Joann Muller 09.03.07

Chrysler, with a new owner and a new boss, is placing a big bet on a fledgling Chinese automaker.
The Chery A1 is a cute little car. It’s a four-door hatchback, with a 1.3-liter engine, dual air bags and antilock brakes. The two-tone interior, with air-conditioning, power windows and a CD player, is surprisingly appealing for a car that sells for just over $7,000 in China.

It may not quite live up to American standards. The engine needs refinement, and some parts don’t fit as well as they should–not to mention concerns about the safety of anything made in China these days. But it’s just the type of low-cost small car Chrysler needs if it hopes to grow both here and overseas. Divorced in August from Germany’s DaimlerChrysler (nyse: DCX - news - people ), it has a new owner, Cerberus Capital Management, and a new chief executive, former Home Depot (nyse: HD - news - people ) boss Robert L. Nardelli.

The automaker’s future hinges less on a change in ownership than on a change in strategy. Right now Chrysler is a regional player, with all but 8% of its $62 billion in sales coming from North America, compared with General Motors (nyse: GM - news - people ), which gets half its sales from overseas. And Chrysler is overly dependent on gas-guzzling trucks: 68% of its U.S. sales are pickups, minivans and SUVs, compared with 60% at GM. Yet Chrysler, which lost $2 billion in the first quarter, can’t afford the $1 billion or more it would take to develop a new generation of minicars. Nor does it have the small, efficient engines it would need to power them. Chrysler’s smallest offering now is the Illinois-built Dodge Caliber. Considered a subcompact in the U.S., it is still too long (174 inches) and wide (69 inches) for many foreign markets.

Chrysler’s small-car solution, instead, lies with Chery Automobile, a Chinese carmaker with bold ambitions of its own. Chery has been building cars for just eight years but is already China’s fourth-largest auto manufacturer, with sales of 300,000 vehicles in 50 countries last year, and plans to sell 1 million cars a year by 2010.

Enticed by that growth, Chrysler President Thomas LaSorda–the architect of Chrysler’s turnaround strategy before the arrival of Cerberus and Nardelli–signed a deal with the fledgling company in July. Starting next year Chery will build up to 100,000 vehicles, similar to the A1, that will be sold under the Dodge brand in emerging markets. By 2009 Chrysler and Chery plan to co-develop another small car, perhaps the Dodge Hornet, which would be good enough for the U.S. market. The Hornet would be the first Chinese-made car sold by a big automaker in the U.S. "It allows us some speed to market and to position Chrysler where we might have a product void," Nardelli said on Aug. 6, his first day on the job.

This may not be the best time to be talking about importing anything from China, given the recent safety problems of toys, dog food and toothpaste. Indeed, a Chery sedan failed badly in a recent independent crash test in Russia. That car won’t be sold in the U.S., but the test didn’t help Chery’s reputation. Chrysler says it will work closely with Chery to make sure the cars it sells meet all safety and emissions laws. "If we put our brand on stuff, sometimes you only get one chance," LaSorda admits. "And if it’s not right, you pay the consequences."

Chrysler must also worry about its engineering know-how walking out the door. As with most Chinese manufacturers that learned the business by tearing down cars and reengineering the parts, Chery has run into a few skirmishes over intellectual property rights. In 2003 its QQ minicar debuted six months before a nearly identical car built by General Motors in Korea, the Chevrolet Spark. GM sued Chery in China, accusing the company of copying its design. GM lost.

"Chrysler took a silver plate and gave it to them," says Erkut Uludag, a partner in the Detroit office of Roland Berger Strategy Consultants, referring to the latest deal. By collaborating with an established American carmaker, says Uludag, Chery will quickly learn lessons that otherwise would have taken years, like how to nurture a brand in the U.S. or build a dealer network. Chery officials don’t hide their desire to sell cars under their own brand in North America. "The U.S. and Europe are the toughest markets in the world. It’s where you validate yourselves," says Lin Zhang, general manager of Chery’s international division.

LaSorda responds that Chinese automakers are coming to the U.S. sooner or later anyway, moving even faster than the Japanese and Koreans. Many cars sold in America already have a substantial number of Chinese components, including engines. And General Motors’ next Buick will be co-developed with Chinese engineers. It’s only a matter of time before Buicks are exported from China as well.

Chery rose up in Wuhu, an industrial city of about 700,000 in China’s impoverished and mountainous Anhui province, a five-hour drive from Shanghai. In the late 1990s provincial leaders decided to quietly form an auto company in Wuhu, even though the Chinese government had issued restrictions that limited automaking to a handful of joint ventures between foreign automakers and state-owned Chinese partners. They recruited Anhui native Yin Tongyao, an executive at Volkswagen (other-otc: VLKAF.PK - news - people )’s Chinese joint venture, to launch the operation, using tools purchased from the outdated factories of established manufacturers.

Chrysler started doing business with Chery four years ago, when it was building just 90,000 cars per year. Back then Chery bought engines from Chrysler’s Brazilian operations. Today Chery makes its own engines–20 different ones, ranging from a tiny 0.8-liter up to a 6-cylinder now undergoing testing–with the help of avl, an Austrian engineering firm.

Chery sprang to prominence recently amid a well-publicized plan by entrepreneur Malcolm Bricklin to export 250,000 Chery-built luxury cars to the United States. Chery eventually dumped Bricklin in favor of Chrysler, and even Bricklin admits it was a logical decision. "Chery realized they were not capable of doing what I wanted to do," he says.

By the end of August Chery will celebrate making its one millionth car. Its complex is more vertically integrated than most U.S. factories–stamping body panels and building engines and transmissions, along with cars, all on one site. This year it will produce 400,000 cars in two shifts.

Yet its plants aren’t especially up to date. While the paint shop is as modern as any U.S. factory’s, workers wearing respirators (but no eye protection) still use small paintbrushes, rather than automated tools, to slather sealant on critical weld spots.

Managers tout the Chery Production System, or CPS, which is modeled after the vaunted Toyota (nyse: TM - news - people ) Production System, but the factory lacks the clockwork efficiency of a Toyota plant. Chery’s vehicle assembly line runs at a rather slow pace, churning out one car every 120 seconds compared with half that at the best North American plants. As in most auto factories, the majority of final assembly is done by manual labor, but even here, Chery’s operations seem less efficient. Workers scamper over the car’s frame–and each other–to attach seats, instrument panels and wiring harnesses. Even supplies are handled inefficiently, with rows and rows of auto parts stacked up along the assembly line, awaiting installation.

Chery might be ready to take on the world in five to ten years. By then Cerberus might just be looking for a buyer for Chrysler.

Additional reporting by Fara Warner.