Monday, March 29, 2010

Questions raised by Geely’s Volvo Purchase

As recently as the day-before-yesterday, I was still expressing my skepticism that the Geely-Volvo deal would ever happen. From my perspective, Ford had far more reasons to keep Volvo than it did for selling it at a huge loss, and for a comparatively small amount of cash that will barely knock a dent in its debt.

But neither Li Shufu nor Alan Mulally asked for my opinion, so the deal has apparently gone through.

What now?

Now that Li Shufu appears to have succeeded, against all odds, in his quest of owning a well-known foreign brand, how will he repay the generosity of the various organizations that helped him to achieve his dream?

A Political Issue

As the Financial Times’ "Lex" column points out today, “(China’s) biggest auto deal to date is not a strictly private transaction”. Of the total purchase price of $1.8 billion, $1.6 billion is in cash. Of that amount, about half is coming from several local governments in China who will be “helping” Geely to build Volvo factories in their areas. In addition, about $900 million in working capital is coming from state-owned banks – the banks that are frequently criticized for lending only to state-owned companies.

Furthermore, now that a global luxury brand has Chinese ownership, we can be almost certain that the black sedan of choice for state officials will no longer be an Audi or a Mercedes. It will be a Volvo.

China’s government has made no secret of the fact that the state intends to remain the major player in the automobile industry, nor of their desire to build “national champions” able to compete on a global scale. Geely is ostensibly private, but it has needed government help to move into the big leagues, further blurring the line between public and private (an issue I highlighted in relation to Geely last June).

What will be the eventual cost of this help? Will Beijing now begin to have influence on Geely’s strategic direction?

As before, I think many Chinese may find this line of questioning a bit ridiculous: Well of course the government will expect something in return! This is how business works! The business brings in expertise, the government offers support. It is a symbiotic relationship.

I approached this question from a different direction just a few weeks ago in relation to the failed Hummer deal. Sichuan Tengzhong was unsuccessful in its bid for Hummer largely because the proposed deal was in violation of government policy. Geely has been successful in its bid for Volvo for the opposite reason: it is completely in keeping with government policy.

The lesson seems clear. The price of not following policy is likely to be failure. The reward for following policy is not only a greater chance of success, but also material support where needed – regardless of whether the business is private or state-owned. But what will be the price of following policy? For this we can only speculate at this point.

What is fascinating about this case, however, is that following government policy in China need not always be detrimental to business strategy. Perhaps the goals of both the government and Geely are met in this single transaction, and neither side loses.

To me, this is a mind-blowing revelation. Neo-liberal economic theory tells us that governments cannot run businesses because they are conflicted with political objectives (and perhaps the US government’s ownership of GM bears this out), but is China the exception that proves the rule, or has it found some way around the strictures of Western economic theory? Is China re-writing the rules of capitalism, or is it merely breaking them?

There is one other question this transaction raises, and it is more of a business issue than one of political economy.

A Business Issue

In discussing the Geely-Volvo deal with a (Chinese) executive at a Chinese automobile company about two months ago, I asked whether he thought Geely could manage Volvo if the deal were consummated. His response was that Geely would need a lot more money than it currently has.

As he explained it, an auto company not only needs to fund research and development for new models, but it also requires about $1 billion of R&D a year on each existing product line, just to keep the models fresh and to introduce incremental innovation. (The figure seemed high to me, so I asked again, and he repeated the number, $1 billion.)

“If Geely is relying on the government for at least half of a comparatively small purchase of Volvo, how can Geely possibly fund Volvo’s ongoing R&D pipeline? Add to this the likelihood that Ford has probably way underinvested in Volvo over the past few years. I’m not sure Li Shufu fully understands what he is getting into”.

Will Geely need to get further into bed with the state in order to feed the R&D pipeline? And if so, at what further cost, if any, will this help come?


  1. Hello Greg,

    Is this win-win theme unique to China, though?

    I know that European governments have offered tax breaks, deals on land rentals and other incentives to get car plants within their borders etc (although admittedly less with cold, hard cash to fund major acquisitions...although last year's bail outs need to be considered as something similar, perhaps...)

    But your point is more that this is going to be a full-on JV between Geely and its local government hosts? What will be interesting to see is how the different priorities of the different partners shape the overall direction of the business, and how that is reflected in decision-making (and the financial rewards). The top execs at Geely won't want to go the way of Brilliance Auto...

