China Losing Luster with U.S. Manufacturers

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"China is in a league of its own in terms of risks associated with intellectual property and quality," says Kevin O'Marah, AMR's chief strategist.

In fact, China ranked highest in 9 of the 15 risk factors. Rising labor costs are still an important factor for businesses, with 35% citing China as the leading source of concern. Other risk categories where China ranked highest included regulatory compliance, commodity price volatility, supply-chain security breaches, and information technology problems. The shortage of Chinese managerial talent—long one of the top risk factors during the go-go era that ended last year—has tailed off as a major worry.

The findings don't suggest a mass pullout from China, O'Marah says. Two out of three companies said they still plan to expand there, mainly because they already have operations and component suppliers in the mainland. But that's a big falloff since May, when four out of five companies said they had China expansion plans. The number of companies saying they plan to actually decrease sourcing from China rose from 9% to 17%. Asia in general is falling from favor as an import source, the AMR study found.

Less-Visible Costs of Outsourcing to China

Where are the hottest new places for manufacturing investment? For U.S. companies, Latin America seems poised to be the big winner. The number of companies planning Latin expansions rose from four out of five in May to five out of six in October. Mexico is by far seen as the leading destination, cited by 73% as the primary source for new outsourcing. AMR also found that more production work is expected to shift to the U.S., with the percentage of companies planning to invest at home rising from 22% to 33%. Of course, this snapshot of corporate plans may have changed since the survey was taken. The deepening U.S. recession may prompt U.S. companies to curtail expansion anywhere.

The souring attitude should be disturbing to China's leadership. If the issue were just eroding price advantages, that would be less cause for alarm. Costs could swing back in China's favor, for example, with fluctuations in currency rates, commodity prices, or changes in China's job market. What's more, Chinese manufacturers have a long history of sacrificing profit margins with lowball pricing to win market share.

The AMR study suggests, however, that U.S. companies are starting to better appreciate the less-visible costs of producing in China. Quality problems, rampant piracy (BusinessWeek, 10/2/08), allegations of sweatshop abuses, worker protests, and other factors not only drive up costs but also harm the value of brands and corporate reputations. "Companies are realizing that the fully loaded costs of importing from China are a lot higher than they imagined," says O'Marah.

Trouble is, China will not be able to improve its quality problem overnight. It will require a long-term transformation of China's regulatory bureaucracy, legal system, and management practices. And Beijing has been promising to control intellectual-property theft for decades, with unimpressive results. If China doesn't start making progress fast, the current slump in export manufacturing (BusinessWeek, 3/27/08) could be the beginning of a longer-term pullback.

Business Exchange related topics:
U.S. Manufacturing
Global Outsourcing
China Business

Engardio is an international senior writer for BusinessWeek .