By Keith Fitz-Gerald

Contributing Editor

On the heels of yet another Mattel Inc. (MAT) recall last week, many investors are wondering if shoddy manufacturing and poor quality control will be China’s undoing.

I don’t think so.

In fact, I’m sure of it.

As a longtime China observer, I can tell you that that this is an important signal that China has arrived and is here to stay as a major power player in global markets.

I also believe it’s truly a silver lining in what appears to be a very cloudy issue at the moment.

Let me explain …

A ‘War’ Declared

On the heels of some very embarrassing product-safety and product-quality recalls, China has “declared war” on product quality. This sounds dramatic, and it is. To understand just how significant this is requires a quick and admittedly simplistic lesson in Asian culture. In Asian countries such as Japan and China, public embarrassment – referred to as “losing face” – is something to be avoided at all costs. It doesn’t matter whether we’re talking about a person, or a group: Having to publicly admit that you’ve erred – “losing face” – is complete and total humiliation.

So when a person, a government department, or the central administration concedes that errors have been made and that it’s “declared war” on these humiliating product-quality problems underscores just how committed China’s government is to fixing this. Indeed, a public commitment like this is typically reserved for politically motivated messages or some other agenda item that the Chinese politburo wants worked into “the system” at all costs.

As you can see, then, this is about as serious a response as China can issue on any matter; and it’s especially telling that they’ve chosen this wording when it comes to product quality and safety.

Why do I say this? If Western consumers are permitted to even think that that the phrase “Made in China” is some kind of joke (remember “Made in Tijuana” back in the late 60s?), a cause for concern, or Consumer Reports code for “avoid this product at all costs,” then the entire Chinese juggernaut would come summarily to a screeching halt – which is the absolute last thing that the world economy needs right now.

Not only would this be bad for workers and consumers all over the world who have come to depend on low-cost Chinese products – in some markets, workers actually owe their entire livelihoods to an economically healthy China – it would prove devastating to China, itself, and just as that country stands at the cusp of the greatest stretch of national wealth creation of any in mankind’s history.

Ideally, the big economic battlewagon, the S.S. China, could single-handedly steam through the subprime-slime blockage, dragging the rest of the world economy along with it.

But a successful blockage – especially one that launches a fusillade of negative-perception salvos – would be devastating, and would essentially enable the subprime-mortgage and credit-crunch assault teams to counterattack, steam right back through our meager central-bank-reinforced financial defenses, and establish a beachhead in our economy that will made D-Day look like an Annette Funicello/Frankie Avalon beach movie.

Needless to say, this would be bad for consumers all over the world who have come to depend on low-cost Chinese products. It would be even worse for workers with a stake in China’s ongoing transformation into a semi-capitalist market. And the short-circuiting of this evolution would be especially devastating to China, which stands at the cusp of the greatest period of wealth-creation in mankind’s history.

Therefore, China’s leaders are pulling out all the stops to preserve – indeed, to bulk up – the cachet of the “Made in China” brand, and to protect their nation’s economy. In doing so, they hope to motivate Chinese companies to take product quality more seriously realizing full well that if they don’t, global consumers will.

To do that, China’s leaders have pledged more than $1 billion to create product safety-and-inspection programs. They’ve also taken the highly unusual step of creating a cabinet-level position for product safety and health. At its head is a woman by the name of Wu Yi who’s known as “China’s Iron Lady.” She’s viewed as China’s top troubleshooter and is regarded as somebody you don’t want mess with or cross in any way.

Vice Premier Yi has been given broad, sweeping mandates to get the situation under control and the power to implement practically any policy changes she wants. Which is exactly what she’s done with a highly innovative 20-point program for manufacturers and vendors that specifies everything from registration requirements, to product-tracking and mandatory inspections – and it must all be completed by the end of 2008.

But it doesn’t stop there. The program also includes a zero tolerance policy for government officials – and this is the interesting part – who fail to do their jobs by providing adequate oversight as part of the program.

You might think this is just a bunch of smoke and 10 years ago I would have agreed you. But times have changed. Madam Yi’s programs already are producing results.

She’s seen to it that legions of inspectors are crawling all over farms, groceries and manufacturing facilities in effort to stem the global glow of everything from fertilize- tainted medication to counterfeit toothpaste to fake Viagra.

