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(Bloomberg) — On the outskirts of Monterrey, Mexico, Chinese auto-parts makers are rapidly setting up plants to supply Tesla Inc.’s next factory. They join the ranks of Chinese manufacturers that opened Mexican facilities in response to Trump-era tariffs — and this new surge has set off alarm bells in Washington.

Chief Executive Officer Elon Musk invited Chinese suppliers to Mexico to replicate the local supply chain at Tesla’s Shanghai plant, according to people with knowledge of the situation. The company plans to build a cheaper next-generation electric vehicle at a massive facility in the state of Nuevo Leon, helped in part by $153 million in local government incentives.

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Tesla didn’t respond to a request for comment. Its Austin plant isn’t the only one in the US buying Chinese-owned Mexican-made parts, as exports continue to rise.

The value of Chinese auto parts made in Mexico and exported to the US reached $1.1 billion in 2023, up 15% over the previous year, according to previously unreported preliminary data from INA, Mexico’s national auto-parts industry association. Last year, there were 33 Chinese auto-parts makers registered in Mexico, 18 of which exported to the US, according to INA.

Despite US government officials’ concerns, it makes sense that Tesla and other carmakers want to tap China’s “highly organized, highly efficient supply chain,” said Venkatesh Prasad, chief innovation officer at the Center for Automotive Research.

“No manufacturer anywhere in the world is going to miss the opportunity to include that as part of their value proposition as they try to manage margins,” Prasad said.

Recent Chinese arrivals in Mexico include Ningbo Tuopu Group Co., Shanghai Bayon Precision Automobile Component Co., Suzhou Dongshan Precision Manufacturing Co., Zhejiang Yinlun Machinery Co. and Chinaust Group, a joint venture between Lingyun Industrial Corp. and Georg Fischer AG.

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These firms make heating and cooling systems, shock-absorption products, metal components and other parts.

The trade war then-President Donald Trump started in 2018 helped spur Chinese investment in third-party countries like Mexico. By 2023, Chinese industrial companies were using 9.31 million square feet of Mexican industrial park space, up from 1.28 million square feet in 2019, according to market data from development firm Finsa.

China’s increased manufacturing presence in Mexico comes as its direct exports to the US have fallen to their lowest since 2010.

Electric vehicles assembled in Mexico can also qualify for a US consumer tax credit of as much as $7,500 under the 2022 Inflation Reduction Act, President Joe Biden’s signature climate law. To do so, they must adhere to strict limits on the amount of battery materials coming from “foreign entities of concern,” or firms with ties to rival countries such as China.

Chinese companies that are “in a big hurry to get established to become suppliers” to western car manufacturers are opening shelter companies under Mexican business guidelines, said David Barrera, director of business development in Nuevo Leon for Banco BASE SA.

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Automakers and some global suppliers have not spoken up about the trend for fear of endangering their own interests in China. But the trade group for Canadian auto-parts manufacturers and the United Auto Workers have flagged what they deem an “alarming” increase in China’s Mexican investments to avoid US trade policy enforcements.

Passenger cars exported from Mexico, the US’s largest trading partner, are exempt from tariffs if they comply with the US-Mexico-Canada Agreement trade rules.

Big US Fear

US tax lawyers have even identified a path through which a Chinese-owned subsidiary based in Mexico could build full EVs that would qualify for the $7,500 US tax credit, so long as no battery minerals or components were sourced from China.

This is a big fear for both US EV manufacturers and government officials. China’s BYD Co. recently surpassed Tesla as the world’s top-selling EV manufacturer, largely thanks to its lineup of cheap models.

Read More: Chinese Sales Swamp Competition in Soaring Mexican Car Market

In November, members of the House select committee on the Chinese Communist Party wrote to US Trade Representative Ambassador Katherine Tai calling for action against Chinese manufacturers “preparing to flood the United States and global markets with automobiles, particularly electric vehicles” propped up by “massive subsidies.”

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In response, Tai wrote that the Biden administration is “clear-eyed” about the Chinese plans and was looking at ways to make Trump-era tariffs “more strategic.”

US Treasury Secretary Janet Yellen traveled to Mexico in December to strike an agreement on strengthening Mexico’s foreign investment screening.

BYD, Chery Automobile Co. and SAIC Motor Corp.’s MG brand already are looking to open plants in Mexico. These manufacturers could start construction in four years, begin production in six years and then export vehicles to the US, said Roland Berger consultant Oscar Silva Eguibar.

“The only way that the Chinese companies can avoid anti-dumping measures and really be able to export EVs to the US would be by establishing full manufacturing capacity in Mexico,” he said.

Bloomberg reported earlier this month that the Biden administration was considering restricting all imports of electric Chinese “smart cars” no matter where they’re assembled. US officials are concerned that the vast troves of data these vehicles collect could present hacking or national security threats.

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Chinese battery maker Contemporary Amperex Technology Co. Ltd. is considering building a plant in Mexico, and companies including BYD have expressed interest in lithium mining in the country. China dominates the mining and processing of critical minerals such as lithium needed for EV batteries, adding to US concerns.

Free Trade Rethink

Flavio Volpe, president of the Automotive Parts Manufacturers’ Association in Canada, warned that state-backed Chinese suppliers in Mexico could displace market-driven investment from North American companies.

US and Canadian concerns could lead to changes in the next review of the North American free trade agreement USMCA in 2026, said Kelly Ann Shaw, a partner at law firm Hogan Lovells in Washington, who has focused on international trade.

“You could see a situation where, if there is a real problem of Chinese parts coming across the border, whoever is president says, ‘We’re just going to demand more commitment from Mexico to stop that,’” she said. 

Mary Lovely, a senior fellow at the Peterson Institute for International Economics in Washington, believes the US needs to pick its spots on protectionist measures, because too many could stifle innovation and make vehicles too expensive.

“If there isn’t Chinese involvement, how do we keep the industry competitive?” Lovely said. “If we try to produce everything at US wages, we’ll end up with a vehicle that can’t compete in any sense.”

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