In the wake of product recalls last year, many rushed to China’s defense by claiming that low prices were to blame and that importers had been pressuring manufacturers into making products for no profit. This claim—that factories were poor and pitiable—did not square with my own observations of China’s manufacturing sector. For years, I had watched as manufacturers built fantastic capacity expansions—the owners of these factories personally transformed by sudden wealth. China was in the midst of the greatest economic boom in world history, as anyone knew, and although it could have been argued that certain factories prospered while others perhaps did not, this possibility also did not ring true. What seemed more likely was that factories were choosing to enter into business arrangements in which they earned zero profit—and that somehow this strategy proved economically efficient.

Profit zero scenarios are a product of Chinese business history. Back when state-owned factories acted in place of a social welfare program, manufacturing’s primary goal was not profitability, but job creation. Throughout the 1980s and into the 1990s, when the planned economy failed to stimulate enough job growth to approach full employment, the Communist Party looked to private industry, and entrepreneurs who could put people to work garnered a degree of political clout with government officials. Profitability was important, but it took a back seat to the achievement of political aims. Manufacturers consequently found themselves motivated to sign cross-border agreements with foreign companies. 

While one benefit was the acquisition of new technologies, even more important was the opportunity to learn how business was done in a market-driven economy. It was in this environment that Chinese companies willingly gave up short-term profit opportunities. Some manufacturers viewed their first big contracts the way a college graduate looks at an unpaid internship—a sacrifice made with the understanding that it would pay off later. Labor in China was already cheap, and factories willing to forgo a profit margin made themselves even more attractive. With prices held artificially low, importers rushed into the market. 

Manufacturing in China was not without risks, though, and in a market not closely regulated by authorities one of the major challenges importers faced was counterfeiting. In one pervasive example, a factory might accept an order for 500,000 pieces, but then continue producing a total of 700,000 pieces. The half-million pieces would be offered to the importer at cost, and the surplus would then be sold through backchannels at a markup. Some importers marked up their products five to 10 times cost. Fighting with an importer for a 10% profit margin made little sense if a factory could backdoor the product—or an “inspired” version of it—for a markup of 100% to 300%. Intense competition was a driving force, and it made a difference that should a manufacturer attempt to work out a profit margin, its competitors might offer to produce at cost and take the business away.

The factory that manufactured a shirt for $5 willingly sold it to the importer at cost, even knowing that the importer was selling it for as much as $25 or $35. Manufacturers understood the game. There was an element of risk in trying to squeeze a margin out of a large importer, and it was an especially unwise thing to do from an economic standpoint if that customer had a product that was unique. 

Many of China’s export industries were style-driven: garments, shoes, home furnishings, lighting, accessories, toys. For a major importer to succeed, it needed low prices. More importantly, it needed to know that its products could move quickly from the drawing table to the store shelf. China won many manufacturing contracts not simply because prices were low, but also because lead times were short. Importers, who often suspected that suppliers were engaging in some form of counterfeiting, were willing to tolerate a degree of it in exchange for manufacturing efficiency.

Manufacturers would often seek to avoid upsetting customers who provided them with original product designs by keeping knockoffs out of those markets where the customer operated. Large importers had less to worry about anyway, since they operated within primary markets where their intellectual-property rights were protected. Trademarks and patents in many secondary markets, however, were another matter. China was at an international crossroads of sorts, attracting importers from both kinds of markets. For many, the answer was to take products created in the “first market” and sell them into the “second market.”

First market importers invested in designs, knowing that intellectual property was protected at home. These companies did not care whether products were finding their way to second market economies, mostly because there was no hope in capturing sales in these economies. And, so, products created in the United States went through the back door and turned up in the Middle East, Latin America, Russia, points throughout Asia and elsewhere. The second market was a huge part of the global economy and existed even within portions of the first market. Bootleggers in the U.S., for example, succeeded in finding and importing products made in China for legitimate U.S. companies.

Thousands of manufacturing agents appeared on the scene almost overnight and helped move first market products into the second market. The Canton Fair, which had been around for decades, saw a proliferation of exhibitors. Meanwhile, a similar phenomenon was taking place at the commodities exchange at Yiwu City. Both marketplaces were known as special outlets for knock-offs, even as Chinese authorities heavily promoted them. It was never the first market customer who sourced products out of these increasingly popular venues, but instead a “One-Container Charlie”—a trader who stretched his resources just to fill a single ocean-going container once every few months.

Volumes in the second market were typically modest, but margins were often wide. In the first market, products tended to move straight from the factory floor right into the big-box retailer’s supply chain. In the second market, products had to pass through  layers of distribution, which meant increased costs. An item that retailed for $1 in America, often sold for $2 or $3 in less-developed countries. For the second market importer, this spelled opportunity. Somewhat telling perhaps was that importers in the U.S. were moving China-made goods to Latin America by shipping them first into warehouses located in Miami and Los Angeles.

