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THEY MAY not know it yet, but soon most companies in Scotland will need a China strategy of some sort. Already Scotland's manufacturing sector, like that of the EU and the US, has largely migrated to the Middle Kingdom. From cheap toys and sporting goods, to shoes and clothing to electronic components, China has been the place to make things. Low wages, relative indifference to the niceties of planning or the environment, plus government export subsidies have given China manufacturing muscle never seen before. As of late 2007, however, with the transformative event of the Beijing Olympics in view, what the former Scottish Executive called "the China Challenge" has suddenly and drastically changed.

The global coming-out party of the summer games has increased the strain on the Chinese to maintain social stability in the face of massive disparities in wealth. Once that controversial landmark has passed, we can expect to see cracks appear in the infrastructures and systems that have supported business growth so far.

A dramatically strengthening currency has made China not much less than 15% more expensive to operate in than it was five months previously. Business taxes have increased and export subsidies have been reduced or eliminated. Complex new labour laws have removed what was euphemistically called "labour flexibility", making it expensive and difficult to "scale" (ie sack) workers. Better local conditions in China's interior means that fewer people are prepared to move to the better-established coastal areas to find work. This has seen existing businesses shelving expansion plans on the mainland and going elsewhere.

Scottish companies should now be asking themselves serious questions about whether China is really the place to procure products and help them to stay competitive. My advice to them is simple; be sure of your market research, and ensure you have validated your value proposition. If you still think there is a market, be aware that it is significantly more expensive to penetrate than before. I myself am planning a major re-organisation of my own company's activity in China based on a sudden proliferation of these game-changing factors.

Not that China has ever been trouble-free. The attitude towards portable intellectual property, for instance, has been notoriously cavalier. There are numerous examples of products "walking" out the factory door and being replicated next door or in the neighbouring township at a cheaper price than you can afford to make them. So what should Scottish companies be doing to maintain worldwide competitiveness and protect their intellectual property rights, while reaping the benefits of China's 1.3 billion consumers?

First of all, we should ask why and how, just as we thought we were getting comfortable with the China we believed we knew, the landscape has morphed into something different. The People's Republic has once again changed the rules of the game.

Such changes are a natural function of China's "catching up" and are not entirely unpredictable or undesirable. But the stumbling blocks that remain ahead make the nature and the timing of progress particularly hard to call. For example, the glaring absence of the rule of law in significant areas will eventually slow down investments. Lack of transparency and "special" rules continue to discourage or prevent certain types of investment.

The Beijing government wants to grow past the former model of state-planned, state-managed and state-subsidised companies. It now wants to pass an increasingly greater burden on to foreign entities to pay for its currently unfunded social benefits. Starting with individual "withholding taxes" - personal income tax withheld from employees' pay which is then matched by the employer - introduced in the 1990s. These are added to housing subsidies and healthcare costs, and now the latest labour laws make it difficult and expensive for companies to downsize. The new employment law, "agreed" at last June's National People's Congress, and introduced in January 2008, is designed to offer greater employment security for workers by adding an increasingly onerous burden of severance pay on employers.

Social benefits costs in general have rocketed, both in real terms and as a percentage of base wages. A complex formula, incorporating an annual minimum cost, derived from the average base wage in Shanghai or other such big cities, amounts in effect to a staggering 55% tax burden on companies. As recently as 1998, this cost was only 10%.

By any standards this represents a huge additional cost. Shanghai is now an uncompetitive place to manufacture goods. Minimum costs may seem low at £300 a month, but this is for unskilled labour. A mid-level manager can now cost upwards of £2000 a month, not significantly different from their European equivalents. It seems like the unreformed "iron rice bowl" era, the paternalist-communist era swept hastily aside by the pro-growth Deng Xiaoping - an era of state housing and cradle to grave employment and care - is back with a vengeance. This time the new provision is being paid for by foreign companies.

When China first opened to Western investment in the early 1980s, it was still a net exporter of food and energy. Only a few years ago domestic oil prices were actually 10-20% less than the world average; and energy was readily available. Within two years, the Tarim Basin fields, China's main centre of domestic oil production, have declined dramatically. China has become a significant importer of foreign oil. Already the biggest worldwide producer of cement, beer and steel, it is also the biggest importer of copper, aluminum ingot andcomputer memory chips. Nearly all the manufactured goods exported out of China contain both electrical components (copper) and plastic (oil). The impact of increased import prices is dramatic.

In the 1990s, China's manufacturing exports were primarily assembled from foreign sourced components. Most of the value add came from abroad. To meet demands from foreign buyers for lower prices each year, a migration began around 2000 to locally-sourced materials and components. Six-month long supply chains and increased domestic content have driven up input prices even faster than inflation.

