Thu. Jul 7th, 2022


It took just one week after Vladimir Putin ordered an invasion of Ukraine for Volkswagen, BMW and Mercedes-Benz to suspend production and sales in Russia. Germany’s carmaking trio, which usually avoid commenting on international politics, each issued carefully worded criticisms of the war.

Their decisions were not excessively painful. Together, the three carmakers sold fewer than 300,000 vehicles in Russia last year, a small fraction of the 13mn they delivered worldwide.

Yet there was more than a moment’s hesitation in the boardrooms of the big automakers. Withdrawing from Russia, says an adviser to one of the German carmakers, was one thing, but what if, in a similar scenario, there was pressure to withdraw from China, which accounts for upwards of a third of sales at all three companies?

“That,” the person said, “would be close to an existential crisis”.

Nowhere is this prediction more true than at VW, the world’s second-largest carmaker by volume. It employs roughly 500,000 people in Europe and runs the continent’s largest auto plant in Wolfsburg, 125 miles west of Berlin. But beneath the hood, in terms of revenues and profits, VW is more Chinese than German.

VW, which was the first foreign manufacturer to build a presence in China almost four decades ago, relies on the country for at least half of its annual net profits — the precise number is not disclosed. A VW car, or one made by subsidiaries Audi, Porsche and Skoda, was sold in China every 9.5 seconds in 2021. Over the years, VW has come to be “viewed as a synonym for the German business community” in that country, says the company’s China boss, Stephan Wöllenstein.

German chancellor Olaf Scholz and foreign minister Annalena Baerbock attend a cabinet meeting in the Federal Chancellery in Berlin
From left, German chancellor Olaf Scholz and foreign minister Annalena Baerbock have signalled a shift in foreign policy that could lead to a more fraught relationship with China © Andreas Gora/POOL/EPA-EFE/Shutterstock

Even before the Russian invasion of Ukraine, VW was concerned that a new coalition government in Berlin could imperil what one former executive described as the carmaker’s “gold mine”.

The new government, led by Olaf Scholz, has signalled a shift in foreign policy that could lead to a more fraught relationship with China. In an interview with a German newspaper on December 1, before the new coalition government was in place, soon-to-be foreign minister Annalena Baerbock made it clear she would differ from her predecessors when it came to dealing with Chinese leader Xi Jinping.

Calling the Chinese government an “authoritarian regime”, and highlighting forced labour practices in the region of Xinjiang, where VW has a plant, Baerbock said she believed “a values-driven foreign policy [was] always a combination of dialogue and toughness”, adding that “eloquent silence is not a form of diplomacy”.

The Chinese embassy in Berlin responded with a terse reminder that it preferred “bridge builders to wall builders,” while the Chinese ambassador “wanted to know what the hell was going on,” according to one prominent German executive approached by the diplomat.

Two weeks later, after Lithuania angered Beijing by recognising a de facto Taiwanese consulate, German auto suppliers Continental and Hella suddenly found products made at their Lithuanian sites were being held up at Chinese ports. “You see how the Chinese reacted to Lithuania,” says an executive at one of VW’s largest investors. “The bigger companies in Germany are very worried.”

The shift away from former chancellor Angela Merkel’s emphasis on dialogue comes at a time when VW’s leverage could be declining. Despite its strong position selling traditional cars, the company has struggled to gain traction in China’s fast-growing market for electric vehicles.

That could leave VW even more vulnerable if the invasion of Ukraine generates a strong backlash against China — especially if Beijing were to lend military support to Russia.

“I don’t want us to be facing a similar situation with China in 10 years,” Lars Klingbeil, co-chair of the Social Democratic party, told Der Spiegel at the weekend. “We have to drastically reduce our dependence on authoritarian states. We can see that with Russia in terms of our energy supply. With China, we can start now.”

VW’s group chief executive, Herbert Diess, has acknowledged that company no longer holds the same sway in Beijing. “China probably doesn’t need VW,” he admitted last year, “but VW needs China a lot.”

A path to ‘democratic openness’

The German company was one of the first multinationals to enter China in the early 1980s, after Beijing relaxed rules on outside investment. The country, in the words of the then chief executive Carl Hahn, quickly became VW’s “motor for global [economic] expansion”.

With bicycles still the dominant form of transport and the domestic car industry producing just a few thousand cars a year, China courted VW. One former VW official remembers a trip to the country with German politicians in the early 1990s, which included a dinner with then premier Li Peng, who had been a central figure in the bloody suppression of the Tiananmen Square protests in 1989.

The Chinese politician told the delegation of executives and lawmakers that wealth would pave a path to liberalisation. “Li said: ‘we need economically stable conditions to allow more democratic openness’,” the person recalls. The premier added: “You can’t vote on an empty stomach.”

