Every cloud supposedly has a silver lining, and Chinese industry's bill for complying with stepped-up safety standards after a string of embarrassing product recalls is no exception.

The additional outlays will further inflate the China price: the rest of the world is already paying a bit more for Chinese imports due to the gradually appreciating yuan and higher costs for everything from land to labor.

But industry executives say the extra burden, along with the phasing out of tax breaks and new curbs on low-end manufacturing, will also serve China's strategic goal of pushing its companies to make higher-quality goods that consume less energy, produce less pollution and command fatter profit margins.

This is a crisis. The spate of product quality problems is an illustration that China's low-cost strategy has reached an end point, said Craig Pepples, the chief operating officer of Global Sources, which brings buyers and suppliers together through online marketplaces and sourcing fairs.

The only solution now is for China to move upmarket and provide a slightly higher-end quality of product, Pepples said.

He said China, like other Asian Tiger economies before it, needed gradually to abandon its instinct to offer the lowest possible price to attract buyers.

It's now getting to the point where it's so low that they can't do it without getting into unsafe product and manufacturing practices, Pepples said. It's a turning point for China.


Plagued by safety problems with toys, toothpaste, tires and seafood, China has pledged to spend $1 billion by 2010 to improve food and drug safety and inspect farms, factories and ports.

It has blacklisted 429 exporters and set an example by executing a former food and drug safety chief for taking bribes.

Kent Kedl, general manager of Technomic Asia, which advises companies on marketing and strategy in China, said too many firms had neglected quality management in their drive to cut costs.

Companies need to invest more than they have to this point to manage quality. They've taken too much of a laissez faire approach to it, Kedl said, adding: There's a cost associated with this.

At the same time, exporters are having to cope with the abolition or reduction on July 1 of value added tax refunds on 2,831 export lines, 37 percent of China's total.

Kedl said some poor-quality, low-margin manufacturers have relied on the VAT refunds for their net profit, so the loss of the tax break could force them to the wall.

This may weed them out. We won't know for a while, but this could raise the quality of these suppliers just by business attrition, he said.

The tax changes have been particularly directed at industries such as metals and cement that guzzle energy and belch pollution.

In a related initiative, new rules took effect on Thursday aimed at penalizing low-end, labor-intensive export processing.

Exporters in industries accounting for 15 percent of China's exports, including toys, plastics and furniture, will have to pay a 50 percent deposit on imports of 1,853 different raw materials such as metals and textiles.

The deposit is repayable when the finished goods are exported, but businessmen say their cash flow will be hit hard.

The Chinese government is trying to motivate their local companies to climb higher on the value chain. They've been motivated to move even faster on product quality because of some of the international things that have happened, Kedl said.


Financial markets will be tracking whether the accumulated costs eventually translate into slower export growth and higher prices on shop shelves in Europe and America.

James Jin, Greater China general manager for MFG.com, an online marketplace for manufacturing, said suppliers and buyers alike are expecting prices to rise in differing degrees.

But he said the instinct of companies sourcing goods in China was to try to work with their suppliers to save costs or, if need be, seek out a new supplier in China.

People are still sourcing here. It's not the end of the world, Jin said of the change in tax refund policy. It doesn't mean that China doesn't have a competitive manufacturing cost structure any more.

Pepples agreed: Yes, prices are going up. Pressure is on suppliers, but from a buyer's perspective China is still an invaluable aspect of the sourcing strategy. They can't replace that product at that quality point in any other location.

Kedl forecast huge pressure on prices but said most manufacturers still had scope to squeeze out costs.

Moreover, a lot of companies are in China not only to export but also to produce for the local market. So only the biggest players would consider the expense of relocating from China.

You don't back out billions and billions of dollars of sourcing overnight, Kedl said. It's taken 10 years to develop it to this point, so it's going to be like turning a cruise ship -- it'll be very slow.