To be or not to be ... in China: pursuing a China strategy is likely on the minds of every senior financial executive--with the lure of low-cost labor and 1 billion customers--yet despite the promise of great rewards, the reality is that every step in the process is fraught with great risk.

Must your organization have a China presence in order to be competitive in the 21st century? That's the question many top executive teams are now grappling with. Is it just too hard to ignore the lure of the substantially lower costs and higher profits that other companies are enjoying by offshoring or outsourcing production and/or services to China?

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Now, however, running up the white flag in the U.S. and raising the red star at your factories or facilities is not without risks. Some of the biggest risks can be framed within the context of these three questions: 1) Should your company make the move to China? 2) If so, how can it protect itself from the many risks inherent in such a strategy--from intellectual property theft to geopolitical instability? 3) If your company does not embrace a China strategy, how can it compete with a "China price" that is substantially less than the present price you're paying? Ultimately, it comes down to: Can you afford the price of not joining the crowd in China?

The Economic Vise of the 'China Price'

It's no secret why more and more U.S. companies are outsourcing or offshoring to China. Yes, cheap labor is abundant in countries ranging from Bangladesh and Cambodia to the Dominican Republic and Nicaragua. However, China's low-wage workforce tends to be far more skilled, better educated and highly disciplined. The result is both low-cost labor and high-quality production--a potent competitive edge.

In addition to cheap labor, China is also unencumbered with Western-style environmental or health and safety regulations that can drive up costs. Today, as a result of these labor cost, regulatory and other advantages, Chinese manufacturers undercut world prices by as much as 50 percent.

Wielding this "China price," China has captured over 70 percent of the world's market share for DVDs and toys, more than half of the share for bikes, cameras, shoes and telephones; and more than a third for air conditioners, color TVs, computer monitors, luggage and microwave ovens. It has also established dominant market positions in everything from furniture, refrigerators and washing machines to jeans and underwear (yes, boxers and briefs).

And it's not just favorable production economies that are attracting corporations from all over the world. There is also the obvious lure of the world's largest consumer market. As China industrializes and incomes rise, it will likely become the fastest-growing market in the world--the predicted "1 billion new customers."

These prospects of low-cost production and 1 billion new consumers notwithstanding, a more sober analysis strongly suggests that setting up shop on Chinese soil may now offer more risks than rewards.

Copy That ...

Moving operations to Chinese soil will significantly increase a company's exposure to counterfeiting and piracy, which are highly profitable ventures, since pirates and counterfeiters don't spend big sums on R & D. They also don't have to spend huge sums on marketing to build and sustain a brand and open new markets. They simply piggyback on the efforts of legitimate companies--while in the process, destroying much of the brand value and good will a company builds up.

Most large corporations are now maintaining intellectual property protection armies. Nike Inc. has full-time anti-counterfeiting officers in Beijing, Shanghai and Guangzhou, and initiates about 300 raids in China a year. Luxury-goods maker Louis Vuitton employs a network of 250 trademark agents, investigators and lawyers. The collective cost of maintaining such teams, conducting raids and paying for litigation and enforcement likely runs into the hundreds of millions of dollars.

Now, you don't have to move your facilities to China to become a victim of counterfeiting or piracy. But offshoring or outsourcing your production to Chinese soil can significantly increase such risks. Consider, for example, one typical scenario of how your company can become a victim of China's sub-rosa "global supply chain" of piracy and counterfeiting.

You contract with a Chinese factory to make 1,000 units of your product a day. However, rather than just run two regular 8-hour shifts to produce the amounts contracted for, the factory also runs a third "ghost shift." This extra production is then shipped right out of the back door and into world markets.

Another variation on this theme is the "startup counterfeiter." Consider the case of the Taiwanese folding-bike maker Dahon Inc. Its investigators discovered a competitor called Neobike International Co. Ltd. that was producing bikes that were almost identical to the existing Dahon models. As it turned out, three of the five Neobike founders were former Dahon employees. The obvious risk: you provide Chinese managers with the know-how and all they need to produce your products and soon they go off to do it on their own.

