Game of Chicken

China, the second largest economy of the world known as a notorious export powerhouse, has witnessed an impressive growth in domestic demand across many industries over the last several years. Expectations of brisk export and domestic consumption combined with negative real interest rates have led to a mad rush for capacity expansion. Unfortunately, although domestic consumption delivers double-digit growth, e.g. the auto industry, supply in certain sectors has already surpassed demand, implying new capacity is being added at a rate much faster than total demand growth.
One illustrative example is Pirelli, an Italian tire company, recently announced to launch the largest plant of China in Yanzhou City, Shandong Province, with annual output of 10 million passenger tires. According to conservative estimates, there’re 300 to 600 independent tire companies in China and new factories emerge almost dayly. Besides Pirelli, multinationals like Michelin, Goodyear, Bridgestone, Continental along with a long list of domestic and other Asian players have made similar announcements, building the largest plant(s) in China. Not a month goes by without another new “large” tire factory being added to the already impressive list of 300-600!
China currently has a production capacity of about 300m tires, roughly 25% of global demand. By contrast, China’s domestic market is less than 50% of the domestic production capacity. With new capacity being added at rate greater than demand growth, the gap between supply and demand keeps widening. So, where are these tires going? Export, you would say!
Yes and No! Export has been the safety valve of this “pressure cooker” style tire industry for the last several years to balance out the equation! Imports from China have grown at an alarming rate in many Western countries. However this growth in exports is more to keep the factories running rather than to fulfill an unmet demand. Thus, the widening supply-demand gap and the necessity of factories’ smooth operation has put significant price pressure on China made tires and triggered authorities in importing regions to keep alert on potential dumping. China made tires accounted for an impressive 45% of the imported tires in the US in 2008. In 2009 US imposed an incremental 35% anti dumping tax on China made tires! Brazil and India followed suit in the following years. EU may be the next to impose similar duties, and its new environmental regulations and labeling laws have exposed China made tires to additional risk. Global economic slowdown hasn’t helped tires exporters either! Obviously, the export centric model has come under severe stress. Astoundingly, the new capacity building goes unabated!
Another bewilderment comes from its lack of consolidation. None global or local players busy at capacity scale-up in the industry has ever thought about acquiring those weak peers in several dozen! There have been hints of consolidation but nothing meaningful. As a result, a raft of local as well as all the top global players focus exclusively on building new capacity and actively selling in China, leaving the market extremely fragmented. None of the top ten global players have a double digit market share in China.
It is not very uncommon to have highly fragmented market for goods that require relatively low capital investment and other barriers to entry, e.g. know-how, regulation, access to labor etc. However, the art and science of assembling a complex composite of rubber, steel & fabric and of ensuring them to perform at peak levels at 100-150 km/hr, is hardly a low barrier! Additionally, the over $300m capital injection for an economically viable plant is by no means low! Why then China tire market continues to defy generally accepted principles of economics?
The answer may lie in the theory of “Game of Chicken”, which means that while each player prefers not to yield to the other, the worst possible outcome occurs. The name “chicken” has its origins in a game in which two drivers drive towards each other on a collision course: one must swerve, or both may die in the crash, but if one driver swerves and the other does not, the one who swerved will be called a “chicken,” meaning a coward. Consequently, both drivers would rev up their cars and spin their wheels – signaling their intent not to swerve!!! Much in the same way, everyone in the tire industry is expecting others to swerve i.e. exit or default, and trying to show their “courage” by building more capacity believing the bigger they become, the less likely they will fall! 
 What worse is, “Game of Chicken” carries weight not only in the tire industry but in a series of capital goods manufacturing sectors like automotive, shipbuilding, cement, glass, construction machinery and materials, etc. This supply bubble cannot last forever and there will be many casualties in this irrational game when laws of economics eventually prevail.
Question is: who will be the last few men standing when the dust settles in this Game of Chicken!