Rising Wages Rattle Chinas Small Manufacturers-Texglobe

The effects of China's rising wages and stronger currency are rippling through the close-knit group of textile and garment makers in the eastern town of Zhili, and challenging the future of small-business success stories like it around the nation.

"We have to raise prices to cope with higher costs," says Fu Weimin, who runs one of the hundreds of small garment workshops in Zhili, where it seems nearly every business specializes in some part of the production of children's clothing. "Every year salaries go up."

Wages in China have been rising for years, but pressure is now particularly strong as the rebound in the nation's economy runs up against the shrinking supply of younger workers caused by the one-child policy. Big foreign companies have felt the effects, with the local operations of Toyota Motor Corp. and Honda Motor Co. hit by strikes and Hon Hai Precision Industry Co., the world's biggest contract manufacturer of electronics, promising raises of at least 30%.

But the impact could be even more pronounced on China's more than 10 million small businesses, which account for 60% of the economy and 80% of jobs. Many small, light manufacturing businesses crowd together in highly specialized "clusters," particularly here in Zhejiang province on the eastern coast.

Huzhou, just down the road from Zhili, is noted for its bamboo products. The city of Wenzhou is famous for manufacturing a large share of the world's supply of cigarette lighters. What they all have in common is a reliance on the low-cost labor that is in increasingly short supply.

"The cluster-based model is labor-intensive. The real question is whether it can survive in the new environment of labor scarcity and higher labor costs," says Zhang Xiaobo, an economist at the International Food Policy Research Institute in Washington, who has researched the effect of clusters on rural development. "Right now is a critical transitional period. Some clusters will survive, some will collapse."

Since China relaxed its currency's peg to the dollar in mid-June, there is added uncertainty for those manufacturers who depend on export markets. The yuan is up by 0.75% against the dollar so far this year.

"If the currency appreciates 5% or 10% then we wouldn't be able to do this business anymore," as it would wipe out China's cost advantage, says Cindy Wu, sales manager of Da Wei Zipper Co. Such fears from businesses are a big reason China's government, despite outside pressure, is generally expected to limit the pace of its currency appreciation.

Banding together in clusters has helped Chinese entrepreneurs overcome the hurdles to running a business in a state-dominated economy, says Mr. Zhang, the researcher. Start-up costs are lower, because each business can specialize in just one narrow segment. With production split up among many firms, each one can give credit to its customers and get credit from its suppliers, easing the burden of financing. Buyers like clusters because they can find everything they need in one place.

Zhili??the name could be translated as "Weavertown"??has focused on children's clothes since the late 1980s, when one local factory discovered they were more profitable than pillow covers. Imitators spread quickly, and as the town's reputation grew it attracted more clothing companies. Today Zhili is a sprawl of low-slung buildings, a mix of family businesses in narrow alleys and larger factory complexes.

Li Qiang started out making children's clothes in his native Inner Mongolia, but moved to Zhili 11 years ago. Because traders all know Zhili, he can sell much more than he could back home. Plus, he says, the local government is helpful, and "people here are honest."

"What is holding us back now is finding enough workers," Mr. Li says. With rising material and labor costs eating into margins, he needs to increase his sales volume to keep up profits. But Mr. Li can't find enough skilled labor, even with wages already 40% higher than in other provinces. And it's hard to abandon Zhili's network and relocate to a cheaper province, a move that would require a big investment.

To cope with the shortage of younger workers, many of Zhili's factories now recruit married couples in their 30s. Lin Yunjiang, general manager of Haodeli Garment Co., says almost all of his 240 workers are married couples. He has converted his employee housing from single-sex dormitories to individual apartments for couples.

Other entrepreneurs are trying to break out of the dependence on low-cost labor by investing more in capital equipment. "I figured out that a company's competitive advantage is in its technology," says Ye Ahua, who founded Bestex Textile Co. six years ago with his sons. He says he invested more than 20 million yuan in equipment for producing high-quality cotton cloth, when most local garment factories invest less than half a million. As a result, the factory needs only 70 workers.

For more entrepreneurs to follow in his footsteps they will need better access to financing than they have gotten from China's banking system, which favors big state-owned corporations. The government has promised to improve things, and says loans to small businesses are now growing faster than those to big ones.