Machine cultures

Back in September 2008, when the financial crisis was beginning to escalate into a global economic crisis, German Finance Minister Peer Steinbrück was publicly critical of large-scale stimulus packages to fight the effects of the downturn. He referred to them "crass Keynesianism" and accused governments of "tossing around billions."

Steinbrück saw the crisis, while serious, as localized within the finance industry. He was very wrong.

Over the following year, the economic crisis took an outsized ax to Germany’s export sector, which comprises 47% of the country’s economy. According to official statistics, exports dipped 18.7% year-on-year by July, the largest contraction since World War II. Economists are now predicting that German GDP will shrink by 5-7% this year.

Particularly hard-hit product lines included luxury automobiles and, more importantly, high quality manufacturing machinery, which alone accounts for more than 40% of total German exports. But recently it appears that, thanks to China, help – of a sort – is on the way.

Stimulating Germany

While it is likely that a slowly rising tide of global recovery is helping to lift the German export boat, many machine manufacturers are also benefiting – directly or indirectly – from the massive increase in Chinese government spending. In fact, 56% of German companies in China expect to benefit from Beijing’s stimulus package, according to an August survey of 189 German companies in China jointly carried out by the German Chamber of Commerce and Fiducia Management Consultants.

They may already be benefiting. Nearly every sector of German machinery and equipment exports to China has risen since the trough in February. Shipments of electrical equipment and machinery came to US$1.7 billion in February, but by July they reached US$2.45 billion. Exports of transportation equipment went from US$588 million to US$853 million.

"[Machine tool] exports to China have increased to 20% of the total amount of German machine tool exports. I have never seen one single country that was able to achieve such a percentage," said Gerhard Hein, head of the economic and statistical department of VDW, the German Machine Tool Builders’ Association.

For the most part, German companies are enjoying the benefits of the stimulus indirectly. For example, Karsten Wachholz, regional director for Asia at German automotive engineering and design firm Edag, said that the Chinese government is purchasing large quantities of taxis and buses with the stimulus funds. This generates sales for Edag’s equipment and engineering services.

Likewise, Joachim Zwicky, general manager at Weiss-Voetsch, a firm that makes environmental testing chambers for quality control, said that a huge influx in research and development funding to Chinese companies in the automotive and pharmaceutical sectors has been a boon for business. Many of those players need to purchase new testing chambers for their research.

Long-term worries

Despite these short-term improvements, some German companies are nevertheless concerned that the China stimulus might ultimately prove to be a bad deal.

"The government during this crisis is giving money to [Chinese] companies to develop themselves," said Wachholz. "Our major Chinese competitors receive RMB10 million [US$1.46m] each year from the government for R&D, but they are instead using it to get into business and taking jobs for ridiculous prices."

Starved of credit, more than half of the companies that participated in the Chamber of Commerce and Fiducia survey said that conserving cash and reducing costs were the goals for 2009. Meanwhile, their Chinese counterparts – buoyed by a Beijing’s loose monetary policy, under which bank loans increased dramatically in the first half of the year – are investing heavily in competitive technology. The result has been a rapid improvement in capability. For example, nearly half of Chinese machine tool firms now use advanced numerically controlled (NC) machine tools, much higher than previously low levels, according to Hein of VDW.

Beijing has also dedicated US$3.22 billion to the cause of import replacement. "[China’s] target is to substitute at least 70% of high end machine tools which are currently procured from foreign suppliers," Hein said. At the same time, the government is steadily revoking import tax exemptions previously granted to certain classes of machine tools.

Unfair trade

Further hampering German companies’ efforts to compete are direct actions by Beijing that have an obvious tinge of protectionism. Most notably, there has not been a transparent implementation of the "Buy China" clause in the stimulus package. Some foreign companies argue that they are being discriminated against in government and state-owned company purchases, even if they are wholly owned foreign enterprises based in China. Nationalist sentiment also plays a role.

"Purchasing executives of Chinese companies may prefer buying from truly Chinese companies as opposed to foreign-owned companies established in China," explained Jürgen Kracht, managing director at Fiducia.

In one extreme example, this May the Chinese government banned foreign companies from bidding on 25 wind turbine contracts throughout the country, despite the generally superior technology of foreign firms and the heavy investments they have made in China. Joerg Wuttke, president of the European Chamber in China, stated publicly that he fears a "partial reversal" of the liberalization of the Chinese economy.

In addition, Kracht believes that China is taking advantage of the fundamental weakness in demand for German products to push for very low prices. "Very few companies are buying sophisticated German machinery at this point worldwide. Chinese companies know that and so they are making sure they get a better price than they did in the past."

