The story of China's economic miracle is so well-known that it hardly bears repeating. For nearly 25 years, GDP has grown 10 percent while exports have grown 16 percent year over year. China will soon become the world's largest exporter and possibly the second-biggest economy. It has also been the largest recipient of foreign investment among all developing nations for 15 years.

What is less well-known is that despite this success, the Chinese government is very concerned about several important shortcomings. Growth and investment have been concentrated in the major coastal cities, so economic development and consumer wealth has become extremely uneven across the country. Hundreds of millions of people still live in very poor conditions in the hinterlands where infrastructure is lacking and the economy largely undeveloped. For the near future, the government has announced that its top priority is to create a more "harmonious society."  This change in policy includes:

• Shifting the export mix up the value chain from commodity-level materials to higher-value products with greater R&D content

• Focusing economic development in the interior provinces, which have largely been left out of the nation's success

• Building logistics infrastructure, both in the central provinces and between the hinterland and port cities, and

• Stimulating domestic consumption to improve the standard of living for people throughout China.

This new economic model has broad implications for the supply chain strategies of foreign companies whether they are sourcing from China, manufacturing for export or serving the domestic Chinese economy, according to Jamie Bolton, a partner with the Accenture consulting firm in Shanghai, where he is responsible for the North Asia supply chain practice.

"The basis for China's growth is now broadening from quantity to quality and from investment and export to domestic consumption," says Bolton. "The government's recent five-year program focuses on the creation of a knowledge-led, innovation-oriented economy supported by greater domestic consumption."

Higher-Value Sourcing

Most companies that have entered China have been looking simply to source low-cost components and production based on the availability of cheap labor. Now, according to Bolton, there is a clear shift to categories of goods with more technical and engineering components, reflecting China's desire to become a higher-quality category provider. To some degree, the shift is inevitable. Many categories of low-value products are now available at even lower costs from other countries in Southeast Asia, Western Asia, Africa and Latin America where labor is cheap. Many types of apparel manufacturing, for example, have largely moved out of China to Viet Nam and Indonesia. China's export boom has also created huge imbalances of trade with the U.S. and Western Europe. China is increasingly under pressure to lessen this imbalance by importing more Western products, increasing the value of the yuan against other currencies and simply exporting less.

One clear signal that the government is shifting its policy on exports is its recent move to significantly reduce the value-added tax refund for nearly 3,000 categories of products, nearly all of which are very low-value. This refund on exports from China was an incremental benefit for sourcing from China. Many Western importers, especially large retailers, are likely to look elsewhere for these categories of goods. 

"The clear move in China now is to shift up the value chain to focus more on R&D and innovation," says Bolton, adding that China, just like Japan and Korea in decades past, is trying to position itself as a high-value-added country rather than just a source of cheap goods. "China doesn't want to be the world's manufacturing floor for every product."

Some contract manufacturers, for example, are on a path not just to be higher-level suppliers, but to eventually build their own brands. Galantz, for example, is a Chinese contract manufacturer that makes about 75 percent of the world's microwave ovens. Nearly all the major brands source from Galantz for their products. In the last few years, it has opened about 2000 retail outlets in China under their own brand name.

"At some point in time, they will be looking for a global brand presence of their own," says Bolton. "This evolution will be happening with many Chinese suppliers."

Certain industries such as automotive and high-tech have anticipated this shift up the value chain. They have developed ways to achieve the greatest value from Chinese sourcing by developing international procurement organizations (IPOs) that are physically in China and in close contact with key suppliers.

"These companies are looking at how much incremental value by using a Chinese supplier base that will build up R&D and product innovation," says Bolton.

This sourcing strategy is in sharp contrast to procurement through trading companies and agents that many companies have used for low-value products.

"Using trading companies is easy, but this approach also jeopardizes long-term success," he says. "Companies that use a trading company have no visibility into the product or the processes."

In fact, Bolton suggests that recent news stories about tainted Chinese food products and other quality problems are an indication that too many Western importers lack the right sourcing processes on the ground in China.

Most economic activity and prosperity have been in China's coastal cities such as Shanghai and Guangzhou where port facilities are world-class and the infrastructure very good. The government is pushing economic development in the inland provinces, primarily by creating clusters of industrial specialization. Chongqing, for example, is specializing in automotive and industrial production. Investment in transportation infrastructure is a key element in this plan. The government is investing $20bn in rail infrastructure alone.

"Besides the quality issue, relying on trading companies also prevents any ability to build up supplier relationships, gather market intelligence or understand how to control costs in the long term," says Bolton. "The importers are relying on the relationships the trading agents have with suppliers, so there is a barrier between them and the true China supply market."

Companies that are successful in sourcing from China are the ones that have a physical presence here, according to Bolton.

"We think companies can get 15 to 25 percent incremental savings by going direct to market through a physical presence here and by passing the trading companies," he says.

