 2015, 2017 and 2018 respectively so far.

[4]http://www.stats.gov.cn/tjsj/zxfb/201802/t20180228_1585631.html

[5]http://www.caam.org.cn/xiehuidongtai/20180111/1605214622.html

[6]节能与新能源汽车产业发展规划

[7]China’s Auto Industry: Foreign Ownership Limits Scrapped

[8]http://auto.sina.com.cn/news/hy/2018-04-19/detail-ifzihneq1508759.shtml

[9]http://auto.gasgoo.com/News/2018/05/26051621162170042858C501.shtml

[10]http://europe.autonews.com/article/20180417/ANE/180419782/vw-bmw-daimler-could-gain-from-china-removing-ownership-caps

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