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China's factories feel the squeeze
Sitting in a windowless conference room surrounded by the remote-control toy Ferraris and Mercedes he sells the world over, factory owner Kuma Gu summed up what it's like to manufacture products for American consumers these days.
"A lot of Chinese companies have a saying," he said between drags on a cigarette. "Do you want to kill yourself? Then do business with Wal-Mart."
Gu wasn't looking for sympathy. He has thrived for years amid the economic miracle that has transformed this one-time steamy fishing village into one of the world's largest manufacturing bases.
But as he discussed the lead-paint fiasco that has damaged his industry's vital relationship with U.S. shoppers, Gu put the issue in far broader context.
China's export machine, he said, has become a victim of its own success.
For decades, the economic relationship between the United States and China has been based on a crystal-clear calculus: American consumers wanted low-cost goods, China delivered them.
But exponential growth along the sprawling Pearl River Delta just north of Hong Kong has triggered sharply rising costs for everything from labor to plastic. And as the Wal-Marts of the world continue to press for lower prices, Chinese manufacturers are getting squeezed.
Many factory owners, government officials and U.S. importers interviewed in China linked the toy-safety problem to this market pressure, part of the profound changes under way in an economy on the rise.
Just as Japan and Taiwan did before it, Southern China is struggling to mature from a Wild West economy that thrives on cheap labor and lax regulation to one valued for its technical ability and high quality. That future may come. But for now, China is like a gangly economic adolescent, fast-reaching adulthood but still prone to explosive, childlike outbursts.
The shift is upending many of the low-cost assumptions that have fueled China's staggering growth. For years, migrant workers have flooded to Chinese factories on the coast providing a seemingly limitless supply of dirt-cheap labor. Now, the government is trying to rebalance the economy by encouraging industrial development inland, allowing more workers to stay home and forcing companies to come to them.
In coastal cities like Shenzhen and Dongguan, this has translated into a labor shortage. Amid China's ravenous appetite for raw materials -- oil in particular -- other costs are rising too. Meanwhile, the flip side of the government's friendly policies inland are hostile ones for coastal industries that use lots of labor and environmental resources. Add in a rising yuan against the dollar and the region's low-cost advantage is beginning to slip away.
The result is that many small to mid-size outfits like Gu's find themselves locked in a new and volatile struggle for survival. All developing countries have suffered the ills of headlong industrial growth -- periods of lawlessness, environmental degradation and quality issues -- offering many reasons for China's product meltdowns. But with costs rising precipitously in China, many experts say the pressure to shave pennies through bad behavior has increased, especially as foreign buyers continue to exploit the market's chronic overcapacity by shopping door-to-door for vendors who will do whatever it takes to win business.
"It reaches a point where things aren't economically viable and corners get cut by subcontractors and sub-subcontractors," said Steve Vickers, head of a security company called International Risk and former commander of criminal intelligence for the Royal Hong Kong Police. "That's called capitalism, I guess. But it's reckless."
Made in China
China's problems couldn't seem more distant from the bland forest of glass office buildings lining Interstate Highway 88 in suburban Oak Brook. But in the third-floor office suite that houses RC2 Corp., toy designer Jeff Bricker is only a high-speed Internet connection away from RC2 offices in Dongguan, just north of Shenzhen.
Bent over a drawing table covered with plans for a new Thomas and Friends talking train set, Bricker explained how product teams in Oak Brook dream up Thomas toys, beam them to design engineers in Dongguan and wait for the products to flood back from 35 contract manufacturers so they can be sold all over the world.
He also lamented the damage done to the Thomas brand from RC2's recall this year of about 1.7 million lead-tainted toys.
"Hopefully, [parents] will realize these things can happen," Bricker said. "Hopefully, the trust will come back."
Curt Stoelting, RC2's chief executive, knows that hope rings hollow with parents when it comes to toy safety. He hardly thinks doing business in China is reckless, but the recalls have made him painfully aware of what can go wrong when a global supply chain snaps a link under pressure.
He still isn't sure exactly why lead paint ended up on many of his wildly popular train toys. He doesn't even know whether to blame the manufacturer or the company that supplied it paint.
"What I can tell you," Stoelting said recently after returning from China to inspect the situation, "is that corners were cut. Our very specific requirements were not followed."
RC2 had given its contractors price relief to cover rising costs. It had been confident that its testing procedures -- which met or exceeded industry standards -- were adequate. "But it turns out they weren't," Stoelting said. Having been lulled by his contractor's good behavior over a period of years, he added, "We took things for granted."
Mattel Inc., which has recalled nearly 2 million of its own lead-tainted toys this year, has told a similar story -- only its long-term contractor killed himself after being duped by a supplier. Like RC2, Mattel and many other companies subject to recalls have acknowledged that their testing procedures were woefully inadequate.
Quality control experts used to working in China say the mistake companies like Mattel and RC2 have made is assuming that China -- still a developing country -- offers U.S. companies a mature and stable manufacturing platform. China is certainly capable of manufacturing high-quality products. But Kurt Schneiders, co-founder of PRO QC Systems in Hong Kong, said a combination of overcapacity, lax regulation, rising costs and pressure from buyers has encouraged the desperate, uneducated or unscrupulous to do whatever it takes to win business.
