From knockoff bags to knockout brands
By Geoffrey Colvin

(FORTUNE Magazine) – PAULO ZEGNA KNOWS ALL ABOUT product counterfeiting in China, but he was still surprised to see his own name being stolen. He's co-chief of Ermenegildo Zegna Group, the Milan men's fashion house that also manufactures some of the world's best wool cloth, and earlier this year thousands of yards of fabric with the Zegna name woven onto the edge were discovered in southern China--but his company hadn't made it. Zegna cloth had joined the long list of products being faked in China.

A familiar tale but for one unexpected detail: Instead of the low-quality ripoff you'd expect, the cloth was pretty good. Zegna won't say it matched the real thing, but it was good. And why shouldn't it have been? As he noted last month at the FORTUNE Global Forum in Beijing, "The Chinese now buy the same machines as everybody else, they hire the same consultants, they compete with us to buy the same raw wool in Australia." Result: Somewhere in China a company is turning out high-quality woolens worthy of being marketed under its own name, which could presumably be built into a valuable brand, yet the firm chooses to steal someone else's name.

If that sounds crazy to you, you're not alone. It sounds crazy to many Chinese businesspeople too. Despite all we read about China's hundreds of thousands of engineering graduates, the next great phase of business development will center on a very different skill: brand building. And just as with China's earlier ascendancy to become the world leader in low-cost manufacturing, its development as a brand powerhouse may be far stronger and faster than many Western companies are ready for.

As the Chinese realize, brand owners typically collect most of the profit. A pair of Nike running shoes that leaves a factory in China at a cost of $5 may sell in the U.S. for $100, and while Nike doesn't pocket all the difference, it makes way more than the factory owner. The situation is the same in consumer electronics, clothing, toys, and many other industries. Until recently, Chinese firms were happy to cash in on their labor-cost advantage and make more money than they'd ever seen. Now, led by companies like Lenovo (computers), Haier (appliances), TCL (consumer electronics), and others, they're going after the larger sums that flow to brand owners.

Chinese firms don't command any special brand-building talent. There is no analogue to their labor-cost advantage in manufacturing; on the contrary, they must overcome a business culture built in large part on brand piracy. Yet Western companies should fear the potential of Chinese brands. That's partly because Chinese marketers may understand their home turf better than anyone else, a significant edge when that market holds 22% of the world's people. And a Chinese company that builds a powerful brand at home may develop economies of scale and learning-curve advantages that will strengthen it globally. For decades those phenomena helped American companies stay on top. Now, in industries such as cellphones and PCs, where China is already the world's largest market or soon will be, the tables may be turning.

Chinese companies will face obstacles as they develop brands. The greatest is probably the country's image among Western consumers as a land where workers toil in appalling conditions for pennies a day, taking jobs from the rest of us. In a world where buyers care increasingly about the behavior of the companies they buy from, Chinese brand managers will have to confront such issues. Another obstacle may be the Chinese government's own enthusiasm. The State Bureau for Quality and Technological Supervision has established a Chinese Brands Promotion Committee, and a more deadening influence on brand development is hard to imagine.

But such obstacles look surmountable. If they are, then Western companies need to prepare for a new kind of Chinese competition. So far, Chinese companies have revolutionized global business through pure nuts and bolts. Now they're preparing to take a giant step into the ineffable, emotional power of brands. If they can get that right, what they've achieved so far will seem insignificant by comparison.