Are Chinese Companies a Threat to <i>Your</i> Small Business? A closer look at how our free trade policies with China and the Chinese business environment may impact the future of your company

In recent months, as the U.S. economic slowdown has continued,American companies, and many legislators representing districts hithard economically, have begun to lash out at China. Touring theSouth, Democratic presidential candidates Richard Gephardt and JohnEdwards stopped at textile factories across the region that were onthe verge of bankruptcy. There, they condemned American free tradeagreements with China for allowing Chinese companies, which paymuch less for labor, to undercut U.S. manufacturers and driveblue-collar jobs overseas.

Meanwhile, Cabinet members of the Bush administration, touringthe country to promote the president's economic packages,received many angry complaints from businesspeople concerned aboutthe China threat. And U.S. textile makers last month filed apetition with Congress asking legislators to cap textile importsfrom China, using World Trade Organization (WTO) provisions inforce since China joined the WTO in 2001 and charging that Chinaunfairly undervalues its currency and underpays its labor force.(In response, the General Accounting Office has agreed toinvestigate the valuation of China's currency.)

Some of these fears are real. Last year, China received the mostforeign capital inflows of any nation, surpassing the United Statesas the world's favorite locale for investment. Meanwhile,Chinese wages, which average around 60 cents in manufacturing jobs,aren't rising in most fields. Ming-jer Chen, a China businessexpert at the University of Virginia, says the country'sburgeoning labor pool, the result of increased migration from poorinterior areas to richer coastal regions, seems likely to guaranteelow-wage labor in most industries, at least for the nearfuture.

Increased Chinese production by low-wage workers, combined withthe undervalued Chinese currency, does allow China to undercutcompetitors, triggering a kind of deflation that may push some U.S.firms out of business. As The Economist has noted, the costof a mountain bike has plummeted around the world, largely becauseChina has come to dominate bicycle production. For some U.S.textile manufacturers, it's very difficult to compete now, saysChip Coker, CFO of Coker International, a South Carolina textilecompany.

And, critics of free trade with China say, now it's not onlyblue-collar jobs that are leaving for the Middle Kingdom. Though adecade ago China was known mostly for manufacturing low-value,labor-intensive goods, in the past ten years, it's become aleading producer of low-end electronics, and has begun to developdomestic automobile, telecommunications and white goods firms. OneChinese white goods company, Haier, has even opened factories inthe United States.

In China itself, the situation is more complex. China may be anincreasingly powerful competitor for U.S. firms, and in manyrespects, Shanghai looks like a modern equivalent of any U.S.capital. At ubertrendy coffee houses around Shanghai, smartlydressed young men and women chew over business on their trillingmobile phones. The city's high-rise skyline is dotted withcranes and construction equipment, and in brokerage houses near theBund, Shanghai's waterfront, investors study market tickersintensely.

But appearances can be deceiving. Despite the First World veneerof Shanghai, most Chinese companies remain far behind the UnitedStates in terms of application of technology and in overallproductivity. What's more, many Chinese entrepreneurs remainstifled by a bewildering and often corrupt legal system, abureaucracy still staffed by Communist officials with littleknowledge of market economics, poor physical infrastructure andother major problems. Because of these obstacles, in many sectors,China is still years from competing with U.S. firms makingexpensive, higher-value goods. Most of what China does well isproduce low-value items that aren't economically feasible tomake in America anyway, since these lower-wage jobs left Americadecades ago anyway.

U.S. businesses often complain about the health care, safety andpension regulations they have to deal with, but red tape in theUnited States pales in comparison to Chinese entrepreneurs'hassles. Howard Li, co-founder of Newtone, a Shanghai-basedtelecommunications company, says his company has to focus much ofits energy on courting government officials, since the governmentin China essentially retains a monopoly over telecoms.

Meanwhile, Chinese businesspeople in other sectors say thatbecause Communist Party officials still have so much leverage overwhere companies can incorporate and who they can do business with,they often spend large sums of money feting Party leaders at lavishdinners and even take on excess workers who have ties to the Party.Worse, many small businesspeople are unable to obtain loans frombanks when they're in direct competition with larger companiesthat are still linked to the state and, by extension, to theCommunist Party. Jun Zhao, the Beijing representative forChinaVest, a venture capital firm focusing on China, says Chineseentrepreneurs turn to VCs precisely because it is so hard for themto get a loan.