Many Chinese manufacturers had customers in both first and second markets. At one factory, a single first-market customer might account for one half of the factory’s production volume. The other half was likely to be made up of 50 smaller customers, mostly from the second market. Most of the factory’s profit margin would derive from the company’s smaller customers. The factory hardly minded the extra effort that so many small customers required. In fact, small customers were the factory’s bread and butter. 

Americans understood bilateral trade issues, but they often failed to take in the bigger picture. The U.S. accounted for only one-fifth of China exports, and it comprised an even smaller portion of profitability. In the eyes of many manufacturers, America’s primary role has been to provide China with the means for creating business opportunities elsewhere.

There were other reasons a manufacturer would sign up for profit zero, one of which was raising its profile. Working with Wal-Mart, for example, has rarely been a profit-generating opportunity since it is a discount retailer, but Wal-Mart’s reputation for factory inspections is so strong that other buyers are willing to pay a premium to work with a supplier that has been pre-approved by the retail giant. Wal-Mart’s significance for China has often been misplaced as it accounts for roughly 2% of exports to the U.S. Its real value is in providing factories with a reputation that can then be commoditized.

Of course the opportunity for profit zero would not have been made possible without help from the banking sector. Chinese banks loaned money to manufacturers for years without pressuring them to make payment, and, while foreign economists suggested that nonperforming loans would cripple the economy, China ultimately proved the value of a profit-zero strategy. Some of the bad lending that went on was occasionally the result of corruption, but the average loan made to a manufacturer was legitimate. Industry in China has long been in the habit of building production capacity well in advance of any actual need. Importers hesitated to place orders unless they saw a factory that at least on the surface looked capable. Manufacturers and bankers understood that a shining new factory was like a billboard. In most economies, an entrepreneur must prove a need for a capacity expansion before money is lent.

Rising prices have not only to do with macroeconomic factors, and importers have been reporting their suppliers are less interested in providing favorable terms. It’s not rising prices that cause stress for first market importers as much as it is the change in attitude of many suppliers. The factory owner today has almost everything that he needs. He has acquired technology, he’s built his reputation, he knows more about design, and the factory’s base of low-volume, high-margin customers has grown to the point where it provides economies of scale. The factory owner who was once willing to do anything to hook that first big deal is now folding his arms and suggesting to the importer who brought him his first big piece of business that he isn’t very much interested in working together. The importer who was once fawned over has been reduced to begging to have product made, and it is only after the business appears nearly wiped out that the factory owner begrudgingly agrees to fill its large but unprofitable orders. It is not out of sympathy for the importer, however, that this is being done. The manufacturer has his eyes on another opportunity: the promise of a third market—China’s domestic economy.

While the domestic economy lay at the manufacturer’s feet, few local operators  found profit potential there. Out of hundreds of thousands of manufacturers, only a handful has managed to find a foothold, though the ones that have are considered veritable heroes by a public that believes these companies are succeeding in building out the local economy. The problem for exporters who like to turn inwards is that the domestic economy was different. Especially in the design sectors, there were numerous niches to be found globally. A shoe that sold well in Moscow might fall flat in Memphis or Milan.

Competition in the domestic market has always been fierce, and in any number of areas, it required economies of scale. The factory owner wished that he could raise prices on his larger first market importer, but he needed to retain volume. The factory owner engaged the first market in order to access opportunities in the second market, and he took the two markets collectively as a chance to break into China. Because there was a political premium placed on companies that managed to crack the China market, manufacturers that attempted to do so were willing to make continued sacrifices. 

Before the boom in exports, manufacturers stayed away from the third market, allowing Western companies to move in instead. Foreign companies invested large sums while dreaming of enormous potential, and China benefited as foreign investment accelerated domestic growth. One of the big questions going forward is whether the government will allow foreign companies to compete unfettered, or whether they will burden foreign firms with increased taxes, regulation and the unequal enforcement of laws that were meant to apply to foreign and domestic firms in equal measure. China has been more open than either Japan or Korea at comparable stages in economic development—but one has the sense that profit zero will play out on the macro scale, that the day will come when the nation will come to see the work of foreigners as largely done.

U.S. politicians pushed bilateral trade with China expecting that greater economic prosperity in China would lead to increases in political openness, and trade was seen as a way of integrating China more closely into the global economy. Chinese political leaders have viewed international trade differently by seeing exports as a means to an end. China wishes for itself greater levels of self-sufficiency. China may never be able to do away with exports, but the nation looks forward to a day when it will need the world a bit less.

Mr. Midler is a principal of China Advantage, a professional services firm that assists foreign companies in China.