At this year’s Shanghai car show, for the first time ever, new German cars like the Volkswagen ID7 and Mercedes Maybach EQS did not steal the show. The real stars of the show were innovative electric cars from Chinese brands, such as the eye-catching BYD Yangwang U9 hyper car, the Nio ET7 with its swappable battery, and the incredibly affordable $11,000 BYD Seagull. This dominance of Chinese cars is quite surprising, as only five years ago, German car manufacturers ruled both the global and Chinese car markets while, back then, Chinese companies were only known for their, somewhat crappy, low budget cars.
But, now, just five years later, China appears to have surpassed Germany’s formidable car industry, becoming the world’s second-largest car exporter last year.
Journalists quickly made the connection, with statements like the following appearing in the Financial Times:
China, already the world’s biggest market for electric vehicles, is set to knock Japan from the top spot for global car export volume this year after overtaking Germany in 2022.
So, supposedly China is beating Germany thanks to its electric vehicle miracle. But, how exactly did this happen?
Well, to answer that question, let’s first ask ourselves,
Is China’s EV sector actually beating the German car industry thanks to Electric Vehicles?
Because there are two big problems with that narrative.
The first is that the headlines about China becoming the world’s second biggest car exporter focus on the number of cars sold. However, what car companies actually care about is revenue, the number of cars sold times the price of these cars. And while China sells more cars, Germany charges a higher average price. Therefore, when it comes to export value, Germany still holds the top spot, with China only ranking 12th.
The second problem with the narrative comes from connecting China’s export numbers to its dominance in the electric vehicle sector. Because, if you look at China’s export numbers of electric vehicles in more detail, you will see that almost half of them are … Tesla’s produced in China. Only 2% of exports are from innovative Chinese brands like BYD and NIO. The rest of the export figures are from European brands like Polestar, MG, and Volvo that are either owned or co-owned by the Chinese.
What weakens this connection even further is that electric cars only accounted for about 16% of Chinese export sales figures. Instead, most Chinese car exports were from established Chinese brands like SAIC and Chery which export cheap cars with an internal combustion engine to emerging markets. And this is a segment, that the German car manufacturers have abandoned on purpose, simply because these low-cost fuel cars aren’t very profitable.
So, while the Chinese do now export more cars than the Germans, it doesn’t have so much to do with these innovative electric cars. They mostly started exporting low-cost fuel cars that German manufacturers aren’t interested in exporting. And, therefore, Germany can relax, China has not beaten the German car industry at all.
Well…. not quite, because as it turns out the Chinese have actually beaten the Germans in the luxury car market that really counts.
The Chinese Car Miracle
You see, just a few years ago, the Chinese car market was dominated by German brands such as Volkswagen, BMW and Mercedes. For example, in 2020, foreign brands controlled roughly 64% of the Chinese car market, of which Volkswagen roughly had a third, making it the best-selling car brand there by far. But the flipside of this dominance was that German car makers also increasingly depended on China for their profits. For example, in 2020, Volkswagen reported that 40% of its profits were generated in China.
But, now just three years later, some industry experts fear that Volkswagen might not even have a future in China.
You see, while Volkswagen continued to dominate the fuel vehicle segment, the Chinese market electrified at an unseen pace, from 5% of the market in 2018, to 26% today. And in the electric vehicle market the German car makers combined only have a 2.7% market share. As a result, it’s not surprising that BYD, which you may recall from the Shanghai auto show, recently surpassed Volkswagen as China’s best-selling car brand. And indeed, if we look at the top 10 EV’s sold in China in 2022, we can see that there is only one foreign car maker that is competitive in China and that is Tesla.
And that shift is already reflected in the market valuations of these companies. Looking at the world’s largest car companies by value five years ago, we can see that German companies, along with Japan’s Toyota, dominated the market. However, today, Chinese car manufacturer BYD is valued higher than many of the most prominent German companies. These valuations likely reflect that Chinese car makers, like BYD, are set to continue dominating the profitable Chinese market and may also dominate the world’s second-largest EV market, Europe, Germany’s home turf.
So, yeah, perhaps it is not so crazy after all to say that the Chinese beat the German car makers in just five years.
And so, that brings us back to the main question of this video
How did China beat the German car industry in just five years?
Well, to answer that question, I first need to give you an idea why beating the German car industry was considered almost impossible.
Sure, in the ideal competitive markets taught in economics classes, a country skilled at car production, like China, will inevitably break into the car market as long as all countries allow market forces to work. And yet, for years, while China’s liberalization allowed its companies to master many industries, they just couldn’t break into the global car market.
