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Credit FAQ: How The Chip Shortage Will Shake Up China's New Energy Vehicle Market

The global chip shortage that has disrupted automakers' operations in China since late 2020 will get worse before it gets better. Fast auto demand recovery since the second half of 2020 and increasing demand from consumer electronics largely explain the tight chip supply globally. S&P Global Ratings believes the shortage may slow but not derail the recovery of the Chinese auto sector.

Investors are keen to understand the effect of the chip shortage on the Chinese carmakers and our views on the new energy vehicle market. We address these and other questions here.

Frequently Asked Questions

What is the current chip shortage situation and how will it evolve?

In the first quarter this year, China's passenger vehicle wholesale volumes increased 75% year on year. However, this was 3.6% below the pre-pandemic level in the first quarter of 2019, mostly due to the chip shortage.

The supply of semiconductors is increasingly tight. In our view, the hit on auto production will be larger in the second quarter, with more domestic and overseas automakers announcing production suspension plans in March-April 2021.

We believe chip shortage won't derail the recovery in the Chinese auto market in 2021. The supply chain disruption will likely gradually ease from the third quarter of 2021, with the semiconductor industry adding more capacity for the auto sector. Carmakers should be able to increase production in the second half, recovering some of their lost volumes. We still anticipate a 5%-9% year-on-year growth in Chinese light vehicle sales in 2021. We will revisit our assumptions if the shortage lasts longer than we now anticipate.

The Chinese government aims to improve the portion of semiconductors made and consumed in China to 70% by 2025, from 30% in 2019. This measure of self-sufficiency is particularly low in the Chinese auto sector, at less than 10%. Considering the research and certification time needed to qualify auto chips, it will take some time for domestic chip producers to take share from foreign brands, in our opinion.

We anticipate China's carmakers will accelerate research and investment into self-designed chips, to stabilize supply chains and reduce their reliance on imports. The firms are mindful that the electric and self-driven vehicles that are increasingly in development rely on sophisticated semiconductors.

For example, Zhejiang Geely Holding Group Co. Ltd.-backed ECARX established a joint venture with Arm China, Siengine, in 2021, to design a 7 nanometer auto chip that is to be manufactured by Taiwan Semiconductor Manufacturing Co. Ltd.Dongfeng Motor Group Co. Ltd. established Zhixin Semiconductor Co. Ltd., which is slated to produce its own power management integrated circuits in the second quarter of 2021. For both companies, their initial supply of self-made chips will only satisfy a small part of their total demand.

Which rated auto companies are more affected by the chip shortage?

Carmakers with more exposure to the mid- to high-end internal combustion engine (ICE) models are likely harder hit. The current supply shortfall is most acute for 8-inch fabs, which make the key parts of electronic stability programs (ESP) and electronic control units (ECU) that are essential in luxury models. Lower-end models don't usually use ESP, and only need a small quantity of ECU.

Producers of new energy vehicles (NEVs) might face more challenges in securing chip supply. On top of the weaker bargaining power of NEV producers, given their smaller size, NEVs also use more semiconductors than traditional cars. Nevertheless, production disruptions have been only on a small-scale for NEV makers in China, potentially due to their still limited output volumes. Up to now, only NIO Inc. announced a five-day production halt in end-March 2021, which brought its first-quarter deliveries down to the lower range of the company's earlier projection.

The first-quarter sales volume of the Chinese carmakers we rate are largely on track, having reached about one-quarter of their full-year target. China FAW Group Co. Ltd. seems to be least affected, with first-quarter sales increasing 35% from the first quarter of 2019, likely because of the continuous rollout of new models and improving capacity utilization. Beijing Automotive Group Co. Ltd. saw the highest sales drop from the same period in 2019. This was likely due to the underperformance of its proprietary brands and of the Beijing Hyundai joint venture (JV).

Rated Automakers Are On Track To Meet Their 2021 Sales Target
1Q 2021 Sales ('000 units) YoY growth (%) Sales vs. 1Q 2019 (%) 1Q as % of 2021 sales*

Beijing Automotive Group Co. Ltd.

496 39 (13) N.A.

China FAW Group Co. Ltd.

1,059 74 35 26

Dongfeng Motor Group Co. Ltd.

703 94 4 21

Geely Automobile Holdings Ltd.

334 62 (9) 22
*Company projections. 1Q--First quarter. YoY--Year on year. N.A.--Not available. Sources: S&P Global Ratings, China Association of Automobile Manufacturers, company announcements.

The visibility on chip inventory is low. Some rated carmakers had two weeks' inventory in March, while others worked on a principle of just-in-time delivery. Geely Auto stated that it has secured chip supply for three to six months, but we see high uncertainty on execution. Dongfeng mentioned in its 2020 results call that JV brands experienced some production disruptions in the first quarter of 2021. We anticipate a recent fire at Renesas Electronics Corp. may exacerbate shortages for Dongfeng's Japanese JV brands in the second quarter.

What effect will the emergence of the electric-vehicle market have on the sales and margins of China's traditional carmakers?

NEV sales growth has always outpaced that of ICE cars. This trend will continue. In our view, China's NEV sales will grow by 40%-50% year on year in 2021-2022 on the back of rising consumer acceptance. This is reflected in robust sales growth in emerging brands that mainly target individual consumers, not business customers. Meanwhile, traditional carmakers are accelerating their NEV model launches to gain share in this fast-growing segment.

