Editor’s Note: The strong export performance of the “New Three” (solar PV, EV and battery) in the past few years has generated interest in the manufacturing revolution in China today that is not only reshaping the country’s industrial landscape but also its footprint on the Belt and Road. In the past week, a WeChat post titled “The Economics of Involuted Kings” went viral. Supposedly written by an investor in China’s renewables and EV sectors, the post tries to explain the underlying momentums in the industries at a time when many Chinese companies are down valued by the capital market. While the post contains many “feel good” elements common in this genre of online literature praising Chinese industrial might, some of the author’s insights might be of value for our readers.

Originally written in Chinese by Will Shen on WeChat, translation was assisted by ChatGPT. The source of the Chinese term “involuted king” (卷王) can be found in this New Yorker explainer.

I recently went on a business trip to China for two weeks.

This is my fourth time this year. Every time I go on a business trip to China, it brings me a different shock. This time is no exception.

I have been working in the mergers and acquisitions industry in the automotive and new energy fields for more than 20 years. Yet I have never seen such a market with such high degree of involution.

For example, a large machinery producer in south China has as many as 26 suppliers of stamping, welding, and sheet metal. The bidding has reached a level where the stamping machine with a capacity of 2600 tons can conduct molding operations for less than 4 yuan per time. At this price, the customer requires that the time from project approval to trial production should not exceed 40 days.

In another case, a photovoltaic company forgot to blur the logo of the customer company in the background when showing off a signed order of 1 GW on their social media. The next day, their competitor snatched the order with a price difference of only 1 cent.

In yet another case, a manufacturer of electric vehicle charging stations developed a new generation of products that were just about to be launched, but their competitor managed to make a 50 kW DC high-speed charger the same size as a 7 kW AC charger.

The production capacity of energy storage batteries has increased dramatically, and prices have plummeted. The price of some 280Ah batteries has dropped to 0.25 yuan. There are many more examples like this.

From the beginning of 2021, the production capacity of domestic lithium iron phosphate batteries has increased 12 times, and the production capacity of ternary lithium batteries has increased 5 times. The total battery production capacity has increased 8 times.

Facing such fierce competition, if you think companies would cut spendings to weather the storm, you are wrong.

In the automotive and new energy industries, an optimism on the verge of a gambler’s mentality is spreading. For most players, the global energy revolution and electric vehicle revolution are just beginning. Every company I visited is aggressively recruiting, expanding production capacity, increasing research and development spending, and increasing overseas marketing investment. Customer orders and inquiries are flooding in, and everyone is working hard, hoping to break through and soar in this cycle.

The “involution” in China is all-encompassing. For example, in the electric vehicle market, major automakers are pushing a new generation of products every six months over the past three years, releasing new models and configurations at lightning speed. Prices have also dropped to a point where electric vehicle prices in China are now generally 30-50% lower than equivalent models in Europe and the United States. They were slightly higher three years ago.

Those car manufacturers also need to make money – especially the COEMs that rely heavily on the domestic market. As a result, the pressure is transmitted all the way down to the component manufacturers, equipment manufacturers, and automation manufacturers. The lower the price, the longer the payment cycle. This forces component and automation suppliers to have a high-level of manufacturing flexibility and incredibly fast project speed. It is said that BYD’s Seagull completed the entire process from project approval to trial production in just three months.

Rapid iteration and production have increased the turnover speed of assets and funds, allowing companies to survive even in the face of meager profits.

The same speed also applies to domestic wind power, photovoltaic, and energy storage projects. A well-known home appliance company in Shenzhen launched its household photovoltaic EPC business in 2021, and expanded to an installation team of over 100,000 people in 2022, completing a household photovoltaic installation capacity of nearly 10GW that year. From visiting households in rural China, to project evaluation, to delivery and installation, and grid connection, the entire process is operated using AI and drones, and can be completed in as fast as 3-5 days.

By comparison, it is common for European car companies to take five years from project approval to mass production for a new model or platform, and three years is considered fast. The various new features of the Mercedes-Benz and BMW concept cars displayed at this year’s auto show may appear in a new model of Chinese EV in 3-6 months, while the German brands have to wait two to three years for the actual car to hit the market.

Similarly, for household photovoltaic installations, it takes European EPC companies at least three weeks and usually over a month from contacting customers to on-site evaluation, material preparation, and completion of installation.