"Nobody wants to pay for quality," Schneiders said. "Not buyers, not manufacturers."
Made to order
For Lawrence Chan, chairman of the Hong Kong Toys Council and founder of a large Mattel supplier called Wynnewood Corp., this isn't a surprise. It's simply the risk of doing business on the mainland. On a Saturday morning in his sparse but bustling office in Hong Kong's Kwun Tong District, Chan explained that the further you get down the food chain in China, the more trouble you encounter.
Big companies, he said, tend to have sophisticated managers who are well aware of U.S. regulations. They also recognize that skimping on paint doesn't save enough money to offset the very real risk of a recall.
But in China's ever-expanding market, there is always another company that will bid lower if a buyer looks hard enough. Some will even open up a new factory to get the business. Big companies under price and time pressure often subcontract to smaller ones with less sophistication and fewer resources.
"At large companies, management is at least informed that [using lead paint] is a no-no," Chan said. "But for subcontractors, are they totally aware? And has management informed employees?"
Chan insists that few Chinese companies -- even unsophisticated small ones -- would knowingly use toxic substances. But he gave the example of a small subcontractor rushing to produce 10,000 pieces on deadline.
"Sometimes they run out of paint for a small portion of the order," Chan explained. "Then due to ignorance they say, 'Oh, here's some paint that is similar.' Then they have a problem."
Chan knows that U.S. buyers face pressure to "squeeze every fraction of a penny. It's their job." But if they want quality, he said, they have to lift their heads from the price sheet and consider where they are.
"This has been a great lesson for everybody," he said. "Sometimes you have to pay for what you want."
Made to listen
For RC2's Stoelting, this lesson means two things. First, he knows he has to spend more money on testing in Dongguan, where RC2 has an office to engineer products, perform quality assurance and manage its large stable contract manufacturers.
The company has beefed up its quality control procedures to include more in-process audits and the testing of every batch of paint that comes through the door. RC2 also makes Bob the Builder, Johnny Lightning and John Deere toys, as well as children's products under The First Years and Lamaze brands.
The second implication of Chan's lesson, however, is more reflective of what's really going on in China.
Recognizing that cities like Dongguan are becoming too expensive to give him what he needs in terms of cost and efficiency, Stoelting is planning to move 200 miles inland to a 400-acre site in Wengyuan. Labor, land and taxes are cheaper there and utilities are more abundant. He studied moving as far as Vietnam, which many in the outsourcing world call "the next China."
The recall experience hasn't blunted Stoelting's faith in globalization. A 47-year-old former Arthur Andersen consultant, he believes companies like his are in a perpetual search for cheaper places to manufacture.
Made for change
A decade ago, when RC2 first teamed with several manufacturers to build an office-production complex in Dongguan's Chang'an district, the area was surrounded by rice paddies. Companies built multistory factories like those found in Hong Kong. Labor was so cheap that Chinese firms ignored automation and lean manufacturing techniques. Those things made sense in Japan. Here they were unnecessary.
Chang'an remains a rough-hewn industrial district in many respects. The smog is thick and rolling electrical blackouts are the norm. Although Jetson International Ltd., one of RC2's dedicated factories, uses rudimentary automation to produce wooden Thomas trains and track, workers still toil in the 90-degree heat with nothing but paper surgeon's masks protecting them from sawdust and other hazards. Wages have been rising, but they are still puny by Western standards. Production workers in Dongguan earn less than $150 a month.
Nevertheless, signs of change are everywhere. A five-star hotel has arrived, restaurants have blossomed and office towers are on the rise. The real growth is coming from computer-parts factories that are as modern as any in the world.
Wynnewood's Chan remembers paying workers $6 a month in the years after Deng Xiaoping opened the south for development in 1978. Even in 1989, he had to argue with his Chinese partners about putting in a fire escape in a multistory worker's dormitory with only one exit.
"I wasn't even asking them to pay for it," Chan said. "The value of life was very different at that time."
Robin Munro, research director for the China Labour Bulletin in Hong Kong said labor conditions remain primitive by U.S. standards. Dormitories are still crowded, long hours of overtime are still expected and worker safety remains a distant concept. But Monro also said the pendulum is swinging. The Pearl River Delta has developed such a dismal reputation that as industry develops inland, workers increasingly head home or never leave. That has created a labor shortage of 12 percent to 15 percent in the region.
Made at a price
At the Chitone labor market near Dongguan's gleaming new civic center recently, the shift was obvious in the interplay between potential employers and job seekers packed into the market's top two floors.
At one booth sat 28-year-old Li Jun, whose company makes plastic bags for supermarkets around the world. On this day, he was looking for office staff. But two months earlier he had been forced to hire an agency to travel inland to recruit factory workers to fill out the company's staff of 280.
Li said the worker shortage had driven wages up around 30 percent over the last three years. Production workers used to get around $100 a month. Now they are paid closer to $140. Retaining workers also means improving living conditions, albeit from rock bottom standards.
