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Car loans ‘affordable’ in China, may stoke demand
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Demand for cars is tightly related to urbanization. Chinese cities have sprawled dramatically, and many people living in suburbs feel compelled to own a car, especially in areas with low levels of public transport. In the past, as the value of houses increased, house owners began feeling richer than they were in reality. This “wealth effect” ramped up demand for cars. We track monthly changes in house prices and car sales and find there is a correlation of 0.62. We therefore believe that slowing house prices will negatively impact car demand.
Of course, car demand depends on affordability as well. As of 2013, wealth management products have helped households reach their savings targets more quickly and freed up funds for consumption, including car purchases. We found a correlation between the real interest rate and car sales of 0.75, with a time lag of six months. In 2013 the average nominal interest rate for wealth management products jumped to more than 4 percent, reaching 5.6 percent in January 2014. The rate decreased to 5 percent by this August but was still a healthy 1.7 percentage points above the interest rate for one-year deposits. About 50 percent of liquid household assets are in wealth management products.
Other factors in car demand are the Consumer Price Index and nominal interest rates because households can’t invest outside of China and the yuan is not fully convertible. Households have high saving targets because the social security system is underdeveloped. When China forges a better balance toward consumption and freer capital flows, demand in China will not depend so much on consumer prices and interest rates, but that isn’t likely to happen for several years.
Currently, slowing house prices are putting a damper on car sales, while high real interest rates keep a lid on demand. What would happen if real interest rates decrease again and even become negative? In that case, households would invest less in wealth management products, especially if implicit guarantees on returns change. While this removal of moral hazard would be welcome, it would invariably put consumer demand — specifically for cars — on a negative trajectory. Of course, real returns also decrease with inflation. While there doesn’t seem to be a danger right now, an upswing of the pork cycle is expected in 2015 and will push consumer prices up.
Oversupply and low margins
Despite the uncertainty, most carmakers will try to keep up the number of cars they manufacture. They have several options. They can decrease car prices, introduce more entry-level models or reduce the cost of carmaking by removing extras. The carmakers can also increase inventory for some time and pump up dealership inventories. But these strategies will work only in the short haul. Dealers are already suffering from oversupply and low margins.
A major way of keeping up demand is to increase the proportion of cars that are financed. We call that “financial penetration.” Volkswagen’s financial penetration rate, for example, stands at 10 percent, and the automaker has said it expects that to rise to between 40 percent and 50 percent in the next few years. According to autohome.com, 17.5 percent of vehicle purchases are financed currently, which is still very low compared with 50 percent in Japan and 70 percent in the US. BMW, meanwhile, has already reached financial penetration rates of more than 30 percent in China, up from 10 percent just three years ago. The financial penetration rates of Mercedes and Audi are slightly lower than BMW’s at about 25 percent right now. In some lower-tier cities, the rate is as high as 60 percent. There are bound to be risky loans among these since there is no credit history system in China yet.
Car loans are very affordable for consumers in China. For example, VW charges only between zero and 3.99 percent interest on the loans. The original equipment manufacturers bundle the loans into asset-backed securities and sell them on, thereby bearing no risk and freeing up funds for yet more car loans. The securitization doesn’t come free, of course, and the carmakers have to bear the interest rate costs, thus taking a hit on their margins.
The trend toward higher financial penetration will make it harder for Chinese original equipment manufacturers to compete. Most of them either don’t have their own auto financing arms or have very low financial penetration. The manufacturers don’t have experience with auto loans and compete with international companies that have decades of experience. The decreasing margin through securitization will also be much harder to swallow for car makers with already razor-thin margins. Higher financial penetration not only spurs demand, but also tends to increase the market share of more expensive cars as they become more affordable. This will also tend to push households into the arms of the international carmakers.
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