With its booming economy, huge manufacturing base, enormous supply of natural resources, and expanding consumer spending, it's no surprise that China is high on the agenda for businesses around the world. More than 90 percent of multinational companies say that China is important to their global strategies, with 52 percent calling it critical, according to Mercer Management Consulting.

One indicator of China's economic expansion is its gross domestic product (GDP), which is growing at a staggering rate and has averaged around 9 percent annual growth for more than a decade. But along with the opportunities from doing business in China come risks. 

China Sourcing and Supply Chains

The No. 1 reason cited by companies for doing business in China is to produce goods to sell into the China market. The promise of low-cost manufacturing remains one of the primary reasons companies look to China as a sourcing base. Although other countries have lower labor costs than China, they cannot match it for overall manufacturing costs because they generally lack the infrastructure, have higher cost and fewer available raw materials, impose regulatory tariffs, have poor speed in shipping, and so on. Over the past 20 years, China's rapid manufacturing development has earned it the moniker "the factory of the world." And as China tries to move in an equally grand fashion toward becoming a base of the global knowledge industry, it is developing a work force with more technical skills.

Another change that has developed in companies' China strategies over time is an increased focus on serving not only export markets, but also the country's domestic market. Many upstream suppliers to industry have moved operations to China to be closer to their downstream customers, such as in the electronics and textile sectors. The No.1 reason cited by European Union (EU) firms for doing business in China was to produce goods for Chinese markets, according to a recent survey by the European Union Chamber of Commerce in China. In a similar survey conducted of U.S. companies by the US-China Business Council (USCBC), 57 percent of respondents said their main objective in China was to access or serve the China market.

Logistics Bottlenecks

Whatever a firm's objectives in China, logistics operations within the supply chain can make or break its business. Although the situation is getting better, enormous inefficiency still exists in China's logistics, evidenced by the fact that logistics in China account for about 10 percent or more of a product's retail value, compared to only about 3 percent in the United States.

The development of logistics in China has been held back by a number of factors. At one level, the poor national logistics situation reflects a history of fragmented markets with much local self-sufficiency. Added to that, the government's authority and policy on transportation development and oversight have been split between various ministries, creating a patchwork infrastructure. Chinese firms have relied on their own transportation assets and have, thus, been slow to accept third-party logistics providers. Finally, until quite recently, foreign third-party logistics firms have been excluded from domestic logistics.

Third-party logistics providers, whether domestic or international, currently cite two major obstacles to their growth: excessive regulation, such as the need for cross-province operating licenses, which hinders the provision of nationwide logistics solutions; and a shortage of managerial talent.

Despite much progress, Chinese domestic logistics remain far more challenging than export-oriented, cross-border logistics.

The Chinese government is pushing to create positive change in the logistics arena. For example, foreign logistics companies are now allowed to establish wholly owned subsidiaries in China. Such companies are able to serve multinational manufacturers striving to build integrated national sales networks across China. The completion of China's superhighway system is one indication of the government's drive to develop key infrastructure that will, among other things, assist in opening up the country's interior, which has lagged the coastal provinces in terms of development.

Despite much progress, however, domestic logistics remain far more challenging than export-oriented, cross-border logistics. Among the problems that remain to be tackled are a lack of industry specialization and technological know-how among Chinese logistics providers, the need to streamline customs systems, and illegal road tolls and other charges at the local level that can increase costs.

Product Safety

Sixty-three percent of all product recalls of imported goods resulted from products made in China, reports the U.S. Consumer Product Safety Commission.Product safety is now one of the most prominent sourcing risks resulting from manufacturing in China, and it poses a significant risk to any company's brand and reputation. According to the U.S. Consumer Product Safety Commission, 63 percent of all product recalls of imported goods resulted from products made in China. Likewise, the European Commission reported that of all product-recall notifications submitted in 2005, more than 50 percent originated in Asia, with most of those from China. And for companies serving China's domestic market, new laws have come into effect aimed at protecting consumers.

Some companies have responded to product-safety concerns by insisting their Chinese facilities and suppliers manufacture according to the same standards in place in North America or the European Union. Even in those cases, it is important for companies to understand how to plan for and resolve potential product-safety crises that may arise from their Chinese operations. 

Among the steps companies can take to reduce the likelihood and severity of major product-safety events from their China operations are to:

• Establish a management system for product safety and products liability;
• Analyze product-risk exposures and design and implement product-recall plans;
• Investigate availability and pricing of products liability insurance;
• Develop the capability to track and trace products from manufacture all the way through to delivery to the end consumer;
• Enhance contractual protections with suppliers, vendors, and customers;
• Audit supply-chain production quality; and
• Understand how to comply with the variety of local, national, and international regulations, treaties, and laws.

 Managing China Sourcing Risks

It's important to note that the cost savings China sourcing will deliver are rarely as large as first imagined. A critical early step in China sourcing, then, is to go beyond the initial request for a quote from a Chinese supplier and determine the true costs and risks. For example, while a sample product provided by a potential supplier might meet a firm's specifications, subsequent shipments may not. Thus, there is a cost-not always apparent at first-in monitoring production and shipments on the ground in China.

Difficult challenges arise with shipments made within China, particularly to the interior regions. Foreign third-party logistics providers find it hard to establish a domestic network, while the Chinese logistics firms tend to be subscale and unsophisticated in terms of their ability to provide time-definite delivery or transparent tracking.

When working with China-based suppliers-or suppliers anywhere in Asia-a company should ask itself certain questions upfront:

• Do your China-based suppliers perceive supply-chain risks the same way you do?
• How might the risks your suppliers face affect your business?
• How prepared are your suppliers to control the risks in order to ensure your supply-chain integrity?

 Disaster Preparedness

There's also a greatly heightened risk of supply-chain interruption from natural disasters in China. Asia as a region suffers significantly in terms of the frequency and severity of natural disasters such as floods, tsunamis, typhoons, and earthquakes.

A recent Marsh survey of Asian suppliers of European companies indicates that many of them are not fully prepared to manage the risks from natural disasters. Only 28 percent of the survey respondents said they were fully prepared for-and could maintain business as usual in the event of-a natural disaster affecting one of their key facilities or suppliers. More than half said that they have some contingency arrangements in place, but that operations and suppliers would suffer significant delays if a natural catastrophe hit. And 20 percent of those surveyed said they had no contingency plans at all.

Although there are many potential rewards to sourcing in China, a company that simply reacts to sourcing and supply-chain difficulties when they happen-without having a plan in place in advance-is likely to suffer unpleasant consequences.

The full report, Understanding China's Business Risk Environment, is available for download at http://www.marsh.com.

Tom Walsh is a senior writer/editor at Marsh who works with colleagues across the company and with others from Kroll and Mercer to develop thought leadership reports around key issues affecting organizations today.