US News, July 22, 2008

After Long Boom, China Faces an Industrial Downsizing

Many factories close as China tires of being the world's junk maker.


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.

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.' "

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."