But companies are also realizing that, in the long term, they must adapt their products to market realities. While most German machinery manufacturers remain confident in their technological superiority and after-sales service in the high-end sector, which usually caters to manufacturers producing goods for export to the West, the current demand is for medium-quality machinery in developing economies.

This trend is leading to a new business model for medium-sized German machinery companies – producing high-end tools in Germany and the lower-end products in China. In fact, Bernd Reitmeier, general manager of Germany Industry and Commerce for Greater China (GICGC), a part of the German Chamber of Commerce, said that in eight years he has never before seen so many investment inquiries from medium-sized companies about setting up operations in China as he has in the last four months.

"Before the crisis, medium-sized companies in Germany had their order books full. They had no need to explore the China market," Reitmeier explained.

Two-pronged strategy

The move to decentralize production is being made mostly out of necessity. Unlike most US companies, China-based subsidiaries of German firms are not producing for re-export to their home market, but rather looking to capture the Chinese market. "The export quota of German companies manufacturing in China is less than 20%. For American companies it is about 55%. For outsourcing, Germany already has lots of low-cost neighbors, such as Romania, Hungary, and Poland," said Reitmeier.

Some German firms have been very successful in establishing a two-pronged production strategy, according to Kracht at Fiducia. Original equipment is manufactured in Germany and sold at a premium price to top-end customers in China, while domestically produced mid-segment machinery, which has been modified and scaled down, costs up to 50% less.

Zwicky at Weiss-Voetsch, which saw a 60% decrease in exports from its home base in Germany, said that the Chinese subsidiary actually posted significant growth last year. "Before the economic downturn, China was a very big market for our products from Germany and the customers were willing to pay a very high price," he explained.

"Now the customers still request high quality, but they aren’t willing to pay a high price anymore. So, we are offering our products from our China base, because we have cheaper labor costs and localized sourcing, so we can cut down the total costs by at least 30%."

Separating production and reducing quality is leading to some institutional goal conflicts. Possible disputes between the German headquarters and the China base have discouraged some companies from expanding production here.

"We would like to start manufacturing more here in China and export to other markets, but this puts us into competition with our headquarters," explained Wachholz at Edag. "That is what stops us from expanding the export markets. However, for markets like India, Australia, and Russia, we are already trying to export from China instead of from Germany."

Besides competition within the company, German machine manufacturers also must be wary of diluting the brand. If both high-end and mid-range machinery is produced in the same factory, customers will then begin demanding the high-end product for the mid-segment price. Generally, companies will only bring over mid-sector production to China, along with a separate sales and marketing team, and leave the high-end to the German headquarters. "Foreign companies need to consider a distinct branding and marketing in order not to cannibalize the existing top-end market of the foreign-produced brand," warned Fiducia’s Kracht.

Fundamental shift

Nevertheless, headquarters in Germany will have to get used to the new system of production as China’s macroeconomic strategy is shifting away from exports and toward domestic consumption. Although selling a lower quality product to Chinese companies will not be easy, the market potential is too large to ignore. Ultimately, German manufacturers must rely on this middle sector for revenues that finance continued research and development of the high-end technologies that made their name.

They will encounter protectionist tendencies that favor their Chinese competitors – ranging from direct government subsidies to more subtle forms of government support, such as tax breaks and discounted land – but these difficulties do not portend the end of Germany’s dominance in the high-end machinery sector.

According to Hein at VDW, German firms have advantages that China is not nearly close to reaching. "If you want to run an automotive factory in an optimal way, it’s a matter of machines, yes, but it’s also a matter of how you use the machines and do simultaneous engineering with the customer. Chinese firms still need a lot of time to reach these abilities."

In addition, markets outside of Asia are especially difficult for Chinese companies to break into. Hein adds that before these firms can even tackle after-sales service and customization, they need to address their lack of distribution channels and service representatives in other markets. When it comes to expensive investments in machinery, relationship building with the customer is essential.

Reitmeier of GICGC believes it will take years for Chinese firms to equal the reputation and presence of German competitors. "Companies are telling me that when it comes to the high-end machinery and niche products, there still is no Chinese competitor," he said.

Much as the economic crisis helped China to realize that its economy was too dependent on export markets in Europe and the US, German companies have realized that they need to expand into Asian markets to cushion for the next downturn. In the meantime, they will keep on building their China operations. After all, 72% of German companies surveyed believe that the Chinese economy will pick up again in the first half of 2010 – far before anyone thinks the recession will be over in the US or Europe.