Carmakers generally make more profit selling ICE vehicles than NEVs. Many NEV producers are still loss-making at the operating profit level, given low sales volumes and high research costs. However, NEVs should reach cost parity with ICE models in the next few years, in our view, given increasing economies of scale and continuous reductions in battery costs.

How will collaboration with tech players help China's traditional carmakers in the NEV race?

Proprietary brands dominate the Chinese NEV market. This includes start-up brands such as NIO and XPeng Motors. In our view, the proprietary brands will likely maintain their dominant positions this year, but competition will intensify as JV brands launch NEV models.

Tech companies have forayed into the auto market in recent years. With cars becoming electrified, increasingly autonomous and connected, it is logical for automakers to partner with tech companies to leverage their abilities in autonomous driving, smart cabins, etc. This saves research costs and shortens the development cycle of new models.

Huawei Technologies Co. Ltd. has partnered with several carmakers including Beijing Automotive. This should improve the functionality of Beijing Automotive's premium NEV brand, Arcfox. Huawei's involvement may also raise the public's perception of the Arcfox brand.

How will retail sales of NEVs play out?

Emerging NEV firms typically sell their vehicles directly in stores they operate. Traditional carmakers such as Geely also intend to sell their NEVs directly to the consumer. This stands in contrast to the traditional dealership model. It allows automakers to better market their NEV brands and control the consumer purchase experience. This includes aftersales services, a big component of NEV sales, with consumers seeking battery warranty extensions and upgrades.

Having said that, a recent trend shows NEV players collaborating with traditional dealers. XPeng entered into a strategic cooperation with Zhongsheng Group Holdings Ltd. to leverage its dealer network, to reach mid- to high-end customers. Cooperating with dealers also allows NEV producers to lower their investment in direct-sales stores.

Will battery electric vehicles or hybrids dominate China's NEV market?

We expect both the sales of hybrids (including plug-in hybrids) and battery electric vehicles to grow robustly over the next few years. In our view, battery electric vehicles should continue to dominate the NEV market as they better fit China's goal of achieving carbon neutrality by 2060.

Plug-in hybrids serve as a gateway vehicle for consumers' transition to fully battery-powered vehicles. As battery technology improves and recharging facilities become more available, we believe consumers will eventually embrace this standard.

Government policies should also support battery electric vehicles achieve dominance. The Chinese city with the highest penetration rate for plug-in hybrids, Shanghai, will stop granting NEV license plates to the vehicles starting in 2023. The dual credit scheme also gives more benefits to battery electric vehicles versus plug-in hybrids.

How does the dual credit policy work in China?

The dual credit policy aims at boosting NEV development through the establishment of a credit trading system in China. Implemented in 2017 by China's Ministry of Industry and Information Technology, the plan requires automakers to earn NEV credits by hitting a threshold for NEV sales. It also requires carmakers to achieve Corporate Average Fuel Consumption (CAFC) credits by keeping the fuel consumption of vehicles lower than a company-specific standard. This fuel consumption target is weighted by the type of vehicles the firm makes.

These standards tighten every year: the requirement for NEV credits rose to 12% in 2020 from 10% in 2019. The threshold for CAFC credits dropped to 100% in 2020 from 110% in 2019. This has the effect of reducing each vehicle maker's buffer for fuel consumption, forcing them to move toward ever greater fuel efficiency.

Automakers with NEV or CAFC credit deficits will have to purchase NEV credits externally, if their own discounted historical credits do not fill the gap. To fulfill the requirements and avoid penalties, carmakers are incentivized to increase NEV offerings, with additional benefits given to fully battery powered vehicles versus plug-in hybrids, as well as NEVs with high mileage or gas powered vehicles with low fuel consumption.

How much income will carbon credit trading generate for automakers?

Tesla Inc.'s income from carbon credit trading accounted for 5% of its revenue in 2020, and exceeded its net profit. Comparatively, Chinese carmakers' NEV credit trading is at a smaller scale.

We expect the NEV credit contribution to local auto OEMs' revenues to grow but remain limited over the next two to three years. In 2020, there was an industry-wide net CAFC deficit, where NEV credits were insufficient to close this gap. This pushed the price per credit to around Chinese renminbi 3,000, from only several hundred renminbi in 2019. As standards tighten in the dual credit scheme, the trend will likely continue.

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Our rated entities might be lagging behind peers in developing NEVs given their traditional strength in ICE. Some may have to purchase NEV credits from competitors. For example, FAW-Volkswagen Automobile Co. Ltd. plans to acquire credits from Tesla. On the other hand, carmakers such as Beijing Automotive may transfer NEV credits internally to Beijing Benz Automotive Co. Ltd. Overall, we believe these automakers' intention to accelerate NEV investment and roll out NEV models will likely narrow the deficits over the next few years.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Claire Yuan, Hong Kong + 852 2533 3542;
Claire.Yuan@spglobal.com
Secondary Contacts:Stephen Chan, Hong Kong + 852 2532 8088;
stephen.chan@spglobal.com
Chloe Wang, Hong Kong + 852-25333548;
chloe.wang@spglobal.com
Sardonna Fong, Hong Kong + 852 25333586;
sardonna.fong@spglobal.com

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