A visitor to Auto Shanghai 2021 inspects the Saic Volkswagen display booth
A visitor to Auto Shanghai 2021 inspects the SAIC Volkswagen display booth. China bailed VW out of the financial crisis and helped pay for the costs of the diesel emissions scandal, which amounted to well over $30bn © Zhe Ji/Getty

Yet even as VW signed two joint ventures with state-owned companies, one with First Automobile Works (FAW) in the north-east of China and another with Shanghai Automotive Industry Corporation (SAIC), there were many who warned Hahn and his successors that the Chinese would eventually use the expertise they gathered from VW to build their own, competing cars.

As one former employee, who was close to VW’s senior management, puts it, VW’s exposure to China “was a ticking clock”.

The clock ticked for longer than most market-watchers expected. The VW Santana was the best-selling car in China for a decade, after which the Jetta model took the number one spot. Other than a small dip in 2005 and 2015, the number of VW cars sold in China grew steadily each year, to a record 4.1mn in 2018, when the global car market peaked.

The Chinese operations sustained VW during the financial crisis and helped pay for the costs of the diesel emissions scandal, which amounted to well over $30bn. The reliance on China was only exacerbated by Covid-19, when after a few months of lockdowns in early 2020, the Chinese economy came roaring back, cushioning the blow of VW’s shutdowns in the US and Europe.

But VW’s sales in China have been slowly declining, with just 3.3mn cars sold in 2021, a drop of 14 per cent, while the Chinese market as a whole grew 4 per cent. Premium marques Porsche and Audi have found a generation of new fans in China’s upper middle class, but the core VW brand has suffered a more than 400,000-unit decline in sales.

Crowds flock to the VW group stand at an auto show in Shanghai
Crowds flock to the VW group stand at an auto show in Shanghai. A VW car, or one made by subsidiaries Audi, Porsche and Skoda, was sold in China every 9.5 seconds in 2021 © Qilai Shen/Bloomberg

More worryingly for VW, its flagship electric vehicles have sold less well in China than managers in Wolfsburg — who have pledged to spend €52bn on the industry’s largest battery-vehicle offensive — had hoped. VW sold just 70,000 units of its electric ID range in the country last year, well below its oft-repeated goal of between 80,000 and 100,000.

The company spent billions on a battery-powered platform primarily because the Chinese government had signalled its commitment to supporting electric vehicles. However, it has faced fierce competition from cheap EVs produced by local competitors such as Wuling, as well as premium models by rivals NIO, Xpeng and Tesla, which started producing in China in 2020. Last year, VW, the market leader when it comes to combustion engine cars, was not even in the top 10 electric brands in the country.

Executives point to chip shortages that have curtailed the entire industry’s ambitions. “We are undersupplied and we cannot fulfil the demand,” says Wöllenstein, even though battery-electric vehicles were given priority on VW production lines. “In total,” he adds, VW “lost about 20,000 units” of its latest EVs in China as a result of supply bottlenecks.

Yet VW managers admit there have been problems with the product too, particularly with on-board software, which initially lacked the capability to integrate popular Chinese social media and messaging apps such as WeChat.

For Chinese electric vehicle buyers, “it isn’t [about] handling, braking, acceleration — it’s how well connected is your vehicle, and here VW is behind,” says Michael Dunne of automotive consultancy ZoZoGo, an adviser on the Chinese market to large carmakers. Being run from Germany, he adds, may have put VW’s China business at a disadvantage.

Wöllenstein says VW is adapting fast — the chiefs of its new software arm in China are mainly of Asian heritage. Yet even VW’s powerful workers’ representatives, who have long insisted that the expertise of its well-paid German workforce is key to the company’s global success, see a need for more local talent in China.

“Our problems . . . in the past have demonstrated that from Wolfsburg we do not always automatically meet the tastes of our customers all over the world,” works council chief Daniela Cavallo told the FT. The supervisory board member, who pointed out that popular functions such as karaoke were not being offered by VW to Chinese buyers, added that “local competence for convincing products in the regions is crucial”.

Chief executive Diess admits that after decades of dominance VW has to remodel its China business. “We are a trusted brand, but we are a conservative brand, well-known for the cars your parents drove, so we are reinventing ourselves,” he says in an interview with the FT.

He adds: “We will remain in China, we will invest . . . we are there to stay.”

VW Santanas used as taxis in Shanghai in 2005

4.1mn

VW cars sold in China during 2018, the peak sales year. For a decade the VW Santana was the best-selling car in China

14%

Decline in sales of VWs in China in 2021, when the company sold 3.3mn cars. The car market overall grew by 4%

70,000

Sales of the electric ID range in China last year, well below the target of 80,000 to 100,000

Dealing with authoritarians

During the Merkel years, Germany supported the idea that closer economic ties with the west would encourage political change in Beijing. “Wandel durch Handel” — change through trade — was a central precept.

