China Power

China has long prided itself on being the world's workshop. Shipments of labor-intensive, low-cost goods—everything from toys to tube socks to tires—turned the country into an exporting colossus, powering growth of nearly 10% a year for the past three decades. But as Beijing is now realizing, there's a downside to that strategy. Exports of tainted pet food, toothpaste, and Thomas the Tank Engine trains threaten to provoke a global backlash against products that say "Made in China." And the mainland's swelling trade surplus has Washington looking to slap sanctions on the country.

These controversies have helped spur a big policy shift in Beijing. China's technocrats are introducing a series of measures designed to change the face of its export industry. On their own, each of these initiatives may not seem momentous. But as a whole they define a major change in China's industrial policy—one that favors higher value-added industries such as sophisticated electronics and heavy machinery, possibly at the expense of low-cost manufacturing and assembly. And they're sure to help boost efforts by companies at the low end to move away from simple production for multinationals and develop their own designs and brands. The potential payoffs: a cleaner environment, better-paying jobs, and an improved reputation for the country's goods.

It won't happen overnight. But the Chinese government is using a combination of carrots and sticks to get companies to fall into line. Twice in the past 12 months, Beijing has cut export subsidies, eliminating rebates on the 17% value-added tax for more than 500 types of high-polluting goods such as fertilizer and leather, while further whittling down rates for some 2,800 other low-tech products. The changes will force companies to make "more technologically advanced products and develop their own brands," Wang Qinhua, a director at the Commerce Ministry, told reporters on July 25. And revisions to China's contract law, approved in late June, are likely to drive up wages on the mainland. That could force companies in low-margin industries such as footwear and apparel either to upgrade their product mix or shift production to cheaper locales in Southeast Asia.

Beijing also is tightening standards on pollution, which could make investments in sectors such as steelmaking, coal, and cement less attractive. "Environmental degradation has become a political-stability issue in parts of China," notes Bear Stearns economist Michael Kurtz. The faster China moves beyond polluting industries, "the more surely growth will continue to pay political dividends for China's leadership."

The revamped industrial policy has implications for international companies. Next year, Beijing plans to eliminate most tax breaks for foreign enterprises, a policy that has been in place since 1991. Yet in a clear sign of the changing priorities, incentives have been retained for areas such as electronics, environmental technologies, and industrial safety.

Beijing's edicts will speed a process already set in motion by market forces. The yuan has risen 9.4% against the dollar over the past two years—not enough to placate Washington, but sufficient to cut into the profit margins of Chinese exporters, particularly those at the bottom of the pyramid. Factor in rising wages and tougher competition from lower-cost countries such as Vietnam, and it's not hard to see why some Chinese manufacturers feel as if they're caught in a vise. "For years, China has beaten its competitors with low costs," says Liu Xueqin, a researcher at a think tank affiliated with the Commerce Ministry. "This strategy has now run its course."

One company feeling the squeeze is Wenzhou Taima Shoes Co., which makes footwear for more than 200 retailers around the world. It will see a 2% decline in net profit as a result of the government's decision to pare tax rebates on shoe exports, figures Vice-President Chen Zhexi. But Wenzhou Taima didn't need much coaxing from the government to try to up its game. When Wenzhou built a new factory in 2005, it imported more costly shoe-manufacturing equipment from Italy to replace its Chinese-made machines.

"Our shoes are now better than those made in Italy," boasts Chen. The company now sells footwear in the U.S. under its own "Paris" brand.

Other Chinese exporters are investing in foreign knowhow. Three years ago, Zhejiang-based High Fashion Silk Co. began hiring Italian and American designers to create clothing and ties for customers such as J.C. Penney (JCP) and Liz Claiborne (LIZ). General Manager Lin Ping says it's money well spent because his buyers are willing to pay some 10% more for the new designs. "A company's ability to survive depends on its innovation," says Lin.

Economists point to China's changing export mix as a sign that the country is making the transition out of low-end manufacturing and into more advanced sectors. One example: China recently turned into a net exporter of industrial machinery, led by the likes of Shanghai Zhenhua Port Machinery Co., which makes more than half of all the cranes used at the world's ports. And high-tech gear accounted for 29% of China's total exports last year, up from 15% in 2000, according to the Commerce Ministry, though the lion's share of those shipments came from plants that are either owned by or working for multinationals such as Dell (DELL), Sony (SNE), Apple (APPL), and Nokia (NOK).

Still, locals such as PC maker Lenovo (LVNGY), telecom-gear manufacturers Huawei Technologies and ZTE, and smaller players like Mindray Medical International (MR) have boosted their profiles overseas. Shenzhen-based Mindray started out selling medical devices in China for Hewlett-Packard (HPQ), Siemens (SI), and other foreigners. But it has always set aside a good chunk of its profits for research and development and now boasts its own line of ultrasound imaging and blood-testing equipment that it exports to more than 140 countries, including the U.S. "We use R&D to put more value into our products," says Chairman Xu Hang.

Some China watchers say all of this is proof the nation is on track to become the next South Korea, Taiwan, or Japan. Don't expect Washington to cheer it on, though. It already looks as if China is set to beat last year's record trade surplus of $177 billion, which has American politicians fuming. And that figure is likely to grow as the country inevitably earns more foreign exchange selling goods such as tractors, WiMAX gear, and medical scanners than it does from toys, textiles, and TVs. "It's very similar to what happened in Japan or in Korea when they migrated from light manufacturing," says Andy Xie, an independent economist based in Shanghai. "The surplus really mushroomed."