From both the emotional and economic perspectives, perhaps no industry comes close to automobiles in generating its share of controversies and opinions. Admittedly, banks are pretty high up on the list too, but most lay people do not even pretend to understand the inner workings of banks as much as they pretend to do about cars. For reasons that are partly economic and partly environmental (and hence economic eventually), current palpitations in the car industry bear watching for Asian policymakers as well as industry executives.

This week’s purchase of Chrysler, a former US Big Three auto maker that had merged with Germany’s Daimler-Benz, by private-equity firm Cerberus Capital Management [1] brings into question the correct industrial-financial model for the automotive sector, as well as the role of governments in fostering or dooming their local talent. While it is possible that local governments and union leaders would attempt to prevent such acquisitions in Asia, such moves would be ill-advised in what is in essence the first among global industries.

Rule 1 for governments: Try not to help

An old Buddhist tale concerns a king whose best friend is a simpleton. After many embarrassments, the tale’s denouement involves the simpleton cutting off the king’s nose when he attempts to kill a mosquito that has landed on the royal person.

This notion of an intelligent enemy being less dangerous than a foolish friend is apparently lost on most governments. The decline of the US car industry has been much discussed; indeed, in a previous article [2] I cited the decline of automotive-engineering capabilities in the United States as evidence of that country’s overall decline in industry and education.

The decline in the share prices of US car makers has much to do with government assistance. After tightening safety and fuel standards on automobiles because of litigation and public demand during the 1980s, the US government allowed domestic manufacturers to use larger truck platforms for making passenger vehicles, and these were exempt from both fuel and safety standards. The “foolish friend” made two important assumptions – first that the time provided to improve their cars would be used by US manufacturers actually to achieve that, and second that Japanese car makers could not catch up with America’s lead in making obscenely large automobiles. Both assumptions proved disastrously wrong.

In much the same way, the Malaysian government has been trying to protect its domestic car makers by imposing punitive duties on imports since the 1980s. The measures have worked to keep the companies going, but have hardly broadened their engineering capabilities, as the failure of Malaysian brands in penetrating other markets shows. The companies in essence assemble older models of their partners for domestic consumption, and unlike Chinese or Indian counterparts have spent precious little on developing their own product lines.

Perhaps the biggest lesson for policymakers, though, comes from India, where the government’s mollycoddling of a limited number of car makers ensured that no significant advances in engineering or design were made for decades. The country slipped to being a nonentity in automobile manufacturing in spite of possessing all the required raw materials in abundance, including the most important one – excellent engineering talent.

The liberalization of the Indian economy starting in the 1990s has helped to broaden the appeal of the market for foreign car makers, who have now started using the country as a production base for both local and export sales. Overall employment in the sector, as well as related products, has more than tripled in the past 10 years – a feat that no socialist government could achieve for the previous 50 years.

Rule 2 for governments: Embrace Wimbledon

The more vexing question for policymakers has often enough, and predictably, been about ownership.

In the aftermath of World War II, the direct involvement of Japan’s government was required to kick-start the country’s industrial reemergence. To ensure optimal usage of scarce savings, the government took upon itself the task of ensuring that investments only targeted areas with the greatest capacity for employment generation, which obviously put export-oriented industries on top. That approach proved successful for Japan, as its car makers went on to dominate the global auto industry.

It has since been adopted with less success by South Korea, and even less so by other countries, including Malaysia as cited above. Even in Japan, the lost decade of economic growth saw some of its iconic car makers slipping, with the predictable stake sales to foreign car makers.

Asian governments looking for a model need to look no further than the United Kingdom, where overall manufacturing of cars has climbed sharply even as its domestic brands slipped one after another into foreign hands. This model is known as the Wimbledon effect in developmental economics, wherein the playing field is dominated by foreign rather than local talent. However, the key takeaway from Wimbledon itself is that while no British tennis player has come close to winning the tournament for many years, it remains the centerpiece of the annual calendar of tennis events, generating in its wake thousands of tourists and millions of pounds in economic value.

That value creation is independent of who plays, and herein lies the important observation for any government, namely that it is sufficient if the car industry employs local citizens, which it must do to survive, rather than to focus on who the owners are. An excessive focus on retaining domestic control on the industry would likely lead to the South Korean situation, where all but one manufacturer slipped into foreign hands in the wake of the Asian financial crisis.

Going back to the Indian situation described above, despite the opening of the sector to foreigners, domestic players are still able to compete, creating a situation with only one clear winner, namely the Indian consumer.

Rule 3 for investors: Bigger is not better

The car industry is dominated by significant risks in its basic operating model.

As people use cars to get from point A to B, but also as an expression of their personalities, car makers invariably have to focus on design in addition to fretting about the level of performance that can be delivered. Inevitably, this involves a tradeoff among price, performance and reliability wherein you would need to pick only two out of three. Thus a car that is cheap and reliable would probably have compromised its performance (ie, be slow), while one that is cheap and fast would probably suffer from poor reliability.

In practice, as car makers invest billions of dollars in design and production methods while confronting uncertain sales expectations, returns for investors can be extremely jumpy. Given that, it would take a fair amount of luck as well as patience for investors to make money while owning shares in such companies. This means two things: first that one doesn’t buy shares in car companies just because they are big in terms of revenues, and second that even car companies with strong product lines can prove to be lousy investments in the future.

I refrained from mentioning the most exciting car market in Asia, namely China, until this point, as all the lessons above apply to its industry.

From being dominated by foreign car makers that operate through favored joint ventures, local Chinese companies have managed to emerge from the shadows. However, many of these companies are not profitable, based on my calculations, and only exist because of the support of their local governments. Inevitably, a lot of these companies will need to merge in the years ahead, even if China’s growth in retail demand is strong enough to warrant many brands co-existing.

Many of the models currently on sale in China are cheap knockoffs of designs from other countries, and production methods still lag other Asian markets, including South Korea. Thus the industry needs a lot of capital, but as the failures of US car makers show, these are not necessarily suitable for public investors to participate in, at this stage anyway. Nor is it a good idea for banks to continue supporting such entities purely to keep up appearances with local government satraps.

As China catches up on these fronts, though, it is important for the government to tighten both fuel and safety standards, to force innovation, level the playing field and, most important, avoid large bankruptcies of the sort seen in Britain. Equally, it wouldn’t want to keep unprofitable car makers on life support for ever.

1. See Barbarians at Asia’s gates, Asia Times Online, January 27, 2007.
2. Feral cats beware, ATol, December 2, 2006.