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?