The People's Dilemma: The Warning Bells of Germany's Manufacturing Crisis

The People's Dilemma: The Warning Bells of Germany's Manufacturing CrisisOnce synonymous with success, Volkswagen and the German economy are now struggling with high costs, eroding technological leadership, and overreliance on the Chinese market. These three challenges not only affect Volkswagen's market competitiveness, but also present formidable obstacles for German manufacturing in a world undergoing rapid transformation

The People's Dilemma: The Warning Bells of Germany's Manufacturing Crisis

Once synonymous with success, Volkswagen and the German economy are now struggling with high costs, eroding technological leadership, and overreliance on the Chinese market. These three challenges not only affect Volkswagen's market competitiveness, but also present formidable obstacles for German manufacturing in a world undergoing rapid transformation. The Volkswagen crisis has become a microcosm of the broader German economic slowdown.

Volkswagen is grappling with its most severe crisis in recent years, which reveals not only managerial missteps but also the German economic model's inability to keep pace with global changes. Soft sales, intensifying international competition, and a costly electric vehicle strategy that has failed to win over consumers have driven Volkswagen's stock price to a 14-year low. On Tuesday, Volkswagen scrapped a 30-year agreement aimed at preventing forced layoffs of employees at its namesake brand. This move signals Volkswagen's efforts to adjust its cost structure and has triggered fierce negotiations with unions.

Meanwhile, the German economy has stagnated. Since 2019, Germany's gross domestic product (GDP) has grown barely at all, even shrinking by 0.3% last year. Some economists predict another contraction in the German economy this year. As Germany's largest employer, Volkswagen's fate is intertwined with that of the country, with the automotive industry contributing 5% of its GDP. "Volkswagen is to Germany what Nokia is to Finland or Samsung is to South Korea," noted Dirk Schumacher, an economist at French bank Natixis. "If this industry significantly shrinks, finding replacements with similar wage levels will be extremely difficult."

Economists and analysts agree that the German economic malaise and Volkswagen's troubles share the same roots: overreliance on the Chinese market, escalating domestic costs, and waning technological leadership.

Overreliance on the Chinese Market

Manufacturing holds the key to Germany's economic success, representing a fifth of its GDP, almost double the proportion in the United States. This sector is concentrated in capital goods (like factory equipment) and automotive production. This economic model has long aligned with globalization trends: German companies set up factories in emerging markets, participate in China's infrastructure projects, and produce cars for a global emerging middle class. While other regions experienced deindustrialization, Germany's industrial base continued to grow. Volkswagen's rise epitomizes this trend.

A decade ago, Volkswagen's joint ventures in China generated 5.2 billion (about $5.7 billion) in operating profit, excluding income from brand licensing, parts sales, and German-made premium models. However, increased global tariffs and trade barriers have led to a decline in German exports. The rise of Chinese domestic car manufacturers has exacerbated this challenge. In 2022, BYD surpassed Volkswagen to become China's best-selling car brand. In response, Volkswagen has adjusted its Chinese strategy, anticipating a decrease in operating profit from its joint ventures in China to 1.5 billion this year.

When Western executives returned to China after the pandemic, they expected the Chinese market to be severely hit, said Ulrich Ackermann, head of foreign trade at Germanys VDMA machine engineering association. But Chinese companies used this time to invest more, increase their competitiveness, making products more cost-effective and production faster.

German foreign trade statistics reveal another significant shift: In 2020, China surpassed Germany to become the worlds largest exporter of machinery. Today, China produces more industrial machinery than the United States, Germany, and Japan combined.

High Domestic Costs

China isn't the sole culprit for Volkswagen's problems. Its massive size, high costs, and lack of flexibility in Germany have resulted in lower profit margins than competitors. While Volkswagen boasts high-profit brands like Audi and Porsche, it remains vulnerable to macroeconomic or industry challenges. The sluggish recovery of the European automotive market following the COVID-19 pandemic, coupled with the lack of Chinese market cash flow support, has further exposed this weakness.

In the past 12 months (ending in July this year), Volkswagen brand new car registrations in core Eurozone and UK markets have declined by about 17% compared to 2019. Management has stated that Volkswagen's production equates to losing two factories, forcing the company to consider mandatory layoffs. Unlike other European carmakers like Stellantis and Renault, Volkswagen's workforce has not significantly shrunk but has even slightly expanded in recent years. This is largely attributed to Volkswagen's unique governance structure, making layoffs extremely difficult. The state of Lower Saxony holds a 20% voting stake in Volkswagen, and the "Volkswagen Law" imposes significant obstacles to major operational changes.

Volkswagen is more like a state-owned company than a private company, said Ferdinand Dudenhffer, head of the Car Institute, a German research center. Volkswagens reliance on its high-cost home market is unusual. In 2023, Germany accounted for 57% of Volkswagen's assets, 44% of its employees, but only 19% of its revenue. By comparison, Toyota Motor (Volkswagens closest rival in terms of scale) had Japan accounting for only 23% of its revenue, 27% of its assets, and 18% of its workforce as of March this year.

In the early 2000s, Germany boosted its international competitiveness by controlling wages, even becoming the worlds largest exporter of goods for a time. However, this advantage is fading. Germany now has some of the highest labor costs in the West, and labor productivity has barely grown since 2019. According to the German Automotive Industry Association, last year the average hourly wage for German auto workers was 62, compared to 29 in Spain.

The war in Ukraine and the German governments decision to abandon nuclear power have also pushed up energy costs in the country. According to the Federation of German Industries (BDI), natural gas prices in Germany are three to five times higher than in China and the United States, while electricity prices are 60% to 75% higher than before the pandemic. "Germany's industrial sector is energy-intensive and heavily reliant on industrial production, so the rise in energy costs has hit Germany particularly hard," said Clemens Fuest, president of the Ifo Institute for Economic Research.

Losing the Technological Race

Volkswagen spends significantly more on R&D than its peers, with analysts expecting its R&D expenditure to reach $19 billion this year, double that of Toyota. However, these investments have not translated fully into market performance. Volkswagens dominance in internal combustion engine technology has not easily translated into an advantage in the electric vehicle space. Core competitiveness in electric vehicles lies in battery and software technology, areas where Tesla and Chinese companies are leading.

A decade ago, the Volkswagen Golf commanded a significant price premium in the market, said Mike Tyndall, an analyst at HSBC. Today, Volkswagens electric vehicles seem to have lost that premium.

Its worth noting that while some German manufacturers lead the world in high-end products like precision lasers and advanced optics, with few foreign competitors able to match their expertise, many companies have faced challenges in maintaining their technological edge. According to the World Intellectual Property Organization, the number of patent applications filed by German companies has been decreasing year-on-year since 2018 (excluding 2023).

Data from the Kiel Institute for the World Economy shows that last year German companies cut investment by 5%, with many shifting to faster-growing markets. Despite Germany's long engineering tradition and strong research institutions, its tech sector remains relatively small. Germany's R&D expenditure as a percentage of GDP is above the European average at 3%, but the issue is that a large part of this spending is concentrated in the automotive industry.

For decades, China has been absorbing German industrial technology, and now the direction of technological transfer is beginning to reverse. Many German companies are building R&D centers in China, taking advantage of local expertise, government subsidies, and less red tape. Analysts suggest that Volkswagen's production costs in Germany are higher than in China, with labor costs being only part of the reason. Another significant factor is that Volkswagen's factories in China are often more automated and digitized.

Volkswagen's troubles are not just its own problem, but a microcosm of the challenges facing German manufacturing. Addressing these issues requires both deep-seated reforms within Volkswagen and a corresponding adjustment by Germany, the world's third-largest economy.