After Long Boom, China Faces an Industrial Downsizing

DONGGUAN, CHINA—When Philip Cheng opened his first factory in this teeming manufacturing city two hours north of Hong Kong, the area was a quiet hodgepodge of farm fields and animal farms. Like many other investors from Hong Kong, Taiwan, Japan, and South Korea, Cheng took advantage of the cheap land, labor, and production costs and built 17 export-oriented factories. A dozen years later, after an extraordinary manufacturing boom, his factories stand on the brink of extinction.

Workers at Philip Cheng's factory for protective helmets.

Cheng, the founder of Strategic Sports Ltd., a producer of protective helmets, is not the only one in financial distress. Many manufacturers in the fast-growing cities of coastal China, dubbed the world's factory floor, are experiencing an unexpected reversal of fortunes that may have profound economic and political implications. For Americans, who imported $321.5 billion in goods from China last year, the result will be higher prices for many products. For China's leadership, any slowdown in its economic juggernaut risks fueling public unrest among Chinese already burdened by growing pollution and harsh labor conditions.

In part, China's manufacturers are caught in a vicious cost squeeze. Many are under pressure from big American buyers to cut prices to offset both the rising cost of shipping brought on by high oil prices and the 15 percent increase of the Chinese currency against the dollar since July 2005. At the same time, costs for labor, raw materials, and land are climbing.

Perfect storm. Those problems alone would be difficult to weather. But there are additional factors compounding the problems for businessmen like Cheng. The Chinese government is actively trying to phase out some of the lowest-wage assembly work, such as making clothing and cheap toys, to build up more complex and more valuable manufacturing operations, including cars and high-tech equipment. To that end, the government last year eliminated tax subsidies on some 2,000 products. A new labor law gives sharper teeth to existing minimum wage laws and other basic labor regulations. And high inflation has prompted curbs on bank lending, which has combined with weak export markets to push the country's growth rate lower for four straight quarters.

All these factors coalesce to create a "perfect storm," says Alexandra Harney, author of The China Price: the True Cost of Chinese Competitive Advantage. "Guangdong manufacturers were already operating on razor-thin margins, and this has pushed them to the edge."

Cheng, for instance, says his overhead has shot up 150 percent in the past year alone because of higher expenses for raw materials, wages, and benefits. Adding to his headache, he's having trouble finding workers despite being in the world's most populous nation, because China's one-child policy has limited the available labor supply.

Mou Weidong, general manager of BW Moulds, a small Dongguan factory, is also being hit hard. His monthly wage per employee shot up 30 percent to around 1,300 yuan a month ($190) after the new labor law went into effect, but buyers continue to demand lower prices. "It's almost impossible for small factories to meet the requirements and survive," he says, adding that many factory owners in Dongguan never reopened after shutting down for the Chinese New Year holiday last February.

Guangdong province—which accounts for 40 percent of China's exports of products assembled from imported components—is taking the biggest blow. So far this year, as many as 10,000 factories have closed in the province's long-booming Pearl River Delta. By the end of the year, that total could rise to 30,000, the majority from labor-intensive industries. Worker dorms in the Dongguan area that just a few months ago were crowded with migrants from farm areas all over China stand empty. "Most of the factories can't survive," says Cheng. "The profit has become less than zero. If there's no help, sooner or later they will die. We're fading away."

What many factory managers fail or refuse to recognize is that their pleas are falling on deaf ears. "The Chinese government is saying it no longer wants to be the world's factory for producing junk," says Andy Rothman, China strategist for CLSA Asia-Pacific Markets, an investment firm. "They're saying, 'If you can't survive by following the rules, then we don't need you anymore.' "