Tesla Inc. on Jan. 7 made its first public delivery of a China-made Model 3 sedan in Shanghai and announced plans to produce the much-anticipated Model Y sports utility vehicle in the country as part of its ambitious plan to capture a major share of the world's largest electric-vehicle market.

Co-founder and CEO Elon Musk said during the delivery ceremony that the Model Y SUV would attract greater demand than all the other sedan models combined.

Musk's bold proclamation comes at a critical period for China's electric-vehicle market, which has seen a sharp slump in sales since the country began phasing out subsidies for new energy vehicles in June 2019.

In addition, questions over sustainable demand for electric vehicles, macroeconomic factors and intense competition are further challenges Tesla faces in China.

Morningstar analyst Ivan Su shares Musk's optimism and expects locally produced Tesla models to be a game-changer in China's EV market.

Su noted that unlike other car brands, price sensitivity was less of an issue for Tesla, especially among brand-conscious upper-middle-class car buyers.

"What Tesla brings to the Chinese market is opening up the opportunity to 'natural' consumers who have previously not wanted to buy EVs because the lower-end vehicles haven't excited them," Su said.

"The Model 3 will be quite successful in China, mainly because China, for one, is a really big EV market and Model 3 is a pretty good looking car."

Tesla has slashed the price of locally built Model 3s to 323,800 yuan from 355,800 yuan, with subsidies by the Chinese government further reducing its price to 299,050 yuan.

The price reduction is likely to not only hit local rivals like NIO Ltd. but will also put pressure on global giants like Volkswagen AG and Daimler AG as they prepare to launch their own electric vehicles in the Chinese market, said Carson Ng, vice president, research, at China Renaissance Securities.

However, analysts do not see Tesla benefitting a great deal from being the first among global automakers with a locally made battery electric vehicle. Rather, the performance of the Model 3 will help others gauge market demand, said Ng.

"Most manufacturers feel that they have the technical capabilities but what's lacking is the demand. If Tesla could sell 8,000-10,000 [vehicles] in a month, that means there's demand in the market and [the rivals] would adjust production," said Ng.

Morningstar's Su said once Volkswagen and other German carmakers ramp up their EV rollout, Tesla's early lead will mean little. Volkswagen aims to deliver 500,000 electric vehicles a year and started trial production of EVs at its Shanghai plant in November 2019.

"I think the market has underestimated the power of German automakers in the sense of their brand strength. The German automakers are already launching EVs at a slower pace, but once they ramp up, the upper-middle-class consumers will be put in a position where they start to seriously consider whether they should buy a Tesla, or rather a BMW or Mercedes," said Su.

Tesla's localization challenges

Tesla has built the $2 billion Shanghai Gigafactory — the first fully foreign-owned auto plant in China — at breakneck speed. After signing an agreement with the Shanghai regional government in July 2018, Tesla started production at the factory in October 2019 and delivered 15 locally made Model 3 sedans to employees on Dec. 30. The latest milestone has led to a surge in the company's share price, which began 2020 at historical highs.

During its fourth-quarter sales update, Tesla said the Shanghai Gigafactory was producing just under 1,000 units a week and has a production capacity of more than 3,000 units per week.

Tu Le, managing director of Sino Auto Insights, expects the site to take at least another quarter to reach the 3,000 units per week capacity.

Le argued that Tesla's biggest challenge will be localizing the supply chain to help address cost efficiency. For now, they are "basically shipping the entire vehicle" over to be assembled in China, but tariffs and shipping make it very expensive to do so, he said.

Tesla aims for its China production to be fully localized by the end of 2020, even though only 30% of the supply chain is currently local. Its battery supplier Panasonic Corp. said it has no plans to build a battery plant in China to support Tesla's Shanghai factory, although Tesla has reportedly reached a preliminary deal with Chinese battery maker Contemporary Amperex Technology Co. Ltd.

Morningstar's Su said the 100% localized supply chain target may be too aggressive, as it is yet to be achieved by other joint venture plants that have set up earlier in China.

"It's a blessing in disguise that the market isn't hot because it'll give [Tesla] more time to ramp up," said Le. "If the market was hot and growing, they'd lose out on sales if they didn't ramp up quickly."