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China's near-miraculous economic rise has been built on the smarts of men like Cheng Wei-lun and the sweat of the 800 workers he employs as chief executive of the Tianji Wooden Products Co. Based in Guangdong province in southern China, the company, which exports $10 million worth of toys and children's furniture annually, is like thousands of other small manufacturers that help form the backbone of the country's formidable export-manufacturing machine. But that frame is showing cracks, and all the brains and brawn in the world might not be enough rescue Tianji Wooden Products. Cheng's costs have gone up 30% in each of the past two years, but competition is so fierce he can't raise prices. "Our profits are gone," Cheng says. "If something doesn't change in the next few months, I will have to shut the factory."

Something is about to change — but almost certainly for the worse. Higher labor costs, a strengthening Chinese currency and soaring raw-materials prices are bad enough. Now, a slowdown in global growth and a likely full-blown recession in the U.S. are about to stress-test China's manufacturing sector like never before — and could result in the shuttering of thousands of factories and cost hundreds of thousands of workers their jobs. Makers of low-end goods are already suffering. The Guangdong city of Huidong was home to 3,000 shoe factories at the beginning of 2007, but as many as 500 of them have closed over the past 15 months, says Li Peng, secretary of the Asia Footwear Association in Hong Kong. One-sixth of 44,200 textile firms tracked by the China National Textile and Apparel Council lost money last year and two-thirds are just breaking even. "Manufacturers' profits are so low that when they hit the slightest snag, they have to close," says Li.

China's sweatshops have every reason to sweat. America buys about 19% of China's $90 billion in monthly exports. As the U.S. economy began to falter in late 2007, China's torrid export growth rate — for the last several years running at an annual rate of 20% or higher — was showing unmistakable signs of a slowdown. In February, it plummeted to just 6.5%, compared with nearly 20% growth expected by economists. Exporters suffered major disruptions from power outages and transportation delays caused by that month's heavy snowstorms, but sluggish U.S. demand was also to blame. In February, the value of U.S.-bound goods showed a rare year-over-year decline of 5.3%.

Although China is the world's second largest exporter, the country is not as dependant upon overseas trade as some. Exports accounted for 36.8% of China's GDP in 2006, compared with 43.2% in South Korea. But China may be unusually vulnerable to weaker international demand because the country has in recent years built too many new factories. With investment capital readily available and China's economy roaring ahead at double-digit growth rates, heavy industry expanded massively. The value of China's steel exports, for example, jumped tenfold between 2003 and 2007, from $5 billion to $50 billion.

China's central government recognized early on that an investment bubble was likely forming. In 2004, for both economic and environmental reasons, authorities in Beijing began pressuring provincial and local officials to curb spending on aluminum, steel and cement factories; state-owned banks were periodically told to stop lending for industrial projects. But local officials often ignored the stop signs. More factories meant more local jobs and more growth, which made them look good in the eyes of their political superiors. Not only that, local officials, who can seize land and issue permits for new projects, were often silent partners in new manufacturing ventures. Too many factories got built as a result.

This overabundance of production capacity means China's export machine is like a race car with no brakes. As long as the road remains smooth and straight, the car roars ahead. But throw in some potholes and a tight turn, and the wheels come off. Factories have been able to increase output in recent years because the global economy has been on a tear. The 2004-07 period saw the second strongest bout of global growth on record — which translated into strong demand for cheap Chinese-made products. But this era may be ending. Most economists are predicting a significant slowdown in worldwide GDP growth in 2008. This slowdown, predicts Lehman Brothers economist Sun Ming-chun, will prove to be the "unmasking of [manufacturing] overcapacity in China." Says Li of the Asia Footwear Association: "The cake is only so big, and when you have too many people trying to eat it, you will definitely have some go hungry."

Some are already starving. China's competitive advantage has been its armies of cheap workers, but that edge is getting dull. Labor costs have increased 50% in the past four years across southeastern provinces — an area of China sometimes called the "workshop of the world" — and a new labor law passed by Beijing will only add to the burden. Jonathan Anderson, an economist at UBS in Hong Kong, says that factory owners in southern China believe the new law will drive labor costs another 10-25% higher. Among other provisions, the new law entitles laid-off workers to one month of severance pay for every year of employment. "In a case where an export market is going down, if you want to reduce your number of workers, then you face a lot of problems," says Stanley Lau, vice chairman of the Federation of Hong Kong Industries. To lay people off, "you need to pay a huge amount in compensation." Nor is there any relief from surging raw-materials costs. And, slowly but surely, the renminbi, China's currency, continues to strengthen — it's now 12% higher versus the U.S. dollar than it was 18 months ago — making China's exports more expensive worldwide.

A major retrenchment could have serious consequences for China's economy and society. The specter of legions of laid-off migrant workers roaming the streets in search of jobs is bound to keep Beijing's economic policymakers, who fear the political consequences of widespread social unrest, up at night. Sun, the Lehman Brothers economist, says as manufacturers are pushed to the brink, China's stock markets could see sharp declines. Given that many large, listed Chinese companies pad their profits by investing in stocks themselves, "a big correction could bring [corporate earnings] even lower, and a vicious cycle could result," says Sun.

Then there are China's fragile banks, which could be hit by waves of defaulting loans as factories fold. Although Chinese banks during the current boom have been able to reduce their unusually high proportion of nonperforming loans carried on their books, declining corporate earnings will diminish borrowers' ability to repay their debts. While it's difficult to assess the overall exposure of banks to the manufacturing sector, it's easy to imagine lenders getting caught in a Chinese-style credit crisis if manufacturing contracts sharply.

Of course, worst-case scenarios don't always come true. Anderson, the UBS economist, isn't overly pessimistic. But he sees China's export growth rate falling from about 25% a year to single-digits by mid-2008. "2008 will likely be the year manufacturers [are] finally forced to take a general hit on profitability," he says. A soft landing for factories might even be beneficial for the country in the long term, because it would weed out inefficient operators and boost China's productivity. A period of "creative destruction" is an inevitable part of any business cycle. China's economic policymakers can only hope that the creative aspects of the coming shakeout outweigh the destruction.

• Bill Powell