And don't expect help from the Chinese government in cracking down on piracy and counterfeiting any time soon, particularly when such activities are fueling as much as one-third of China's GDP (gross domestic product) growth. In fact, Chinese piracy and counterfeiting is an important de facto government policy tool that allows the Chinese government to control inflation, create jobs, expand its tax base and raise the standard of living for its people.

The Dragon Coming Apart at the Seams? Or, China's Problems Could Become Your Problems

Longer term, the most serious problem with a China strategy may well be political instability, yet most U.S. executive teams heavily discount this risk. At first glance, China's Communist Party appears to be firmly in control while the general populace seems quite content after more than three decades of near double-digit annual GDP growth and rising prosperity.

In fact, no one is more concerned about rising internal political instability than Communist Party officials. Over the past decade, protests and riots have risen almost exponentially to nearly 100,000 annually, with both their scope and scale increasing. What is perhaps most alarming about these protests, riots and strikes is the diversity of causes and their broad geographic sweep.

Consider first one of the most baffling paradoxes of the Chinese "economic miracle." While industry privatization has unleashed a wave of entrepreneurial activity and eliminated much inefficiency in China's manufacturing sector, Chinese-style capitalism has also cast adrift more than 100 million workers. Today, despite literally decades of robust economic growth, China's unemployment rate ranges as high as 20 percent or more, particularly in some "rust belt" regions of the country.

Second, to make way for development, the Communist bureaucracy is serving as the primary enabler of land seizures. The problem in many cases is not the evictions per se, but corruption. Blatantly "double dipping," local government officials will accept bribes from the developers for executing land seizures, and then they siphon off the money that would otherwise be paid as compensation to those forced off their land. Add to this dynamic the fact that the government rarely provide for adequate relocation of these individuals, and the result is a socioeconomic powder keg.

Third, 60 percent of China's population--the rural peasantry--must bear a ridiculously onerous tax burden in the cruelest of ways. While these peasants break their backs in the hot fields, Party officials ride around in limousines, enjoy lavish banquets, meet mistresses in upscale hotels and send their "Little Emperor" offspring abroad for schooling--all the while dissipating China's wealth.

As noted in The Washington Post, a fourth of all government revenues are diverted to the "upkeep of the country's 6 million officials at all levels." Moreover, much of this revenue stream--and the income from a myriad of other corrupt activities--finds its way into the vaults and safety deposit boxes of officials in foreign banks, with an estimated US$60 billion stashed away each year in offshore accounts.

A fourth trigger for political instability is the fact that the Chinese countryside has become a dumping ground for every imaginable pollutant. The statistics are startling: 70 percent of China's seven major rivers are severely polluted. Almost half of China's total population is exposed to water supplies that are contaminated by animal and human waste. One in three countryside dwellers lack access to safe drinking water, and cancer of the liver and stomach, related to water pollution, are among the leading causes of death in the countryside.

Finally, there are looming health care and pension crises that make those facing the U.S. look like a walk in the park. As in the U.S, the underlying pension problem is a "pay as you go" system. Today's workers make contributions to the pension fund to support all of those in the retired pool. However, as China grows older much faster than it is growing richer, that retirement pool is growing sharply at the same time the active worker base funding them is shrinking precipitously.

Unlike the U.S., China's per capita income is far lower and, therefore, there are simply fewer resources to support the system. As noted by Richard Jackson, senior fellow at the Center for Strategic and International Studies, "Ultimately, the pension issue becomes an issue of social instability. The government sees that--they can't help but see that. But they don't know what to do."

And, as bad as China's pension crisis may be, its health care problems may be worse. China spends only about 6 percent of its GDP on health care. This compares to about 8 percent in Japan and almost 15 percent in the U.S. There is a shortage of doctors, and sick people are forced to pay for their health care upfront. Those lacking the means to pay are cast out of hospitals and may be simply left to die an often slow and painful death.

