CIO — The 21st century has been, so far, a prosperous one for China. The country has become enriched by its powerful manufacturing industry, which offers low operational costs and a seemingly unending supply of cheap labor to companies across the U.S. and Europe.

China's industrial complex has made the country the world's second largest exporter, behind Germany, according to China's National Statistics Bureau, and more and more products sold by U.S. retailers are made by Chinese manufacturers. At Wal-Mart, for instance, 70 percent of the commodity goods on its shelves are made in China.

But China's rise to power on the world's trading stage has been dogged by controversy. There are the allegations of unfair labor practices, concerns about piracy, and of course, the product safety recalls. In fact, Chinese suppliers have become infamous in the U.S. for product safety transgressions—from lead-paint Thomas the Tank Engine toys to toxic toothpaste and baby formula.

Such scares have further tarnished China's already dubious reputation in the world and have caused U.S.-based companies, including Wal-Mart and Mattel, to lose confidence in their Chinese suppliers and to hold them to stricter safety and manufacturing standards. (See "Wal-Mart's Green Strategy: Supply Chain Makeover Targets Chinese Manufacturers" for how the world's largest retailers is dealing with its suppliers.)

"China has been damned up and down as the main source of risk when it comes to product quality, to IP infringement, to supplier failure when it comes to product defects," says Noha Tohamy, vice president of research at AMR Research.

As 2008 comes to a close, China's dominance as the world's leading supplier is in question. The factors threatening China's supply chain dynasty, including a worldwide economic recession, volatile energy prices that make shipping products from China expensive, and mistrust of Chinese products, are quickly stacking up like runaway train cars, each pushing the other down a dangerous track.

"It's clear that the Chinese do not have control of their supply chain and neither do we," said Michael D. Watkins, a professor at the IMD Business School in Lausanne and co-founder of Genesis Advisors, in a 2007 Businessweek article. "What we're seeing is the logical conclusion of an effort to drive prices down further. The tainted toothpaste was all about suppliers using cheaper ingredients. Everything in China is about driving down price. And now people have evidence that there's reason to worry."

China Has Caught the U.S.'s Cold

The first and most important factor in China's decline is that the global economy is in full meltdown. In the United States and elsewhere, the consumer spending that drives demand for Chinese products has ground to a halt. As a result, China's once vast network of suppliers has been decimated. A recent article in the Financial Times reports that in China's largest export center, Shenzhen, 682 factories had stopped production or closed this year. Shenzhen has been China's leading export area since 1992.

Chinese consumer electronics manufacturers, which supply the guts of PCs, MP3 players, videogames and smartphones, are also struggling to remain profitable, according to market researcher iSuppli.

The apparel industry is suffering as well. The number of Chinese suppliers actively serving the U.S. market dropped more than 70 percent in just three months—from 22,099 suppliers in July to 6,262 suppliers in October, according to the most recent supply chain data from Panjiva, which tracks the relative health of 400,000 suppliers in 140 countries.

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