Chinese entrepreneurs also don't have any semblance of alegal system to support them. One lawyer who worked in Shanghai fornearly two decades says that, despite laws passed in recent yearsdesigned to modernize the judiciary, most cases are stilladjudicated in back rooms by Party leaders. "One case I had,there was a three-judge panel that was supposed to decide it. Oneof the judges read the newspaper throughout the case and never evenlooked at the lawyers during the trial," he says. "LaterI found out that those judges merely wrote up a summary of thecase, gave it to a Party official, and the official made thedecision."

Meanwhile, in the past three months, a series of successfulChinese entrepreneurs, from agriculture businessman Sun Dawu toflower magnate Yang Bin, have been arrested by the police, oftenfor crimes that the government hasn't clearly defined. SomeChinese businesspeople say that the entrepreneurs were arrestedmerely because they challenged established businesses with Partylinks. "Yang Bin didn't do anything that otherbusinesspeople don't do," says one Chinese academicfamiliar with his case.

Partly because of the lack of a functioning legal system,intellectual property piracy continues to be an enormous problemfor Chinese entrepreneurs. Though the Beijing government haspledged to crack down on piracy, copies of the latest Hollywoodmovies, Microsoft software and hottest video games are widelyavailable in Shanghai street markets.

And even those Chinese entrepreneurs who do successfully wadethrough the red tape, prevent their goods from being pirated, avoidbeing arrested, handle infrastructure problems, cater to Partyofficials and get funding still may not match U.S. competitors.Indeed, several experts on Chinese business say China stilldoesn't have many business leaders who understand how to runand market a company effectively.

Given all these problems, there are actually few Chinesecompanies in anything other than low-end industries that are trulyprepared to challenge American firms. Despite the influx of foreigncapital into China, which mostly goes only into a few sectorslocated near Shanghai and Hong Kong, Chinese businesses'rankings of the World Competitiveness Scoreboard, a global rank ofbusiness productivity, has actually fallen in the past fiveyears.

But what does the situation in China mean for U.S.entrepreneurs? First, it means that U.S. small businesses can stillmake up for the advantages China enjoys in cheaper labor and lowerworker benefits. In fact, Chinese high-tech companies still spendless than one-twentieth as much on research as their Americancounterparts, and the Chinese education system's rigidcurricula still does not encourage ground-breaking thinkers withnew ideas. Not surprisingly, the few Chinese companies that havetried to expand outside their home market have yet to provebreakthrough successes. Haier, the most successful, remains a minorplayer in America.

To make up for China's advantages, U.S. entrepreneurs willhave to invest more heavily in research and development. One U.S.executive of a small high-tech company that does business in bothChina and the U.S. says that his company is able to maintain itscentral office in the United States by concentrating thehighest-value research in America. Several leading textilecompanies in South Carolina and North Carolina have revived theirfortunes by going into industrial textiles and the high-endtextiles used in medicine, both of which require considerableresearch and development to perfect. Similarly, savvy smallAmerican manufacturers have been able to remain competitive byexiting low-value fields like basic machine tooling and moving intospecialty manufacturing.

What's more, China's continued weaknesses in high-valueproducts and in marketing mean that U.S. entrepreneurs willing toplunge into China will have a window of opportunity to sell theirhigh-value goods and services in China, before Chinese companiesbecome savvy marketers. In fact, U.S. companies making high-techproducts in a range of industries have made enormous profits inChina selling cutting-edge machine tools, hospital equipment andwireless technology. "If you look around at what technologyChinese executives use, even executives of high-tech companies,they're using Nokia phones, Dell computers," says oneChinese-American executive based in Beijing. "They knowforeign higher-end things are better quality."

And American entrepreneurs in the retail and services sectors,which have been hit hard by the slowdown in the US economy, have ahuge opportunity in China. As Mark Clifford, Hong Kong bureau chieffor Business Week, has noted, Hong Kong has managed tosurvive even as nearly all its manufacturing jobs have migrated toChina, because it's become the most service-centered economy inthe world, with nearly 85 percent of its gross domestic productcoming from services. Similarly small U.S. firms in several keywhite-collar services fields--for example, shipping, businessconsulting, advertising and architecture, for example--have alreadymade headway into China, becoming major players on the Mainlandand, by marketing their foreign expertise, already gotten a leg upon potential Chinese competitors.

Joshua Kurlantzick is a writer in Washington, DC.