By  on February 19, 2008

Some rethinking is happening in the "factory to the world."

With costs on the rise, labor laws getting tough and reality setting in about the hassles of doing business in a transitional economy, the polish is fading from China's gleaming reputation as the world's prime manufacturing spot, industry sources and analysts say.

Although few businesses are actually moving production out of China, many more are thinking twice and considering other locations when they plan new manufacturing ventures.

"Based on what we're seeing in the field, new manufacturing is being placed in other spots rather than China," said Kevin O'Marah, chief strategy officer for the supply chain analysis firm AMR Research. "What's in place is staying in place, but new operations are often going elsewhere."

In the late Nineties and early part of this decade, China became the globe's main destination for manufacturers, lured primarily by its cheap and seemingly endless labor force. The Chinese government, eager to attract foreign investment, used preferential tax policies and promises of smooth logistics to encourage multinational firms to set up shop here. Those forces combined to make China the world's top destination for foreign direct investment, drawing $72 billion to the Mainland in international investment in 2006.

But China's manufacturing rise is proving like any other bull market — eventually feverish investment begins to slow and investors become more concerned about aspects of doing business here that often went ignored when China was seen as the hot place to produce. Roughly one-third of the world's apparel is now made in China.

"At the start, there was a gold rush mentality," explained Cliff Waldman, an economist with the Manufacturers Alliance/MAPI. "In a gold rush period, companies often don't do as much research as they should have."

"Anecdotally, I find that corporations have logistics issues, bureaucratic issues, language issues, that they never fully considered," said Waldman. "You can't really consider these things until you experience them."

Retail billionaire Philip Green bucked the China trend early, announcing in late 2005 that he was moving production from China to Eastern Europe. Green, whose Arcadia Group owns the British retailer Topshop and others, was quoted as saying he wanted his operations closer to retail outlets in Europe for a cleaner, much faster supply chain. But the move sparked speculation that China's rising costs and unavoidable difficulties would lead to a string of similar defections.

Thus far, there has been no exodus. Yet there is plenty of anecdotal evidence that China is no longer the hands-down winner when a company looks at potential manufacturing sites.

Doug Hart, a partner with the BDO Seidman retail practice, said several factors have combined to make China less attractive in recent years. The first is cost.

Wages in the manufacturing sector have risen between 10 and 15 percent over the past five years, according to research from the Chinese Academy of Social Sciences. As China's massive migrant labor force becomes less willing to settle for subpar wages, pockets of worker shortages have appeared and manufacturers have needed to raise salaries to attract and retain workers.

Costs are expected to rise yet again with the implementation this year of a strict new labor contract law that mandates certain obligations to employees. The law gives greater protections to migrant workers — the bulk of the country's manufacturing labor force — and mandates certain levels of benefits for long-term employees.

In addition to labor costs, Hart noted, commodity prices are going up worldwide and China is no exception. Meanwhile, the Chinese government this year equalized corporate tax rates on foreign and domestic companies, meaning that most international firms will within five years lose the tax breaks that helped to draw them here in the first place.

Said AMR's O'Marah: "The cost differential is finally being eroded and many people now want to be closer to their markets."

The potential loss of new manufacturing business appears to be a very calculated risk for the Chinese government. In pursuing an equalized tax policy, stronger labor law and other measures like an appreciating currency that might dissuade some international manufacturing business, the government appears to be on track with its plans to move China away from a manufacturing base to an economy based more on innovation.

Cai Fang, director of the Institute of Population and Labor Economics at the Chinese Academy of Social Sciences, said China is no longer interested in attracting low-level manufacturing jobs that pay poorly and fail to help the country advance. Cai said the new labor law and other moves to boost workers' rights will benefit the country in the long run.

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