A big part of the problem is the cost of medical insurance--$50 to $200 per year in a country where the annual per capita income for the vast majority of the population remains well below $1,000. Within such a system, many Chinese find that the only way to get proper care, even if they can afford to enter a hospital, is by offering so-called "red envelope" bribes.

The bottom line: There are numerous "wars from within" brewing in China that threaten the legitimacy and stability of the Chinese government. Lest any top executive think that Chinese officials have anything but a tiger by the tail, it is useful to remember that China has a long history of politically chaotic upheaval in both its ancient and modern history; just recall most recently the several decades-long Communist revolution consummated in 1949, the radically destabilizing effects of the Great Leap Forward from 1958 to 1962 and the rabid frenzy of the Cultural Revolution in the late 1960s.

China Tweaks 'Uncle Sam's' Nose

It's not just China's budding wars from within that should concern companies thinking of relocating portions of their business to Chinese soil. It's also a possible--indeed a probable--collision between China and the U.S. over access to the world's markets and natural resources.

Nowhere is this emerging conflict more intense than over oil. Already, China has openly begun to tweak the nose of Uncle Sam in its courtship of oil-rich nations. In Venezuela--the U.S.'s fourth largest oil supplier--China is wooing the left-wing dictator Hugo Chavez. In Iran, home to the world's largest natural gas reserves and third largest oil reserves, China is facilitating nuclear proliferation for a radical Islamic regime that is severely undermining U.S. military efforts in Iraq and that has promised to destroy Israel. China is even trying to cozy up to Saudi Arabia--the U.S.'s staunchest Middle East ally and the largest oil producer on the planet.

More broadly, in choosing to be the "factory floor" of the world, China has hitched its star to a heavy manufacturing model that, in less than three short decades, has transformed the country from a quiet agricultural backwater into one of the world's largest consumers of metals, minerals and other raw materials such as lumber. This is a quite different strategy from that other emerging behemoth, India, which is focusing on technology and global services industries.

Pursuing its heavy manufacturing model, China has already overtaken the U.S. and Japan as the world's largest steel consumer. It is the largest buyer of copper, the second largest buyer of iron ore and the third largest buyer of alumina (used in smelters to produce aluminum). China is also one of the top consumers of Thai rubber, Burmese teak, Chilean and Philippine copper, cobalt from the Congo and Indonesian pulp and paper.

China's strategy for securing raw materials is to gain as tight a physical control of these resources as possible. This strategy necessarily puts China into direct geopolitical conflict with the U.S. all around the globe--from the mines of Africa and plantations of Asia to the tropical rain forests of South America. As U.S. former Assistant Secretary of State for African Affairs, Walter Kansteiner, has warned, "China has simply exploded into Africa," and it has with a significant presence in all 54 African nations.

China's Zambia gambit is particularly instructive. This country supplies 20 percent of the world's cobalt and is the world's seventh largest copper producer. China has already poured more than $100 million investment dollars into Zambian copper mines. Illustrating China's penchant for owning resources, a Chinese company is now the proud owner of the Chambezi copper mine, one of the biggest Chinese mining operations on the continent.

The bigger picture here that executives must be mindful of is that economic competition over the world's resources and raw materials is quickly becoming a zero-sum game in which whatever China can lock down will be denied to the U.S. If China played by acknowledged "international rules," that would be one thing. However, China doesn't.

To gain access to these raw materials, it traffics heavily in arms and uses its diplomatic veto at the United Nations to curry favor with despots from Iran to Zimbabwe--all to the detriment of U.S. foreign policy. The military dangers implicit in this putatively economic strategy to control the world's resources are unmistakable.

As noted by Jane Bussey and Glenn Garvin in the Miami Herald in 2001: "At tracking stations in Brazil, Chinese technicians familiarize themselves with new digital reconnaissance equipment that might someday enable them to stalk and destroy U.S. intelligence satellites. In computerized listening posts in Cuba, Chinese experts in electronic espionage scoop up signals from U.S. military satellites and sift through the contents of millions of American telephone conversations for intelligence. [And] at airfields in Venezuela, Chinese military officers instruct pilots in the fine points of new transport planes that the government of President Hugo Chavez has purchased from Beijing."