A German local V2G software and hardware company that completed prototype verification of its product at the end of 2021, had tens of thousands of orders in hand at the beginning of 2022, but only established a small factory in Germany for trial production this year, reportedly to gradually refine the manufacturing process and find the optimal production rhythm and quality. After a whole year of procrastination, they delivered 3,000 units of equipment. Last week, they visited a potential Chinese contract manufacturer who is also a competitor, and the Chinese company evaluated the product for a day, convincing the German company that they could achieve a monthly production capacity of 20,000 units at 60% cost within three months.

Yes, the three years of the pandemic seem like a world away. Chinese technology and manufacturing have created a new world in these three years of “isolation from the world”. While foreigners are still pushing new models at a pace of three years or reducing costs by 3% per year in an orderly manner, China’s automotive and new energy manufacturing has iterated 3-5 generations, with manufacturing efficiency increasing by 10-20% every year and costs decreasing by 30-50%.

This is the “Galapagos effect” brought about by three years of being cut off from the world due to the pandemic.

In 2023, as China opened up after the pandemic, those “mutant creatures” that have been “Galapagosized” in the world’s largest market for three years will flood the overseas market, shocking the competitors and customers in the European and American markets. When foreign customers figure out what is on offer, global orders will arrive in flocks.

During the three days of negotiations at an enterprise in a southeastern province that I led, there were also four other groups of clients from Indonesia, the Middle East, Italy, and South Korea who were conducting on-site inspections and negotiations. The company’s overseas market sales director was running around between various meeting rooms, busy as a bee.

However, the enterprises company’s 2023 Q3 report was the worst since its listing.

Due to the much slower project cycles of these overseas clients, it is expected that the time for large-scale sales to them will mostly be in the second half of 2024 or the first half of 2025. The products sold in the domestic market experienced a sharp price drop in 2023, resulting in flat sales while profits fell sharply. Accounts receivable increased, liabilities increased, and both research and development expenses and capital expenditures also increased significantly. As a result, the company’s stock fell by nearly 50% this year, and investment banks and financial institutions are all pessimistic. There are many similar Chinese companies facing the same situation.

If you just focus on the financial reports of many companies in 2023, it is not unreasonable for their stocks to plummet. However, this is not the true picture of China’s electric vehicle and new energy industries.

Energy is the lifeblood of industry. Energy consumption is the indicator of China’s economy as a manufacturing base for the world. And China’s energy consumption is still increasing rapidly: industrial energy consumption has been growing for five consecutive years, even in the years of the strictest epidemic control in 2020 and 2022.

This is largely due to the rapid depreciation of fixed assets and the rapid increase in capital expenditures caused by the new energy and electric vehicle revolution, resulting in cyclical investments. These capital expenditure demands have had a huge stimulating effect on the equipment manufacturing industry and its upstream industries. For example, the PERC battery production line that just started production at the end of 2021 may be worthless in the TOPCON revolution in 2023. Due to the difference in conversion efficiency between PERC products and the manufacturing efficiency of the new generation TOPCON, the half-new production line from two years ago is a baggage that lowers the efficiency of the enterprise and needs to be cleared as soon as possible.

Similarly, the 400V electric vehicle systems that started production in 2021 will need to be immediately replaced and eliminated after the emergence of 800V EV systems with high charging efficiency. In this regard, all infrastructure related to the design and construction based on the 400V systems may become redundant after a period of time and need to be rebuilt.

Interestingly, it is said that Volkswagen Germany plans to hold on to the 400V system of the ID series until 2027. At that time, when BYD, NIO, and Changan are all equipped with 480KW high-power platforms that can be fast charged in 20 minutes, who would want to buy a Volkswagen that takes an hour to charge and has a range of only 400 kilometers?

The same change is happening beyond voltage systems. Ideal and CATL have developed high-current 5C charge-discharge batteries with a peak of 700A.

In the era of new technological revolution, technological iteration is efficient and endless. For companies, this means that R&D and capital expenditures are also endless. A leading edge can only be maintained for six months. In this way, everyone is always on the same starting line.

The graph below shows the price and production capacity of a new technology/product as the supply and demand relationship changes. In a fully competitive market, enterprises will be in a loss in the first stage of this cycle and in profit in the second stage. For most enterprises, they hope to break through the first stage and enter the second stage as quickly as possible.

There are two solutions: either invest heavily in production capacity to form economies of scale through large capital expenditures, or invest heavily in R&D of production processes to improve manufacturing efficiency through technological innovation. Both will require enterprises to spend heavily while enduring sales difficulties and thin profits in the first stage. This will cause the company’s income statement and balance sheet to deteriorate at the same time.