    I suppose that this issue is reflected in most large Chinese companies - when SOEs have sold a minority chunk to investors but still have to dance to an official tune on most of the key decisions. This might work OK initially, when investors are milking monopoly positions or just enjoying a yield/PE curve that is steeper through the early growth days. But what about the long haul...?

    I am still a sceptic on this one. Government should provide the playing field, and then get out of the way - unless there are externalities and/or market failures in play.

    Which means that I may have shot myself in the foot - what with the inability of the 'most advanced economies in the world' to keep their own house in order...


  2. Thanks, as always, for your excellent points, Will.

    You are absolutely right in that "help" from governments is not unprecedented. The same thing happens in the US.

    The question that I think I was dancing around yesterday, but that your points have just brought to light for me, seems to be whether Chinese officials are able (or willing) to distinguish between debt and equity (or a simple gift).

    In the US, and Europe as well I assume, a tax break or other inducement given to a business is basically a gift. The only thing expected in return is that a certain business locate there.

    Also, on occasions loans may be granted or guaranteed by a governmental entity. And neither party expects anything beyond adherence to the loan contract: we lend you money; you pay us back with interest.

    My sense, based on a lot of conversations had in China, is that in China there may often be unwritten expectations beyond the contract -- expectations that may make a loan look more like an equity contribution.

    And while there is no way I can prove that the central government sees itself as having something akin to an equity interest in Geely, I am raising the question of whether it might -- and if so, what are the implications?

    And if that is the case, then my question is the same as yours. Maybe it works now, but what about the long haul?

    Where we may differ a bit is that maybe I'm not as skeptical -- or at least not as much as I was before.

    Your statement of what the government *should* do matches the way most Westerners feel about the business-government relationship. I guess my question is whether that relationship could somehow be upgraded -- and in a positive way.

    If business-government relationships in the developed world have generally been negative, is it because we have yet to think outside the box of what a business-government relationship should be? And if so, is there anything we can learn from China's experience, either positive or negative?

  3. Very true that I bring a western bias to the table!

    For development agencies and the like in Europe, the gift (tax incentives etc) is normally in exchange for job creation, as I understand it. There seem to be some similarities with Chinese local governments in this regard, although I think - like you - that there are expectations of something more in China.

    Perhaps the question should be whether arrangements of the Geely/government type contribute to wealth creation for the "common good" - jobs, tax revenues, investment etc for an area or community (and not just for a clique). Enough positives to outweigh potential negatives in environmental outcomes, too.

    I don't think the governance structures/media environment are strong enough in China to prevent most of these deals enriching an insider group rather than a wider strata. So while I believe that these kinds of tie-ups can contribute to wealth creation, I am less certain on how widely this wealth is then going to be distributed.

    On the other hand, there could still be job creation and economic growth as a subsequent benefit, so it is not all bad.

    But, given the governance failures at a local government level (frequently acknowledged now by the central government leadership), I also question why we should think that having a local government partner makes the business any more likely to succeed (especially if it has to compete outside China).



  4. More great points, Will. Maybe I should add you to my dissertation committee. :)

    I think you have hit upon an important distinction between central and local government.

    Maybe there is a degree of "playing defense" with local governments in which a private enterprise refuses to play ball with local government at their peril.

    The local government offers their "help", and part of the cost of accepting their help is the personal enrichment of local leaders. Refusal to accept their "help" significantly dampens the future prospects of an enterprise. (I'm just speculating here, but this seems to make sense.)

    Then, the only way a private business will get noticed by the central government (and thus get their help and support when they need it) is to 1) get big and 2) carry out policy in a significant way.

    The private enterprise can't achieve #1 without help of the local government. Achieving #2 means finding a way to stand apart from the crowd as a supporter of policy, and doing so in a way that doesn't bankrupt the company.

    But there's a risk here. If central govt policy is so thick with political considerations that carrying it out would bankrupt a company, then you will get companies only giving the *appearance* of carrying it out.

    If, on the other hand, policy is designed, not only to achieve the government's political objectives, but also to be economically feasible, then companies like Geely and BYD, being private, and being hungry, will find creative ways to carry it out.

    Perhaps this is what we can take away from China. Government can play a positive role by formulating policy that makes sense from an economic standpoint.

    While that sounds almost too simple to be worth mentioning, why, I am compelled to ask, can't all governments get this part right?

    And if China is getting this right in some areas, why can't it get it right in others?

    Thanks again for your questions, Will. This back-and-forth is very helpful to my thinking about this problem.


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