China’s regulators say they’ve nailed dozens of unlicensed pharmaceutical makers, toy producers and even criminal networks involved in shoddy manufacturing and exports. As a result, over 400 exporters have been summarily blacklisted and a former food-and-drug safety chief has been executed for taking bribes.

And those are just the things that we know about. As we explained earlier, to keep from “losing face,” China is notoriously secretive when it comes to its own dirty laundry, so I won’t be the least bit surprised when the news finally breaks about just how many people have been prosecuted for attempting to skirt the regulations by using their “guanxi” – the Chinese world that translates roughly to “connections.”

In their attempt to really deal with the issue head on, China is also attacking the problem through innovative public awareness campaigns aimed at China’s average citizens. There’s a special television series called “Believe in Made In China” currently being aired that features interviews with business executives and regulators.

They’ve even gone so far as to attack the problem through taxation. Earlier this summer, for instance, China implemented a VAT reduction on 2,831 export lines representing some 37% of China’s total exports. This has the net effect of squeezing shoddy, labor-intensive companies for who VAT loopholes were not just a tax break, but are often also the entire profit.

They’ve also required importers to pay a 50% deposit on 1,853 raw materials, including metals, textiles and plastics that are used for base-level assembly before being exported as finished products. In a stroke of brilliance that would do any grandstanding politician in this country proud, the deposits are refunded upon export. But the net effect is, once again, to attack the weaker, more-reckless companies through a cash squeeze that they basically can’t meet.

And this is where it gets really interesting when it comes to your money.

China’s Product Push and Your Portfolio

No one action – in isolation – is particularly noteworthy, especially when compared with similar Western business systems. But when viewed in the aggregate, and backed up by high-level action, China’s response to the growing international product-quality concerns is unprecedented for several reasons:

First, China is trying nip in the bud any notion that they’ve fouled up . While the country and its leaders are a little late on that score, rather than hiding behind lawyers as companies here in the United States are wont to do, China has stepped up and admitted it has made mistakes. This is highly unusual in a country where “losing face” is a major deal, and especially because China perceives that it must answer to the court of international opinion on this issue.

. While the country and its leaders are a little late on that score, rather than hiding behind lawyers as companies here in the United States are wont to do, China stepped up and admitted it has made mistakes. This is highly unusual in a country where “losing face” is a major deal, and especially because China perceives that it must answer to the court of international opinion on this issue. Second, by ordering and crafting such a broad-based and intense response, Chinese officials are clearly trying to force China higher in the international value chain without slowing export growth and without negatively impacting product quality . Not only will this help eliminate future product-quality and product-safety concerns – in a perverse, Darwin-like evolution – it unquestionably make the surviving companies even stronger than they are today. The trick, of course, is forecasting which countries will survive and aligning your money accordingly.

. Not only will this help eliminate future product-quality and product-safety concerns – in a perverse, Darwin-like evolution – it unquestionably make the surviving companies even stronger than they are today. The trick, of course, is forecasting which countries will survive and aligning your money accordingly. Third, China is trying to get companies to abandon their instinctive strategy of always offering the lowest-possible prices to attract buyers . While that sounds harsh, it’s really not especially when you consider that Japan, Singapore, Taiwan and other Pacific-Rim countries have all walked the same path within the last 100 years. This will cause companies to tighten up on their production methods and, among other things, eliminate waste which is presently estimated to cannibalize as much as 40% of the bottom line. The bottom line: Chinese companies that service the product quality purge will likely emerge more efficient, more profitable and more competitive on a global basis than they had been before this controversy broke. This will generate top-line and bottom-line growth.

. While that sounds harsh, it’s really not especially when you consider that Japan, Singapore, Taiwan and other Pacific-Rim countries have all walked the same path within the last 100 years. This will cause companies to tighten up on their production methods and, among other things, eliminate waste which is presently estimated to cannibalize as much as 40% of the bottom line. The bottom line: Chinese companies that service the product quality purge will likely emerge more efficient, more profitable and more competitive on a global basis than they had been before this controversy broke. This will generate top-line and bottom-line growth. And finally, by virtue of this experience, China’s officials and company executives and a growing number of executives at last understand that they must step into the global arena before other global companies lock them out of it – which means that they are going to become even more aggressive in the near future than they have been recently.

I hope Western companies and investors are prepared for this powerful transformation, because even if the “made in China” label if of questionable quality right now, it won’t be in the future. And if China’s stocks get hurt as this saga continues to unfold, view it as a buying opportunity. You’ll be glad that you did.