Of course, not every Chinese supplier has the ability to move up the value chain to offer multinational clients the quality, performance and competitive position that is expected from world-class sources.

"There will be fewer good suppliers, so multinational companies should lock in relationships with those that have the desired quality and capabilities," says Bolton, who also suggests that companies develop a dual supplier strategy. "You may find a supplier that can now provide 50 to 100 percent of your requirements, but it would not be a smart move to make that supplier a sole source or even to shift all of your volume into China for that category. Lock them in for a portion of your sourcing for the next three or four years. Invest in the right supplier development activity by training them in your way of doing things and your standards. But you have to have other qualified suppliers elsewhere in the world."

Inland Economic Development

The benefits of China's economic boom over the last 20 years have primarily been in the eastern provinces, and especially around port cities such as Shanghai. Until quite recently, the central and more western provinces have been ignored by the government and foreign investors,  causing a much lower standard of living in these areas, as well as a flight of workers to the coastal cities.

A key element of the Chinese government's current economic plan is to bring more development, jobs and prosperity to the inland cities.  The economic development strategy includes investing in infrastructure, providing tax advantages and simply steering foreign investment to these areas.  The benefits can be cheaper land and labor, but the down side is often higher transportation costs and delays in getting goods to consumers or back to the coast for export.

A central element in the government's economic planning for these areas is to create clusters of complementary businesses in specific cities. Such industry clusters are an increasingly popular way for local governments to promote their economies. By targeting specific industries, they can better focus on developing distinctive resources and skills. In the automotive industry, for example, there are more than five such industry clusters scattered around the country, competing with one another for domestic and foreign investment.

For example, Chongqing is a city with nearly 35 million people. It is one of the main hubs for automotive manufacturers and suppliers. Nearby Hubei Province, currently the fourth-largest car production center in China, is home to two key players, Hong Kong-listed Dongfeng Motor Co. (which has joint ventures with Nissan Motor Co., Honda Motor Co. and PSA Peugeot Citroën) and Aeolux Automotive Company. The province's automotive clustering has fostered hundreds of auto parts manufacturers, both local and foreign, in its capital, Wuhan.

"This specialization strategy is driving investment where the government would like it to be," says Bolton. "For example, to cut costs, Unilever recently moved its detergents and personal care products manufacturing center 280 miles west, from Shanghai to Hefei, in Anhui Province."

Taking advantage of the favorable infrastructure and the presence of complementary suppliers and buyers, companies like French auto parts supplier Faurecia and several Japanese suppliers have been expanding their business in Wuhan, building factories and increasing investment. By 2010, Wuhan could produce more than 900,000 vehicles a year.

Bolton provides a word of caution: "Despite the obvious advantages of moving inland, companies should not assume that they will be able to simply pick up their operations on the coast and transplant them elsewhere," he says. "Just because a company has set up operations once in China does not mean that doing so a second time elsewhere in the country will be significantly easier, especially given the significant variations in policies, regulations and efficiency of local governments."

Infrastructure Investment

The economic development trend in the hinterland is highly dependent on building transportation and logistics infrastructure in these areas. Building transportation infrastructure is one of the centerpieces of China's 11th five-year plan (2006-2010), and for good reason.

According to the London-based Drewry Shipping Consultants, China spends about 18.5 percent  of its GDP on logistics as compared to about 10 percent in the U.S. and Europe.

"Inland transport costs to the coast from provinces like Sichuan, for export to overseas markets, are often higher than the maritime transport cost from China to foreign destination ports, while inventory management, trucking and rail transport are currently inefficient," says Philip Damas, Drewry's research director who has presented his findings in a report called Opportunities in China's Container Transport and Logistics Sectors: Fixing the Weak Links of China's Economy.

According to Damas, these issues are critical not only for China's economic planners, but also for importers and manufacturers who need to source goods from the interior provinces where poor transport connections remain a major impediment.

"In some cases, it is a chicken-and-egg situation," says Damas. "Manufacturers are unwilling to move to interior provinces while transport providers lack the scale to lower inland costs. Infrastructure investment is the answer."

The government is expected to spend $20bn on building and upgrading the country's railway system alone, which should dramatically improve the ability to move containers in and out of inland regions from coastal port cities. There is a high priority to make these rail improvements quickly because freight rail capabilities seriously trail the growth of containers moving through the ports, which increased by 22 percent in 2006.

"In fact, only about one percent of containers loaded or discharged at the sea ports of China are carried inland by rail," says Damas. "This number is a much smaller percentage than in the U.S. and Europe."

For the long term, government investment in road improvements will be huge, but these will take time. Over the next 30 years the government is projected to spend  $256.4bn on highways. The largest piece of this investment will expand the country's expressway network to 85,000 kilometers-longer than the U.S. interstate highway system-to connect all cities with a population greater than 200,000.

