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.

• Author: Navarro, Peter
• Position: Cover story

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?

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.

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