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This week I passed my China driver’s test and am now legally able to join the fray of bicycles, motorcycles, pedestrians, cars, trucks, pedaled-carriers and gosh know what else whizzing about China’s streets. Since I already hold a US driver’s license, I only had to pass a written test (in English). One of the questions:

Driving on a road covered with ice or snow, try your best not to turn the steering wheel lest the vehicle should

a) skid
b) slide
c) slip

I am still wondering how testing my English ability should help me be a safer driver in China, a country in which more than 89,000 people died last year as a result of traffic accidents, but I passed with 98% right and am now ready to hit the streets.

What spurred me to do this is the imminent birth of my son, which I have mentioned before. My wife, Jessica, and I are deciding whether or not it is safer to buy a car and drive around ourselves or just not let Baby Tom into a moving vehicle for several years. For those of you have driven in China, especially on highways in the countryside, you know what I am talking about. I think my knuckles have arthritis from gripping onto the handles of too many taxis careening down the wrong way of a highway in the black of the night.

For the past few months, several members of my team and I have been interviewing taxi drivers and other drivers about what car to buy. Aside from being useful for my own purchasing habits, the results gave me some good insights into investing in China’s auto sector. While most manufacturers have benefited from the surge in income that has allowed many Chinese to take to the streets in four wheels instead of two, some, like GM (GM) and Volkswagen (OTC:VLKAY), are better positioned than others.

2006 was a bumper year for automobile manufacturers selling personal automobiles in China. 7.22 million vehicles were sold of which 5.18 million were personal automobiles representing a 30% increase in sales of personal autos. The numbers will continue to grow as prices get cheaper and local manufacturers like Chery or Geely continue to sell tiny cars, like the QQ, which make me reminisce of the small two cars that dot the streets of Italy.

Domestic Manufacturing Capabilities

In the US, I drove a Lexus (TM), and my first thought was to buy one here too. But Lexuses are outrageously priced in China because import tariffs are high. For instance, a S600 Mercedes costs $250,000 USD, while Rolls-Royces and Bentleys often top the one million USD mark. The tariffs almost double the price of some cars but have not stopped the ultra-rich from buying expensive vehicles to, more often than not, show their wealth and success.

The auto companies that are best positioned in China have started producing in China to lower costs for aspiration buyers but who also continue to import their high end for the affluent classes. The market is becoming so large that car companies cannot neglect either target segment.

For instance, DaimlerChrysler (DCX) sold 31,300 cars in greater China in 2006, of which the Mercedes brand contributed 21,200 vehicles, an increase of 32% over 2005. The Mercedes E-Class is locally produced which helped to increase sales as aspiration buyers will pony up to get the prestige of owning a Mercedes. But all the S class line remains imported so that the ultra-rich are willing to buy it and Daimler-Chrysler gets the fat margins.

BMW has done the same thing with its lower-end Series 3 and high-end Series 7 line. They have been able to offer luxury cars but been able to differentiate between their brand lines. In other words, they have been able to satisfy the demands of the increasingly affluent in China while not eroding their brand image by going too low-end, as many critics argue Ralph Lauren (RL) or Calvin Klein (PVH) have done in the US by selling in outlets and is mass-retailers. It is just not the same buying underwear in Wal-Mart (WMT) or Target (TGT) as at a high-end shop like a Barney’s New York (BNNY) of Saks 5th Avenue (SKS), even if the brand is the same.

Lexus, on the other hand, is still seldom seen in China despite doing so well in the US and rivaling their German counterparts. One big problem is that they just do not produce locally in China. Even their low-end ES or IS series cost significantly more than BMWs and Mercedes lines of the same quality level.

If Lexus really wants to catch up in China, then they need to both produce in China and import here. Considering how well run Toyota is and how they are beating up GM (GM) and Ford (F) in the US, I have been surprised at how poorly they are doing in China compared to other foreign counterparts. Smart investors will look at the future manufacturing capabilities of the car producers to see whether or not they will be able to take market share. The automobile companies that have wisely invested in product lines in China will be the big winners in China’s booming sector unless they built too much and have overcapacity.

Anti-Japanese Rhetoric

As I interviewed drivers about what car to buy, I realized that a large part of Toyota’s or Nissan’s (OTC:NSANY) problems in China come from nationalism. As we saw recently with Japan’s Prime Minister’s Shinzo Abe’s shameful words about Japan’s sexual enslavement of thousands of women in Asia during World War II, Japan’s Government and its crazy ultra-nationalists constantly destroy Japan’s business interests throughout Asia.

I usually do not like to jump into politics in my columns, but it needs to be said in this case – unless Japan completely fesses up to its horrible wartime record during World War II as Germany has done, Japan’s business community will be hit hard in Asia. I won’t even enter into the much more compelling moral arguments.

When we interviewed drivers in Shanghai, they overwhelmingly told us not to buy a Japanese car because the “Japanese are evil.” Investors should not underestimate the level of hatred most people in Asia have for Japanese. I used to live in the Philippines and Korea and the hatred is as palpable there as in China because Japan does not acknowledge its horrendous actions. Regardless of what political regime runs an Asian country, Japan is uniformly hated in Asia.

When I was a graduate student at Harvard, some of my classmates were sent over by the Japanese Government to study. One of my classmates, a girl with Japan’s Defense Forces (basically Japan’s military when you look at their capabilities and budget size) told a group of us that the sex slaves or “Comfort Women” chose to satisfy the Japanese soldiers and were paid. In all, they were happy with what happened, she said, and that there was no reason for Japan to apologize, let alone feel guilty. Besides, many Japanese argue that Japan paid its debt by giving low interest loans to Asian countries.

Well, the rest of Asia disagrees completely with Japan’s assertions. I do too. The numbers indicate that Japan’s abominable posturing for the crazies in Japan like my former classmate hurt Japan’s business interests. For instance, GM sold 876,747 automobiles in China (including HK) in 2006, while Toyota sold only 308,000 cars in China.

As China becomes the largest consumer market in the world, Japan’s firms will be hurt by the shameful actions of Japan’s leaders. Investors should take note of the outright hatred that even Chinese youth have for Japan, as witnessed by protests in the blogosphere in some of Netease (NTES) games for having what looks like Japanese flags shown in good light.

Repairs, Oil Prices, and the Future

Aside from those buying luxury cars like Mercedes, respondents said that Volkswagen was good because they had repair shops throughout Shanghai which made it “cheap” and “easy” to repair and conserved oil well. Once again, good customer service is key in the minds’ of Chinese consumers who spent too many years being served by hostile salespeople in the State-run era.

The future is bright for China’s automobile sector as long as companies localize their operations, deliver what Chinese consumers want and do not over expand their production facilities and remain hostage to the crazies in Japan.

Unless Japan’s leadership begins to publicly and forthrightly make amends for Japan’s despicable behavior in World War II, and equally shameful behavior since, Japan’s businesses like Toyota and Nissan will be hit hard in China.

CMR Analyst Ben Cavender contributed to this article.

Source: Investing in China's Booming Automobile Sector: Japanese Cars a No Go