Li explained that in March his company added hot water to the dormitory bathrooms and put in air conditioning. The owners hired a cook to replace the meal service because workers were complaining about the food quality. The company bought a snooker table, a big movie projector for the dining
room and started regular exercise periods.
Another manufacturer, Minoya Sharehold Co., was also pushing lifestyle amenities. "We have a beautiful environment," said a colorful sign, noting the company's Ping-Pong and snooker room, as well as its basketball, volleyball and badminton courts.
But Yang Jianjun, a 25-year-old quality control manager, wasn't buying. Minoya was offering almost $190 a month plus overtime for quality control positions. Yang's price was closer to $270.
"I think the salary is too low," he said. " I don't think it would motivate me to work there."
Labor costs at Gu's HK (Shenzhen) Industries Ltd. have jumped by half over the last several years. But that's just the beginning. ABS plastic, a basic raw material in model cars, has more than doubled. Nickel, the key ingredient in batteries, has rocketed from around $16,000 a ton to almost $47,000. Meanwhile, everything has been made more expensive for exporters by the government's policy of letting the value of the yuan float higher in response to U.S. complaints about its trade deficit with China.
Safety, too, comes at a cost. Even before the toy-quality scandals, Gu said, he constantly worried about getting slipped lead paint by a supplier looking to shave pennies. So he demands certification from suppliers and insists they sign contracts taking full responsibility for a recall. He also makes sure he buys from large, established companies. All of this helps him sleep at night. But it also means he pays top dollar for paint.
A few years ago, he said, Mattel came to him and expressed strong interest in hiring HK to build a branded line of radio-controlled toys. The two sides had several meetings and talked about designs. But, in the end, they didn't come to terms because Gu couldn't afford it.
"The quality was very high and the requirements very strict," Gu explained, "but the price was no good, so we wouldn't do it."
A Mattel spokeswoman said the company has no record of working with HK.
Back in Oak Brook, RC2's Stoelting said the reason he's moving inland is that there's no way to avoid the kind of problem Gu complains of.
In Wengyuan, he said, higher transportation costs will be an issue for a while. But because the government is building a new road to the area connecting it to the port in Shenzhen, a 15 percent to 20 percent drop in labor rates pulls like a magnet. Moreover, by building a new compound of factories, RC2 and its partners can leap frog their current facilities. They are designing efficient, single-floor production plants equipped with more automation machinery and laid out to take advantage of lean production systems.
"If labor costs weren't increasing, I don't think there would be motivation to use more efficient equipment and different manufacturing techniques," Stoelting said. "But they are increasing and they're going to continue to increase."
U.S. companies go out of their way to preserve the kind of competition that drives down prices, said K.K. Choy, assistant general manager of Wealthwise Industrial Ltd., a large Mattel contractor. Choy explained that while Mattel gives Wealthwise a steady diet of work producing all manner of Elmo, Dora and other toys, it is also careful to channel some business to smaller firms to keep them in the game.
"For smaller companies, it will be a tough time to keep alive," said Choy. "But Mattel will protect them. They don't want us to get too big."
A Mattel spokeswoman responded that her company uses many manufacturers around the world, big and small.
Made to move
Making life increasingly complicated for the small and the weakened, however, is steadily becoming official government policy in the Pearl River Delta. Cities like Dongguan and Shenzhen are actively favoring big exporters and high-technology companies that can eventually develop their own brands and focus on the domestic market.
One example is a switch in the value-added tax rules that require smaller companies to put up half the tax in cash until its products are exported. Only companies with strong balance sheets can afford to do that month after month.
"It's a way to make life more difficult for smaller manufacturers," said Clement Chen, chairman of the Federation of Hong Kong Industries. "As the economy becomes more mature, they want more mature factories -- more value added, more brands."
If out-of-favor companies agree to move to inland regions, however, those rules will be revoked, Chen said.
Jiang Ling, Dongguan's vice mayor for economic development, said trimming overcapacity, enforcing regulation and increasing quality are not simply government objectives. With the Made in China brand under siege, it is a matter of survival.
"If the quality and credibility of our products is bad, that will ruin our city," Jiang said. "In the past, we paid much more attention to quantity. Now we have to pay more attention to quality."
Even Jiang acknowledges, however, that the transition will be difficult.
For 20 years, economic expansion has been the tonic that cured all ills in China. Growth in gross domestic product has been the currency of political power. Local mandarins have been judged by Beijing on their economic prowess and given resources and clout accordingly. Many officials have built a lifestyle taking bribes for looking the other way when it comes to regulation and even those that haven't see their professional advancement tied to growth in GDP, creation of jobs and general social order.
Jiang admits that "it will take time for different levels [of government and the business world] to accept this concept." He also said it will be a challenge to "better manage officials in government" to make sure graft and corruption don't cripple reform.
Some experts say that the current crisis may give reform-minded officials cover to make some tough decisions. And, already, the government is clamping down by sending out armies of quality inspectors, while recertifying exporters.
Nevertheless, explained Chen, the pain of transition isn't likely to end soon.
"It's a mega-project for the central government," he said, "and unfortunately, it can't be rushed."