China's Secret Growth Engine

Like a growing number of Chinese manufacturers hit by rising wages, Wang Jianping recently packed up his plant and machinery on China's east coast and headed west, where cheaper labor helps offset rising inflation and withering competition. Unlike most of his rivals, though, Wang didn't stop at China's borders. He pushed as far west as Nigeria, where the shoemaker from Zhejiang—a bustling province of 44 million people—has been doing a robust trade since 2004. "We have a very successful operation," says Wang, whose Hassan Shoe Manufacture Co. exports shoes to more than a hundred countries. "Business has never been better."

Leave it to a Zhejiang native to pioneer outsourcing in a country still known for its limitless supply of peasant labor. When it comes to trailblazing more efficient ways to make money, Zhejiang province has always been ahead of the rest of Chinese business. By the time China was getting comfortable with economic reform in the late 1980s, Zhejiang was investing overseas and trading equity stakes in private companies—albeit underground—unfettered by central government meddling.

Once neglected by the state, Zhejiang is now hailed by economists for its bottom-up model of development and fearless regard for the global economy. It's also being watched as a bellwether for the Chinese economy: in recent months, Zhejiang investors have cashed out of frothy Chinese markets, bought into a record number of Western businesses and moved up the business food chain from making simple goods to providing sophisticated Internet services. In October, one of Zhejiang's former provincial governors, Xi Jingping, was named heir apparent to the national party leadership at the Communist Party Congress. He's encouraging the rest of the country to follow the Zhejiang model.

In fact, Zhejiang is less a preplanned model than an organic byproduct of necessity. Sealed off by an enveloping mountain range to the west and by the East China Sea to the east, the province was written off during the cold war as the front line of an American attack, and thus starved of resources by Beijing. "We had no choice but to turn to private business both here and abroad," says Ma Jinlong, director of the People's Government Economic Research Center in Wenzhou, Zhejiang's commercial capital. "As late as the 1970s, few of the provinces had any good business sense but we've always had it."

While much of the rest of China is still run by state bureaucracies, nearly three quarters of the economic output and more than half of the tax revenue in Zhejiang comes from private enterprise. Small to midsize enterprises dominate, funded by an elaborate underground banking network, with a default rate near zero (borrowers tend not to back out on neighbors). Ironically, the underground banking system has made corporate financing far more open than in other provinces, where loans are typically arranged through opaque state banks.

Zhejiang is still home to the world manufacturing capitals for buttons, socks, dyes and textiles, but now it is also going high tech. While Zhejiang is no Silicon Valley, R&D investment in private industry last year grew by 47 percent over 2005, and the value of high-tech companies as a percentage of total industry increased by 26 percent. Alibaba, the e-commerce company that recently launched a $1.5 billion IPO, was founded in 1999 in Zhejiang.

Zhejiang's lack of centralized meddling has sucked in a fat share of China's wealth. Zhejiang ranks 11th in population among China's 33 provinces, municipalities and autonomous regions, but fourth in total trade. Since 1978 its economy has grown at an annual rate of more than 13 percent, three points higher than the nation as a whole, and it is expected to expand by 14.7 percent this year. According to a recent analysis by the Organization for Economic Co-Operation and Development, bank deposits in Wenzhou have recently swollen with heavy remittances, apparently from locals pulling money out of overheated stock markets in Beijing and Shanghai.

They're also pulling out of Zhejiang, however. Wang Ji, a clothingmaker in Wenzhou, says his profit margin has fallen from 10 percent to zero in the last year, and worries that "if there's no profit soon we'll have to retool our whole line or move it abroad." Faced with rising wage inflation, Zhejiang industrialists are already moving factories to more remote areas like southern Jiangxi and central Sichuan, or overseas to Indonesia, Vietnam, Bangladesh, Africa or Central Asia. Foreign direct investment from Zheijiang has doubled since 2005 to $1 billion, making it the most aggressive investor of any Chinese province. "We've taken the lead in relocating overseas," says Wang. "And wherever Zhejiang goes, the rest of China follows."

Zhejiang entrepreneurs have also been cutting mergers-and-aquisitions deals in the West. While Asia accounts for nearly 40 percent of Zhejiang's outbound investment, Europe and North America follow closely behind with 37 percent and 27 percent, respectively. Last year Hangzhou Machine Tool Group Co. bought a 60 percent share in Germany's aba z&b Schleifmaschinen GmbH, a leading producer of high-tech grinding machines, for an undisclosed sum; like many Zhejiang entrepreneurs, the group hopes to leverage the Western company's R&D back home and abroad. In September last year, a company called Zhejiang Huaye Logistics Co. set up an office in Dubai specifically to identify investment opportunities in the burgeoning Gulf entrepôt.

Zhejiang's success as an outsourcing and M&A center has made it an asset for aspiring politicians. Xi assumed the pole position to succeed party boss Hu Jintao in no small part because of his record as a former Zhejiang governor and his association with the region's grass-roots free-marketeering. A province that once prospered from the state's neglect has now become an officially approved model for how to prosper. And with Xi cheering it on, the signs in Zhejiang point to aggressive westward and foreign expansion.