We can anticipate a future scenario of China having to emulate the Japanese manufacturing model: buying commodities on world markets, building world-class, branded products which are also world-competitive. This is not an easy feat as the South Koreans discovered to their cost in the auto sector. They tried to emulate the Japanese model but were never sucessful in raw material procurements, or components sourcing.

TO compete with Japanese manufacturers the Koreans - and now the Chinese - need to price lower than Japanese-sourced products. Failure to do so saw Korean companies lose money on every car they shipped abroad as well as steel and electronics.

Financially the picture is no better. Between November 2007 and April 2008, the Chinese yuan has strengthened by 12% against the pound. Buying locally-sourced wool to make into Scottish tweeds or component parts in high-tech eye-care machinery has become at least 12% more expensive in the last five months. That works out as the equivalent of an annual inflation rate of 29%. Add to that the aforementioned annual upward wage pressure of at least 10% and a six-month supply chain and it's hard to know where to begin to price those China-sourced cashmere scarves for the ladies' department of Jenners.

Finally, while Chinese quality has improved dramatically over the last decade, the recent tainted pet food scandal - where two Chinese companies intentionally exported pet food to the US laced with industrial chemicals - highlighted that consistent, repeatable, arms-length quality is still far from assured. Quality has both a cost and a value - as demonstrated by Canon, the Japanese business machines and cameras multinational. Moving a number of factories out of China and back to Japan, Canon actually increased profits above its increased costs. Consumers are increasingly willing to pay a slightly higher price not to have the words "Made in China" stamped on their products.

Looking beyond the Olympics, China's position as the factory floor of the world is bound to come increasingly under pressure. Its oil and other raw material commodity prices will increase as they catch up to worldwide prices. The Chinese currency is believed to have another 20-30% appreciation still ahead of it.

What happens next? It is possible that low-tech products will migrate to other countries. Japan will re-emerge as a viable alternative. Another attractive model will be production in China through Taiwanese, Korean and Japanese companies. Getting Japanese-level quality, along with the lower labour costs in China is an alternative that many companies in Scotland will find attractive.

Of course, China is not likely to disappear as an attractive proposition for Scottish companies, not while the other main reason for going there - its status as the world's biggest consumer population still exists. And this population is increasingly middle class, and increasingly inclined to buy our products.

What has changed about the China Challenge is that the money in their pockets comes increasingly from those of us who are employing them to make our stuff.

Philip Carmichael is chief operating officer of Fusion Systems Holdings, which employs 100 people in China. He has 32 years' successful experience of living in and working in high-tech Fortune 500 companies there and speaks fluent Mandarin. He is a member of the Globalscot network and sits on the international advisory board of Scottish Enterprise

the lion and the dragon

EVER since Messrs Jardine, Matheson & Co established their opium and silk trading house in Canton in 1832, Scottish companies have played a disproporionately important part in the history of UK-China business links. Even today they have a pivotal role in Hong Kong, a former colony which is now a Chinese special administrative region.

Around 50 Scottish companies operate in China, including RBS, Bank of Scotland, Alliance Trust, Martin Currie, Standard Life, Aberdeen Asset Management, Edrington Group, Clyde Blowers, Howden and Caledonian Alloys. Glasgow's Aggreko has a £17 million contract to help power the 2008 Olympics.

Headed by Dr Mairi Macrae in Beijing, Scottish Development International has four offices in greater China, in Shanghai, Taipei (Taiwan) and the most recent, staffed by Glasgow-born Fiona Donnelly, has opened in Hong Kong.

Scotland's Strategy For A Stronger Engagement With China, published in August 2006, is seen by the former first minister Jack McConnell as one of his significant successes. It identified four key points of entry into China for Scottish companies. They were: micro/opto electronics; energy; financial services and education and life sciences. The SNP-led Scottish government is due to publish a "refreshed" version of the Labour/LibDem strategy, taking into account recent changes.

The first Asian conference of the business network Globalscot takes place in Hong Kong on September 18-19.

how the yuan rules the market

THE rise and rise of the renminbi (aka the yuan) against other major currencies including the pound is an urgent issue for companies using China as a base for exports.

Against the US dollar, the yuan has risen 18% since China abandoned pegging the currency in July 2005, breaching the key psychological level of 7.0 yuan to one dollar on April 10. The dollar has fallen about 4% to the yuan so far this year, after dropping 7% last year.

Firms producing and exporting from China have had to pay more local currency for labour and raw materials, though firms which aim their goods for the huge Chinese domestic market - Scotland's Clyde Blowers, for example - are less affected.

The yuan's rise has been partly permitted to contain inflation. China is the world's largest holder of foreign-exchange reserves at $1.5 trillion. Its central bank has bought foreign currency to stop the yuan from rising too fast. China has also supported the currency against the US dollar, to help curb liquidity inflows through the trade surplus.

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