While infrastructure investment is being made throughout the country, there is the immediate challenge of efficiency and logistics innovation to meet today's service requirements. Third-party logistics providers will clearly play a larger role, according to Accenture's Bolton.

"China's logistics market is one of the largest worldwide, with outsourced logistics services growing as fast as 22 percent a year," he says.

In fact, the Asia-Pacific region, with China in the forefront, will account for a fifth of global spending on 3PL services four years from now. Large multinationals, including Wal-Mart and Caterpillar, increasingly trust their 3PLs to work around the infrastructure and regulatory impediments. While many of these 3PLs are Chinese, all of the leading U.S, and European 3PLs are sharing in this growing market.

"Large companies now entering China want increased control over their supply chain operations," says Chris Woodward, vice president and managing director--China for the Miami-based 3PL Ryder, which has 14 locations across China. "Whether these companies are doing sourcing, manufacturing or distribution, the emphasis is on lifting operational performance to a world-class level, or as close as possible to what they have in the rest of the world." China's logistics and supply chain capabilities are not nearly as robust or mature as other large markets, but it is improving quickly. 3PLs are a key element in this supply chain progress.

Woodward points out that developing supply chains for customers in China is different from how they work with customers elsewhere in one important way. In the U.S. or Europe, companies are constantly refining logistics systems that are already reasonably good. In China, the advances being made begin at a much lower baseline, and the goal usually is not to jump to world-class levels right away, but only to remain cost-competitive.

"Companies here are very cost-conscious, so we need to find the right balance," says Woodward.

A company may be starting with a warehouse that has holes in the walls, no fence, water leakage and other serious problems. Pricing for such buildings is extremely cheap, while the cost for very good warehouses is quite high. Part of the challenge is to determine what level of warehouse is right for the customer's cost and risk sensitivity. Some are willing to pay the premium for an increasing number of world-class warehouse facilities. Others are not, so a 3PL often has to look for a middle ground in warehouse quality.

"Finding this balance requires a lot of local knowledge and people on the ground who know the geography where you are working," says Woodward.

Few 3PLs have made large investments in warehouses and equipment themselves. Just like in other parts of the world, 3PLs in China tend to be asset-light. 3PLs, especially those with forwarding capabilities, will have warehouses of their own near ports, but farther inland space is leased for each specific client.

Domestic Consumption

The Chinese Academy of Social Sciences estimates that the country has an upwardly mobile middle class of nearly 250 million people out of the total population of 1.3 billion. This image-conscious middle class is eager to buy high-end products and services. The consumer electronics market alone has soared by an average of 15 percent per year since 2000 and reached $55bn in 2005. China's 410 million mobile phone users is the largest market in the world. The Chinese auto industry is expected to sell at least 8 million vehicles domestically by 2010 with demand for cars continuing to grow at 10 to 20 percent annually for several years to come. Retail sales in China are going to approach $900bn this year.

Clearly, the Chinese population is eager to buy, and the government wants to encourage this trend, but a major stumbling block has been poor distribution, which adds significantly to the price of goods being sold. For many commodities, logistics costs are 40 percent to 50 percent higher than in the United States, while accounts receivable, a measure of logistics efficiency, often exceeds 90 days.

This inefficiency creates opportunity for 3PLs, according to Ryder's Woodward. As important as China's incredible export growth has been for the logistics industry, the domestic distribution market is becoming just as important.

"The government wants to make the economy less susceptible to global fluctuations," says  Woodward. "The domestic market is where we see a great role for 3PLs. Many of our customers have seen huge growth in their domestic market here, but they find the distribution system so challenging, they come to us to optimize."

For example, Ryder works with a large European white goods manufacturer that is number two in the Chinese market. The company had improved its local manufacturing to its global standards, but its logistics processes were far behind acceptable levels. Ryder did a detailed network analysis, learned about their customer demands and business processes and reduced the network of 18 warehouses down to 11 or 12.

"We streamlined their transportation operations as well," says Woodward. "They now have a much more sophisticated inventory and warehouse visibility capability that gives them a competitive advantage."

While most major 3PLs provide similar transportation and logistics services, Woodward says that Ryder has found a special value-added service in its design and engineering capabilities. "Historically, most 3PLs have been forwarding focused," he says. "No one really focused on network planning, warehouse layout and other industrial engineering work. Our customers have found great value in these design and engineering capabilities."

The services that Ryder provides include classic distribution of goods from manufacturing locations to retail DCs and on to stores. Woodward says that his company has even been looking at home delivery for some clients. A growing part of the business is developing inbound operations for manufacturers. The lean manufacturing, just-in-time model so common elsewhere in the world for automotive and other industrial products is still just a goal for many Chinese operations.

"Distribution, both inbound and outbound, are great opportunities for us," says Woodward. "Chinese people want the same benefits that consumers around the world enjoy, and that is what 3PLs can help bring to them."