Moving Too Fast?

By Matthew Forney/Xi''an

Old Chinese bomb factories rarely die. They just become car plants. At least that's what has happened at Qin Chuan in the northern city of Xi'an. The aging state-owned enterprise, which a decade ago made 130-mm artillery shells, now houses assembly lines that stamp out a boxy four-door hatchback called the Flyer. It built just 17,000 vehicles last year; many of the underpowered and unattractive cars were bought by local taxi companies on the order of provincial officials looking for a captive market. But even that didn't dismay factory managers trying to cash in on China's booming car market. In February, BYD, a maker of lithium batteries in Shenzhen in southern China, bought the Flyer factory. Although the new owner has no experience making cars, it still plans to invest a war chest raised on the Hong Kong Stock Exchange to build a new facility that will start producing four models of Flyers as early as next year. "Once we're established," says Liu Zhenyu, the factory's general manager, "we'll use our batteries to make electric cars."

The business plan of BYD, which stands for Brings You Dollars, might sound fanciful, but it is far from unique. With demand for cars soaring--purchases of passenger cars increased 75% last year--China is now the fourth largest car market in the world, behind the U.S., Japan and Germany. But unlike the more mature markets of the top three, China has more than 200 carmakers, ranging from creaky communist-era holdovers and former washing-machine manufacturers to modern joint ventures run by the likes of Volkswagen and General Motors. Most have responded to the growing demand with massive capacity expansion. Accounting firm KPMG predicts that within two years China will be able to build 4.9 million sedans a year--roughly the output of Germany--and will outstrip even China's fast-growing demand by 2.3 million cars a year.

It's a recipe for glut that could reverberate around the globe, and not just in cars. From microwaves to T shirts to sheet steel, China is building up excess capacity at a breakneck pace. The country's economy grew 9.1% last year and attracted $53 billion in foreign investment, second only to the U.S. economy. The emerging middle class pushed retail sales up 9% in 2003, but industrial output shot up 17%. Economists warn of a crash waiting to happen: if too many factories make too many goods chasing too few buyers, the results are likely to be deflation, widespread business failures, layoffs, loan defaults and shaky banks. And with many other Asian countries retooling their economies to fuel China's boom, the knock-on effects down the supply chain could be devastating. "Overinvestment will lead to a supply shock that will affect the whole world," predicts Dong Tao, chief Asia economist for Credit Suisse First Boston.

Tao might seem like a killjoy. After all, China at the moment is the star on the world economic stage. The country's soaring need for a host of goods, especially commodities such as oil, iron ore and aluminum, is a major contributor to global economic recovery. China is poised this year to pass Japan as the world's third largest importer. But the government needs to keep the economy superheated just to provide jobs for the 12 million to 15 million people coming into its labor market every year. That means finding ever larger markets--both internal and overseas--to soak up all the goods the country is producing. The U.S. already has a massive $120 billion trade deficit with China, which has prompted some members of Congress to call for punitive tariffs. Other countries are equally fearful of a deluge of cheap goods from China.

Those closest to the gears of the global economy were the first to notice the coming storm in China. Albert Stahl, a London ship broker, watched the spot-market price for cargo-vessel leases rise last winter to $22,000 a day for a ship big enough to transport iron ore. He assumed the spike was due to the impending Iraq war. But through the summer the price kept increasing; shipowners even stopped giving quotes in expectation that prices would jump again the following day. Then Stahl began hearing reports of vessels the size of three football fields anchored off the Chinese coast for up to two weeks waiting for a berth, sometimes paying $100,000 a day for the privilege. Finally, he pieced it together. "There's a shortage of available ships in the world because of congestion in China, and nobody knows how to deal with it," says Stahl, a director at CTI Transport and Logistics.

There are other signs that China's economy is overheating. Chinese state-run banks, already technically insolvent, have in the past year been shooting out new loans for factories, roads and real estate as if from confetti cannons. According to China's central-bank numbers, lenders last year handed out about $335 billion, 50% more than the year before. It's just not possible that China's banks suddenly found so many new creditworthy ventures, says Nicholas Lardy of the Washington-based Institute for International Economics. "We've seen the greatest credit expansion in the past 25 years," he says. "I'd expect companies that borrowed heavily to face difficulties when the next downturn starts."

Easy credit has made it simpler for Chinese firms to pile into the car industry. A few years ago, as Chinese consumers began amassing enough disposable income to buy TVs, appliances and consumer electronics, companies crowded into those fields, driving down prices and profit margins until only a few of the largest now compete. Today one of the new hot zones is autos; sales are accelerating, and margins can be fat. "It's too hard to make money from washing machines now," complains Zhao Yong, a director of Guangdong-based Midea, an appliance maker that plans to buy a bus factory near the China-Burma border. "So we'll start making buses and move into sedans." Others, often with no previous experience in auto manufacturing, have devised similar strategies. Sanxing Aux, producer of China's cheapest air conditioners, last fall announced it had purchased a carmaker in the country's far northeast and would soon unveil a line of sport-utility vehicles. At least three other electronic-goods makers have announced intentions to buy auto plants. Even the maker of one of China's best-known liquors, Wu Liang Ye, has revealed plans to expand into cars.

