China’s Electric Vehicle Glut

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China’s Electric Vehicle Glut

For all its seeming complexity, the global auto industry is actually a pretty simple business to manage:

  • Design and build vehicles people want to buy so you can charge more than the variable cost of production and earn a decent return on capital.
  • Run at least 85% capacity utilization through a cycle, again to generate an acceptable return on the billions of dollars required to tool up a plant.
  • Take the cash flows from these two points and develop whatever people will want to buy next.
  • Repeat as needed.

It really doesn’t matter if the product is Ford’s Model T or Tesla’s Model S; 100 years of industrial history shows this is the only recipe that works. Every good company checks these boxes, and every bad one misses on one or more. Even the power of “disruptive innovation” is insufficient to change this. As important as Uber/Lyft are to personal mobility, that black Toyota Camry doesn’t build itself.

Today’s case study on this point: the Chinese electric vehicle industry, which is both the fastest growing large EV market on the planet and its most troubled. Here’s the problem using the same “recipe for success” paradigm:

  • On the plus side, Chinese EV sales are strong thanks to government subsidies and other policies. Want to buy a new gas-powered car in Beijing? Fine, but a license plate will take a year. Buy an EV, and the registration comes with the car the day you take delivery. Add to that a subsidy that can be as much as $6,000, and no surprise that EV sales could be 10% of all new vehicles sold this year.
  • But… All this has pulled an estimated $18 billion of capital into the EV industry and by some measures there are 500 companies planning to enter or already in the space. A recent Wharton school analysis estimated that this will translate into 3.9 million units of production capacity, or 3x demand.
  • Once you break the 85% capacity utilization rule, mayhem ensues. Even companies with good products suffer from price competition and returns on capital can remain depressed for decades. That is no exaggeration: this dynamic has been in place for gas-powered vehicles since the 1970s on a global basis.

The Chinese government can see where this is going, and it appears to be dealing with the problem directly and swiftly. According to a Bloomberg article out just yesterday, China’s Ministry of Industry and Information Technology is drafting up regulations that will significantly curtail investment in the space and only allow companies that have the capital and pre-existing products to compete at scale. You can read the whole piece here:

This seemingly blunt-tool approach to government involvement has one clear precedent in the auto industry: Japan, in the 1960s – 1980s. The country’s powerful Ministry of International Trade and Industry was instrumental in guiding the Japanese light vehicle industry’s investments to produce small, affordable cars for export. Add in a few oil shocks in 1974 and 1979, and MITI’s strategy ended up working very well indeed. Covering the domestic auto industry in the 1990s, I saw the tail end of this progression and had the chance to interview MITI officials in Tokyo. They were justifiably proud of what the country had accomplished.

Fast forward to today, replace “small cars” with “EVs” and “China” for “Japan”, and you have a similar picture. The one difference: emerging economies are much larger end markets for passenger vehicles than they were in the 1960s – 1980s. China’s immediate challenge is rationalizing EV production so it is profitable in the local market. Once that is done, the logical export markets are in Southeast Asia, India, Africa and South America. Developed markets, already fraught with competition and more on the come, can and will wait.

All this buys US/European manufacturers some time to develop and build EVs, so that’s a modest positive for these companies. They will need it. Those three rules for successful car companies – good products, high capacity utilization, and productive reinvestment – will still apply when EVs are the only new vehicles for sale.

Wharton analysis:

Chinese EV sales data: