After Long Boom, China Faces an Industrial Downsizing

Workers at Philip Cheng's factory for protective helmets.

Those factories that survive will be the ones producing more sophisticated products, paying better wages, and doing less damage to the environment. "The Chinese don't want to be making sneakers for Nike forever," says Ted Hornbein, managing director for Asia Operations at Richco, a Chicago company that makes plastic fasteners, and a 16-year veteran of running factories in China. "They want their own brands and the value that European and American companies have been enjoying for the past 20 years."

For his part, Cheng isn't prepared to throw in the towel. "We have to keep this going. We cannot give up," he says. "We worked 20 years to build this up, raising it like a baby." So he envisions focusing on the domestic market, which would get him around the problem of China's strengthening yuan. He's also talking about moving inland. Land and labor there are cheaper, but infrastructure to get raw materials and deliver finished goods is lacking. "It may be cheaper, but how far will we be from the port?" he asks, shrugging his shoulders. "Even if we produce for the domestic market, we still need materials from the U.S., South Korea, and Taiwan."

In March, the American Chamber of Commerce in Shanghai released a survey conducted with Booz Allen Hamilton that found that rising costs in China "are among the factors shaping multinational manufacturers' perception that China is losing its position as the leading low-cost export platform." Nearly 1 out of 5 companies, in fact, has already decided to move at least some China-based operations to other low-cost countries.

Vietnam is the leading alternative. The manager of a string of Hong Kong-run factories, who declined to be named, recently returned from a scouting trip to Vietnam and says he found lower wages, cheaper land, tax holidays, and a currency effectively pegged to the U.S. dollar.

Up the ladder. Still, China will continue to be the world's factory for the foreseeable future. "It has so many institutional advantages," says Harney, citing the strong role played by the industrial clusters that have sprung up in the Pearl River Delta to provide manufacturers with every imaginable product and service. "They have everything you need to make anything, from a motorcycle helmet to a computer," she says.

Moving up the technical ladder, however, won't be easy. "The tools they have now are not necessarily the same ones they need for the next step," Harney says. Some of the biggest obstacles are lax law enforcement, a shortage of skilled labor and management, rampant piracy, and a lack of skills in marketing and financial management.

Compounding the situation, Chinese factories have been squeezed for years by major international buyers that forced them to offer unreasonably low prices—even below cost at times—year after year, while at the same time demanding that they meet tougher standards for employee wages and benefits, quality, and pollution control. Frequently, the only way to survive was to cut corners. Harney says that this practice has sometimes resulted in exploitation of workers and dangerous products that have brought negative publicity, including recent scandals over toys with lead paint, contaminated pet food, and faulty automobile tires.

Exporters seem more determined now to push back on prices. CLSA says that 59 percent of small export manufacturers expect to raise prices this year, up from 47 percent in the second half of in last year.

This will inevitably lead to higher retail prices worldwide—the only way these factories can survive. "American consumers are going to have to get used to paying for the quality they want," says Rothman. "If you want toys without lead paint, you're going to have to pay a little bit more for it."