These homegrown carmakers will have to compete with multinationals like General Motors, Ford, Toyota, Volkswagen and Citroen, all of which have invested heavily in Chinese joint ventures and are muscling for market share. GM, which has made Buicks in China since 1999, will soon launch top-of-the-line Cadillacs and plans to increase total production 50% in the next two years. In a first for the country, Beijing recently announced it will allow GM to import cars made overseas without going through a Chinese partner. Ford plans to increase production sevenfold, to 150,000 cars a year. Volkswagen, maker of the best-selling cars in China, plans to invest $6.5 billion with its joint-venture partner to double annual capacity at its Shanghai plant to a million cars by 2007.

With Japanese and U.S. technology battling it out at the top, the only hope for domestic carmakers without joint-venture partners is to capture the bottom end of the market, then begin the slow ascent up the price-and-sophistication ladder. That's the path chosen by BYD, the former bombmaker. The Flyer retails for about $4,700, making it affordable to the 50 million Chinese earning at least $7,000 a year, whom the government considers middle class. "Look around my office," says Liu, the BYD general manager. He has one dusty filing cabinet, bare whitewashed walls and a view overlooking the decrepit former bomb factory. "We can get by on the slimmest profits."

The Flyer was designed by Chinese engineers, but at least two other companies are suspected of trying to cut costs through a time-tested Asian shortcut: copying Western designs. Analysts once considered cars too sophisticated to knock off. They were underestimating Chinese ingenuity. In 2002 a Volkswagen-like subcompact made by a small company in Anhui province now called SAIC-Chery Automobile began appearing: it was made with components provided by suppliers that were believed to have signed exclusive deals with Volkswagen's joint venture. More recently, Chery has run afoul of GM by releasing a car, called the QQ, that looks almost exactly like a GM model--the Spark--that didn't hit the Chinese market until December. PSA Peugeot Citroen, the French maker of the successful Citroen sedan in central China, faces a similar problem. A local producer called Shanghai Maple introduced a model that looks startlingly like the Citroen: same body, same interior, even the same way of tooting the horn from the turn-signal toggle. "It's exactly the same as the Citroen except half the price," boasts Liu Xiaojun, a Shanghai Maple dealer in Beijing. Citroen suspects that Shanghai Maple poached its suppliers and says it is considering legal action.

The effects of hypercompetition in autos are working their way through the system. The cost of a sedan dropped 9% last year in China. And although the country's soaring demand for metals has caused a sharp increase in raw-materials prices this year, overinvestment could eventually cause prices to collapse there too. A metals trader in the U.S., for example, hangs on his wall a world map with black dots indicating the location of aluminum plants. Most producing countries have five or six dots; China has 130. "China is building smelters like McDonald's opens restaurants," says the trader, who asked not to be identified. He's worried, because China used to be a net importer of aluminum before starting to export and driving down world prices. China exported 621,000 tons in the first nine months of 2003, and far more could hit the market in coming years.

The same scenario of "too much, too soon" applies to a range of commodities. At Anyang Iron & Steel, one of China's biggest steel producers, the company's vice chairman, Wu Changxun, points to a tremendous dirt expanse outside the factory. Workers are erecting a new foundry there that will more than double the plant's output capacity. It is slated to provide part of the 50 million tons in increased capacity expected nationwide by 2005. "Banks are offering us loans even without our asking," says Wu. That money will have to be repaid. Letting extra capacity sit idle is no option. If the economy cools down and demand drops, "all that excess steel could hit world markets and send prices into a death spiral," says Brian Levich, senior steel analyst at the London-based Metal Bulletin Research.

The central government has pondered ways to rein in expansion of what it calls "overheated industrial sectors," including autos, aluminum and construction. But it seems unable to decide how fast the economy should expand and so far hasn't announced any significant changes to dampen growth. In June, for example, the central bank tried to end overbuilding by curtailing mortgages for homes not yet constructed. Two months later, the Prime Minister's office issued a contradictory statement that not only encouraged mortgage lending but also "enhanced loan support" for developers.

As long as the lending taps remain open, developers will keep building. Average real estate prices remained flat last year, despite surging demand. That's because so much new property hit the market, and with investment in residential housing growing 30%, there's lots more to follow. Developers don't seem worried. Vantone Group, a leading Beijing-based builder, recently put 450 apartments on the market at $200,000 each. Within six hours, it had cash deposits for a quarter of them.

But banks have grown dangerously exposed to the property market. Beijing alone has more than 3,000 developers, all highly leveraged. At the same time, unsold properties have increased fourfold over the past four years, totaling 2,475 million sq. ft. in 2002. "The laws of property cycles have not been repealed for China," says Peter Churchouse, who follows property trends in China for Morgan Stanley. "Eventually, the construction companies and the banks that backed them are going to get creamed."

With the government still holding many of the strings in China's economy, it is hard to predict when the problems of excess capacity will boil over. While overheated, China's economy isn't close to collapse. Whatever happens, the country will surely remain heavily dependent on exports. Currently the value of what it sells abroad is equal to roughly 30% of its total economy (the figure for the U.S., in contrast, is 10% to 12%). But the pressures are building, and when bomb factories are producing cars financed by an electric-battery company, the future can only be described as highly volatile.