The bottom line here is that China's economic explosion has put it on a collision course with U.S. economic and strategic interests. A confrontation involving anything from trade sanctions to bullets fired may well be only a matter of time; and your company should certainly be worried about finding itself in any crossfire.

The Global Dangers of a China

What should your company do if it decides against a China strategy? The question is a particularly difficult one because, at least in the short run, the economics of the China price make it very difficult to survive in business, absent a Chinese presence.

One obvious answer is to consider locating to other foreign countries where labor costs are relatively cheap and the business climate is favorable. Vietnam comes immediately to mind. It is strategically located in Asia and it has a relatively large population--about 75 million. It is relatively undeveloped, its workforce is well-educated and disciplined, and it is considered by many the "new China"--one without the attendant pollution and political instability issues.

There is also that other behemoth to consider, India. Still others in the top countries for outsourcing, as rated by Forbes, include Brazil and Chile in South America, the Czech Republic and Poland in Eastern Europe and Malaysia, the Philippines and Singapore in Asia.

However, a second answer to addressing the China question brings to mind the phrase "get into politics or get out of business." Much of China's competitive advantage derives not from natural advantages like cheap labor but rather, in this writer's view, from overtly mercantilist policies such as a grossly undervalued currency and a myriad of direct and indirect export subsidies that blatantly violate world trade agreements. It follows that one of the primary responsibilities of any U.S. company seeking to protect its shareholders and employees is to lobby local, state and particularly federal representatives to take a much harder line against Chinese mercantilism.

Still a third issue that any executive team contemplating a China move must address has to do with how willing the team will be to accommodate a different and, in many ways, far more repressive and corrupt culture and society. Consider the moral dilemma of companies like Yahoo, Google and Microsoft. Each company, when pressed, has caved in to Beijing's demand for Internet self-censorship--and endured the scorn of international critics for enabling Chinese repression just to "grab a piece of the pie."

Consider, too, the well-known importance of guanxi, or personal relationships and networks, in Chinese business relations. To get anything done quickly in China often involves paying for political connections in a guanxi context; all too often, the not-so-fine line between a consulting relationship and a pure and purely corrupt payoff is crossed. Does your company really want to do business this way; and who, in good conscience, will you be asking to conduct these ethically challenged relationships?

The Issue of Trust

There is, of course, the very important issue of trust involved in working with Chinese entrepreneurs. In a culture that places a low (or no) value on intellectual property, in a legal system where property rights are vaguely defined and contracts difficult to enforce, and in a country where language barriers are high, your company will be exposed on numerous fronts. Better understanding that exposure before touching down on Chinese soil is a lot better than a big surprise.

Also, according to an op-ed article in The Wall Street Journal, Beijing is placing new obstacles in the way of foreign companies that seek to establish independent, wholly owned operations on the mainland. The main focus is on "making it more difficult for foreign companies to operate in China."

Finally, there is the financial "balance of terror" that now exists between China and the U.S., which may, in the not too distant future, break down into financial chaos and economic or military conflict. In this balance of terror, the U.S. runs huge monthly trade deficits with China, and China accommodates these deficits by recycling American dollars back into U.S. financial markets. This keeps China's currency grossly undervalued and its exports high and American consumers content--so neither country is willing to interfere with such an unhealthy codependence.

However, longer term, this relationship also exposes the U.S. government to political blackmail. As the trade deficit with China grows, Chinese bankers hold more and more U.S. paper, and accumulate more and more power to destabilize world financial markets should the U.S. oppose China on any one of a number of policies--from Taiwanese sovereignty to cracking down on Chinese mercantilist trade policies.

It should be clear then, from this narrative, that a move to China offers as much quicksand as it does visions of E1 Dorado. Ultimately, a company's goals should be to make sure its China decision is based on a stone cold sober assessment of the relative risks and rewards--rather than irrational exuberance.

