China's home-grown automakers are reeling after Beijing stripped away tax incentives for small cars at the end of last year, a move that helped take the world's largest auto market off the boil, but one that could force weaker firms into consolidating.


In the seven months since the incentives were lifted, the entire sector has downshifted to a more sustainable 6 percent annual growth rate. Analysts say some independents that suffered the brunt of the policy shift might seek tie-ups to stay afloat unless conditions improve.


"It's not a very good year overall, but local brands were hit much harder as the policy support, which had pushed up the demand for Chery and the likes in 2009 and 2010, was not there anymore," said Yale Zhang, managing director of Automotive Foresight, a Shanghai-based consultancy.


Western brands are faring much better, with sales of German and U.S. brands up 20.2 percent and 18.9 percent, respectively, in the first seven months.


But Geely Automobile Holdings (0175.HK) and its peers sold a mere 5 percent more cars than a year ago during the period, down sharply from the sizzling 45.9 percent annual pace in the same period last year, official data showed.


Sales of Warren-Buffett backed BYD (1211.HK) have slumped nearly a fifth. Even domestic champion SAIC Motor's (600104.SS) popular Roewe sedans lost their shine. Monthly sales of Roewe and MG started to turn negative for the first time since April after stellar growth of 77.4 percent in 2010.


Steps by local governments to restrict car sales and tackle traffic gridlock have also dampened demand for smaller, cheaper cars, a segment dominated by local brands.


For example, since the beginning of the year in Beijing, consumers wanting to buy new cars must first enter a monthly lottery to win a registration license. Only one-in-three people are successful and that has favored foreign brands.


"Why should anyone waste their hard-earned quota on a cheap car if they can afford a better and pricier one, especially after the incentives aren't there now?" asked Peter Chen, a 34-year old Beijing resident who won a coveted registration.


Chen took home a Buick Excelle, the second best-seller in July, after ditching his earlier preference, BYD's F3.


In smaller, inland cities where sales of local brands currently outnumber foreign rivals, Chery and Geely are also facing tough competition as General Motors (GM.N) and others roll out low-priced models to grab customers away.


GM is opening 120 sales outlets only for the Baojun sedan that is made at its mini-van venture in south China.


Nissan Motor (7201.T) and Honda Motor (7267.T) are also counting on locally produced Everus and Venucia, respectively, to gain market share in lower-tier cities.


SURVIVAL OF THE FITTEST


Some industry observers say the downturn in sales, if it continues for a few years, offers a perfect opportunity to consolidate China's highly fragmented auto industry, which has too many inefficient and unfocused brands.


Technocrats in Beijing envision having a few strong national brands, but consolidation has been slow due to foot-dragging by local governments eager to build their own auto fiefdoms.


After two major government-mandated reshuffles since 2007, China's Big Three -- SAIC, Dongfeng Motor Group (0489.HK) and FAW -- still accounted for less than half of overall national sales in 2010. In Japan, top automakers' portion is 86 percent with Toyota Motor (7203.T) alone having 53 percent of the market.


"I don't think all the local brands should be hanging in there forever," said Xu Changming, general director with the Information Resource unit of the State Information Center.


"There are some 30 or 40 independent car brands now. It will be pretty good to have four or five left eventually. The stronger ones survive and the weaker ones fade away. That's what happens in a market economy."


The most likely acquisition targets are the little-known private players churning out a few thousand vehicles a year, analysts say.


Perennial M&A targets, such as Soueast Motor in the southeastern province of Fujian, which saw its vehicle sales plunge 12 percent from January to July, could eventually fall prey to big state auto groups, analysts say.


"They will be in trouble if the market continues the subdued growth pattern or turns south as they have no foreign partners to turn to and are unlikely to get any government money," said Zhang Yu, an analyst with A J Securities.


FOREIGN AUTO MAKERS & PARTNERS


Thanks to Chen and other Chinese consumers who are turning their eyes to foreign brands in the absence of incentives, sales of most overseas automakers remain solid, albeit slower than the breakneck pace the brands have enjoyed for the past two years.


Sales at Volkswagen's (VOWG.DE) car venture in Shanghai rose 22.4 percent in the seven-month period, while Daimler's (DAIGn.DE) Mercedes-Benz had a 50 percent gain.


Their Chinese partners, mostly big state auto groups, are also holding up well as locally made Buick, Passat and Focus brands make up the majority of their overall tally.


The previous incentives, which had included subsidies for consumers in rural areas, were introduced at the height of the global financial crisis in 2009 to help shield China's auto industry from a steep downturn. They were scaled back in 2010 and completely phased out at the end of that year.


"Regulators had good reason to come up with the stimulus package," said John Zeng, Asian automotive forecasting director at J.D. Power and Associates. "But it was not sustainable and it has to be phased out sooner or later after the crisis (was) over."