Now, in my humble opinion, the reason for that is that there are that two major market imperfections that shield the global car market from newcomers. The first is learning-by-doing, and, in the car market, it meant that because the German car makers had perfected the internal combustion engine through years and years of trying, doing, and improving. So, it would take years for any new company to catch up. The second imperfection is known as economies of scale. With that economists mean that, as you scale up, you will be able to sell cars at a lower price. And this matter because in the car industry there are really high fixed costs, such as research and development costs. So, for example, if Mercedes develops some new billion dollar tech for its cars, it can spread those costs over the 500 thousand cars that it sells, meaning that it might need to make it’s car $2000 more expensive. But, if some Chinese start-up, that expects to sell ten thousand cars, wants to do the same research, it needs to charge at least $100,000 for that car, just to earn back it’s research costs.
Indeed, Tesla CEO Elon Musk, in an interview, basically agreed with me that to make a compelling mass market car, two things are needed first:
(35:15) is design iteration going through multiple versions of something and then the other is economies of scale, you kinda need both
But, while Musk overcame both of these obstacles through clever marketing and attracting investment, the Chinese government took a more proactive approach, instead of waiting for similar entrepreneurs to emerge.
So, to supercharge its entry into the imperfect global car market, China turned to one of the most controversial tools of economics:
which Oxford professor Nathaniel Lane defines as
political action meant to shift the industrial structure of an economy.
So, that is basically, not letting the market be the market, and actively intervening as a government.
According to this definition, China began using industrial policy when it initially opened its car industry to German companies. To stimulate learning-by-doing, it required them to produce cars locally, and always in collaboration with local Chinese entrepreneurs. What’s more, the country forced these companies to transfer some technology to China. But, while the country made some attempts to fund large car producers, it was never able to get sufficient economies of scale to compete.
When it came to the internal combustion engine, Chinese companies were so far behind that the Founder of WM Motor, mr. Freeman Shen said to the Economist in 2020.
You would have to invest billions of dollars for another 20 years, and maybe then we would be getting close to the Germans,” “It’s hopeless.”
However, this is where China’s made in China 2025 policy initiative comes in, which focused on sectors in which China could ‘leapfrog’ the competition.
Now, the idea of leapfrogging is basically that, while in many industries technology moves slowly, and improves through learning-by-doing, every now and then a new technology comes along that renders all of that accumulated knowledge useless. And when that happens, a government push can allow firms in a developing nation to ‘leapfrog’ foreign incumbents and become a leader in the new technological era.
So, in 2015, under the ‘made in China 2025’ umbrella the country recognized that battery powered electric vehicle are so different from internal combustion engine vehicles, that this was a once in a lifetime opportunity for Chinese companies to leapfrog the competition and start learning-by-doing and building scale to get ahead.
To facilitate this, China started encouraging both local demand and supply. Supply by providing massive loans, investments and subsidies to local EV manufacturing companies, and demand by subsidizing buyers, encouraging the development of local charging infrastructure and by forcing local governments to buy electronic vehicles.
This allowed Chinese producers to get a running start, getting lots of experience by making EV’s and developing scale fast.
And sure, while Germany tried to encourage the transition to electronic vehicles as well, it did so on a far smaller scale. Even worse, the German government focused much of its industrial policy on protecting its fuel car makers from change. For example, when it helped them to pretend Diesel cars were efficient during Dieselgate, and now by blocking the EU’s efforts to ban CO2 emitting cars.
So, although China may not have outperformed Germany’s car industry in terms of revenue yet, it has beaten the German car makers where it really hurts, in the electric vehicle segment in China. And this allowed Chinese car makers to leapfrog the German competition, getting ahead of them when it comes to learning-by-doing and economies of scale. This advantage now even enables Chinese car makers to pose a threat to German car makers in their home region, Europe.
But okay, yeah, let’s see how that will go, because while the Germans are now behind a bit, they are now firmly on board the EV train… and, luckily for them, there are some other barriers to entry in Europe’s car market, like brand power, and establishing a distribution network.
What’s more, I think it needs to be said here that while the ‘made in China 2025’ initiative was really successful for cars, the country also threw a lot of money at sectors such as A.I., Aerospace, and microchips, without similar success. But, still, partially thanks to Chinese success stories like this one, countries like the USA and, even Germany are now more and more messing with markets through industrial policy