Peter Navarro is a Professor at the University of California-Irvine and author of The Coming China Wars: Where They Will Be Fought, How They Can Be Won. He can be reached at [e-mail]. His free weekly newsletter for business executives can be accessed at www.peternavarro.com.

RELATED ARTICLE: Getting the Spice Right ... for the China Market

McCormick & Co. has had a China strategy for more than 15 years, yet it is still learning about the market. The Maryland-headquartered company competes in two major aspects of the global food industry. It serves the household shopper (slightly more than 50 percent of annual sales) with the McCormick brand in the U.S., Latin America, Australia and most of Asia. To U.K. consumers, it is known under the Schwartz brand, and in France and continental Europe, it is Ducros. In Mexico, McCormick is the number one mayonnaise brand.

The company also serves the industrial market, where McCormick supplies a tasty assortment of spices, seasonings, flavorings, sauces and extracts to food manufacturers, global restaurant chains and other food service operators.

Founded by Willoughby McCormick in 1889, McCormick, with $2.5 billion in sales, is pursuing customers in China with new products. Primarily known for "dry" products, it has recently introduced a "wet" line in China consisting of four different degrees of spice in a Szechwan paste. The Chinese market is served by two plants--one in Shanghai and one in Guangzhou.

In the industrial market, McCormick has, in essence, followed its best customers to China and supplies many top-branded multinational food and fast-food companies with ingredients that go into their food products.

A key issue affecting McCormick in China centers on human resources. When selecting personnel throughout the organization, Vice President & Controller Kenneth A. Kelly Jr., an FEI member, says, "getting the right people depends on the stage of development your business is in and what your needs are."

For example, the type of individual you need as a general manager can change. "As a startup, an entrepreneur was needed. Even though you are a publicly traded company, you need a different spirit for a startup. Then, when you get more critical mass, you need somebody who can manage the business. And, things change over time--especially as China is developing."

In terms of personnel, as many have said, it is extremely competitive, with sizeable turnover, and there is also scarcity for the right talent. Kelly explains that as a "Western" company, an ideal employee group would represent a mixture of Eastern and Western cultures. As a publicly traded U.S. company, you need employees who can relate to the Western business environment--who know the objectives, the rules and regulations and can communicate in that fashion.

How to find the right people? Chinese nationals who may have been trained in the U.S., or who have spent significant time in the U.S. and went back to China, are one source. He says McCormick's current CFO of the China business is an expatriate (from St. Louis) who has been in China for the past 12-plus years and is fluent in Mandarin (very important).

He doesn't anticipate that the hiring environment will get easier. If anything, he says, "it is probably going to ramp up." And, although he believes the supply will pick up, along with the demand, he believes "the thirst will be greater than the supply."

Kelly notes other challenges for McCormick:

* Retail: "It's a different consumer business from other parts of the world, and it is evolving." The retail marketplace is composed primarily of extremely small stores (there are some supermarkets and supercenters).

* The distribution model is not like the infrastructure elsewhere, where one distributor can distribute nationwide. "It doesn't exist in China, so you have to set up different networks."

* Chinese law is evolving. "It is a changing environment, and you've got to keep on top of it--making sure you have appropriate advisors to help your business." Kelly recommends using (as his company does) brand-name international law firms and accounting firms.

* Presently, in China, there are few national food brands. "The market is fragmented into numerous regions, separated by differences in language and taste preferences."

This finance guy puts on his marketing hat to add: "That also says there is opportunity." The big question, he ponders, is: "How do we leverage that opportunity?"

--Ellen M. Heffes

RELATED ARTICLE: takeaways

* China offers outsourcing and offshoring advantages that include a low-wage workforce that tends to be more skilled, better educated and highly disciplined than other locations. It's also lacking Western-style environmental or health and safety regulations.

* Its lack of regulations allows China to undercut world prices by as much as 50 percent.

* Moving operations to China will significantly increase a company's exposure to counterfeiting and piracy, which is causing many companies to maintain intellectual property "armies."

* Alternatives to China include Vietnam, Brazil, Chile, the Czech Republic, Malaysia, the Philippines or Singapore.