The political tide is changing, however. Life has already become more complicated for multinationals in China as tensions between Washington and Beijing have grown in recent years. Now the war in Ukraine has led to a dramatic severing of economic and commercial ties with Russia.

Diess makes the case for continued economic engagement with China because of all the improvements it has brought in living standards.

“We all know this world of Russia behind the iron curtain, China closed off,” he says. “This was not very desirable to live in. So many people were drawn out of poverty because of the world opening up.”

When the new government in Berlin was first formed, one of the issues that concerned VW was Xinjiang. VW has had a plant in the region since 2013, after being urged to invest in the west of the country by Beijing. In the years since, China has been accused of human rights abuses in Xinjiang, where more than 1mn Uyghurs have been interned, and of forcing them to do slave labour.

VW, which has its own history of using forced labour during the second world war, has long maintained that there are no indications of human rights violations at the Urumqi site, which employs approximately 650 people. Wöllenstein insists that all employees in Xinjiang have direct contracts with the company “which applies the same standard as in all the other sites that VW is running [in China]”.

Barricades affixed with barbed wire surround a Volkswagen dealership at night in Kashgar, Xinjiang
Volkswagen has had a plant in Xinjiang since 2013. In the years since, China has been accused of human rights abuses in the region © Bloomberg

But in the event of this German government bringing the issue up, “it would be unrealistic to assume that [the Chinese] are grateful for what we gave them”, says the former senior VW employee, or that the company would be shielded from any diplomatic fallout. “I mean what did we give them? We made business there, we made billions and billions and billions.”

The Ukraine war has created an even more complicated situation. The Russian invasion has intensified discussion around the virtues of investing so heavily in countries that have authoritarian political systems and has drawn attention to the potential for China to try to take control of Taiwan through military means.

If China were to provide military assistance to Russia — as US officials say Moscow has requested — that could lead to consumer boycotts and calls for withdrawing from its market.

“What should be putting the fear into German companies is the Russia story in the sense that you can see how risky investments in authoritarian great powers that are considering using their military to take over another territory are,” says Thorsten Benner, director of the Global Public Policy Institute in Berlin.

He adds: “The biggest trailblazer for a more realistic China policy in Germany has been Xi Jinping, because he is doing more than anyone else to convince us that the Merkel approach of becoming ever more dependent on China, and lying to ourselves that China is opening up . . . was wrong.”

Speaking on Tuesday after VW said it might have to expand production outside of Europe in the event of a prolonged war, Diess argued it was unrealistic for multinationals to detach themselves from all authoritarian countries.

Volkswagen chief executive Herbert Diess poses in front of the new ID Buzz electric van during an unveiling event in Hamburg this month
Volkswagen chief executive Herbert Diess, pictured, says it is unrealistic for multinationals to detach themselves from all authoritarian countries © John MacDougall/AFP/Getty

“If we would constrain our business to only established democracies, which account for about 7 to 9 per cent of world population, and this is shrinking, then clearly there would not be any viable business model for an auto manufacturer.”

Some at VW hope the war might actually reduce the focus of the new German government on China. “They are very concerned now with the Ukrainian war,” says a VW board member, adding that since taking office, “this German government has become very fast, very pragmatic”.

While Wöllenstein concedes that “you never know” how Beijing will react to a critical comment by a German official, he says VW still gets “preferential treatment” in China. The company is alone among foreign carmakers in being allowed to form a third joint venture, Volkswagen Anhui, and hold a majority stake in the entity, a sign of the “specific trust that the Chinese government has in the Volkswagen group”, he says.

Still a growth market

Amid the political tensions, VW insists its Chinese business is showing signs of a recovery. VW is currently selling 15,000 electric vehicles in the country per month, which puts it on track to exceed internal targets of selling at least 140,000 battery-powered vehicles this year. Software updates in the coming months will bring many missing features to Chinese VW drivers.

It has built 125 showrooms for the ID range in major cities, often placing them in the midst of shopping malls, and hopes to have around 200 in total by the middle of the year.

But with increased competition, especially in electric vehicles, the decades-old strategy of expanding in China may no longer be a reliable one for VW, says Dunne. “For the first time it’s unclear whether or not [VW adding capacity] is going to work.”

Diess disagrees. “I still think it’s an asset, China will be by far the biggest growth market for the foreseeable future,” he says, pointing out that VW still has double the market share in China of its nearest competitor. “[For] autonomous driving, connected cars, electric cars — they will be the main market.”

Even as VW’s rivals jostle for position, there is plenty of room for expansion. Roughly 200 in every 1,000 Chinese people own a car, compared with more than 650 in Europe. That opportunity, VW executives calculate, is worth the risk of doing business in China.

“If you are not in China, you have a problem,” Diess told the FT. “If you are in China, you have a chance.”

Additional reporting by Edward White in Seoul and Peter Campbell in London



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