If a product are further broken down to multiple dimensions based on its different features, then the same product can almost form a huge supply and demand price matrix composed of different product features on different time axes. Ambitious enterprises (such as Huawei) will simultaneously focus on all product combinations, features, and even technological paths, resulting in geometrically increasing R&D investment and capital expenditures.

This is the truth of China’s so-called “transformation” in the economy. During this period of rapid technological revolution and iteration, many enterprises are facing a triple blow to their income statement, balance sheet, and even cash flow statement. From the perspective of finance and investment, it is a landscape of widespread devastation. However, enterprises maintain an overall optimism because they expect the second stage with rich returns to come quickly with the maturity of the market. Therefore, enterprises are still investing heavily in R&D and capital expenditures. The PMI is generally moving upward, and industrial electricity consumption has repeatedly hit new highs.

Some people may say that this is an investment bubble, resulting in excessive surplus production capacity, and is a waste of resources. This is misguided.

China’s photovoltaic industry has already shown us the effect of extreme R&D capital investment over the past decade. After experiencing several ups and downs in the photovoltaic industry, every few years, someone will shout about overcapacity and investment bubbles. But in reality, we “rolled” over almost all competitors worldwide and created a behemoth industry with annual revenue of trillions of RMB. In this process, the big waves washed away the sand, and the former richest and giants fell, while the fittest enterprises in the competition survived and grew stronger in every crisis.

Moreover, there is no need to worry about the intensive capital expenditures of manufacturing companies causing significant redundancy and waste.

Today’s enterprises are heavily invested in high-tech automated production lines and high-precision equipment, which are being massively localized in China. The manufacturing of high-precision equipment is a knowledge-intensive industry. The capital expenditures are, in fact, a disguised R&D investment in the entire supply chain. These devices may eventually be phased out in the short term, causing a potential huge hole in the company’s balance sheet, but the essence is the experience accumulated by a large number of R&D personnel and engineers and the various intellectual property rights formed.

The outdated production capacity is not the so-called “overcapacity” that investment bank analysts are talking about, which will put pressure on the final market price. With technological iteration and process improvement, old technology and production capacity are no longer competitive. Their actual value is basically zero and does not pose any threat to new technologies and products formed by the market.

These so-called “production capacity” only exist on the company’s books. For example, in 2023, the total global photovoltaic cell production capacity is expected to increase by about 402GW, exceeding 800GW. However, in reality, TOPCON and HJT battery production capacity accounts for about 500GW, and most of the rest are old PERC batteries. Compared with TOPCON or HJT batteries, old PERC is completely ineffective in terms of cost and efficiency and is completely invalid capacity for the real market.

The same story is happening in the process of replacing 280Ah lithium batteries with 314/320Ah lithium batteries. Therefore, although it seems that the market capacity is severely oversupplied, the profitability of newly built capacity is not greatly affected. Those companies that first cross the threshold from stage one to stage two in new technology will make a lot of money, like Jingke’s TOPCON this year. When the domestic “kings of involution” walk out of the country to develop overseas markets, they will have a sense of relief in the less competitive environment.

Due to the huge and relatively closed domestic market, the speed of our industrial ecological evolution is several orders of magnitude faster than that of foreign countries. At the same time, due to the regional and developmental differences in the north, south, east, and west of China, enterprises bred in the Chinese market can often provide products that meet the needs of different ecosystems with significant differences.

In this process, when Chinese companies complete rapid iteration and enter stage two in the domestic market, the overseas market is often still in stage one. Therefore, when Chinese companies and products enter a market through appropriate localization, excellent marketing strategies, and the development of feasible sales channels, they directly turn the market into stage two. This is also the reason why we see Chinese electric cars starting to conquer overseas markets today.

The COVID-19 pandemic of the past three years seems like a distant memory, and this year is the year of the return of Chinese companies as kings in the automotive and new energy fields. The automotive and energy industries are made of valuable, long industrial chains, and can be called the “crown of industrialization”. China is fortunate to have entered a new round of energy revolution at the time when our basic industry and accumulation were completed, enabling us to fully utilize factors such as population, size, scale, and industrial agglomeration effects to our advantage. This is the basic guarantee for China’s industrial and economic leadership in the world for the next 50-100 years.

Compared to this solid industrial foundation, the ups and downs of financial markets, exchange rates, monetary policies, and the flows of foreign capital in and out of our stock markets, are mere sidenotes to a great story that is unfolding.