Western firms that flocked to China are now pulling back

The gloomy investment trend was the focus of twin reports this week from the European Union Chamber of Commerce in China and the American Chamber of Commerce in Shanghai.

“The risk of doing business in China has gone up in the past few years and at the same time the market is slowing down," said Eric Zheng, president of the U.S. group. A poll by the U.S. chamber found the percentage of respondents ranking China as their headquarters’ top investment destination fell to the lowest level since the annual survey began 25 years ago.

China has noticed. In August, the Shanghai city government said one of its most pressing economic challenges was the hollowing out of the “fruit chain"—a reference to Apple’s move to diversify production of some electronics to countries such as India and Vietnam.

Driving these decisions are a prolonged economic slump, intensifying local competition, geopolitical tensions and the rise of alternative manufacturing destinations in Asia. Business chambers say profit margins in China no longer outshine other markets.

Last month, Walmart sold an eight-year-old stake it held in one of China’s main e-commerce platforms for $3.6 billion and IBM closed research institutes in China, affecting more than 1,000 jobs.

Carmakers are scaling back because Chinese companies now hold nearly three-fifths of the passenger-car market. As of this summer, most new cars sold are electric vehicles or plug-in hybrids rather than the purely gasoline-powered vehicles in which non-Chinese automakers long held an advantage.

Japan’s Honda Motor recently suspended production at three plants in China and has reduced personnel through voluntary retirements. Honda’s unit sales in China fell 32% to 209,000 in the April-June quarter compared with the same period a year earlier.

Last year, foreign investment into China fell 8% from the previous year in yuan terms. According to United Nations figures, Indonesia, with a far smaller population than China, is drawing more so-called greenfield investment in which facilities are built from the ground up.

To be sure, most companies aren’t abandoning China. The majority are trying to maintain existing operations, with some saying that staying abreast of Chinese technology helps them sharpen their competitive edge. Walmart is expanding the number of its Sam’s Club stores in the country.

In an annual survey by the EU chamber conducted in May, 15% of the respondents said China was their top investment destination. For years, about 20% of the respondents had said so.

In another poll, about 20% of the 306 respondents surveyed by the American chamber in Shanghai said they would be cutting investment in China this year, citing concerns about growth and moves to redirect investments to places such as India and Vietnam.

In mid-August, China’s Commerce Ministry convened a meeting with foreign companies undertaking large investments in the country and promised to address any financing and bureaucratic hurdles they faced in a timely manner. Attendees included representatives of Danish toy maker Lego and pharmaceutical company Moderna.

Shanghai’s economic-planning agency said last month that the decline in foreign investment in Shanghai was partly because of multinational companies such as suppliers to Apple shifting production capacity out, according to The Paper, a news outlet backed by the Shanghai government. Many Apple suppliers such as electronics assembler Quanta have production bases in the city.

Apple’s emphasis on sourcing from India and Vietnam grew after geopolitical tensions and pandemic-era lockdowns in China.

A decade or two ago, multinational companies were flocking to China, lured by its cheap and abundant labor force and the potential buying power of its 1.4 billion people.

Back then, foreign companies sold to a market eager for their products and could charge a premium. Chinese rivals have since improved technology and product offerings. Local competition is intensifying in cars, steel, sportswear and other industries, often accompanied by cutthroat price wars.

Among the worst hit have been foreign automakers. South Korea’s Hyundai sold a factory in 2021 and shut down another the following year. This January, Hyundai sold its third Chinese plant to a local company for more than $227 million. Meanwhile, it is expanding in India.

Even so, for companies with the right product, China is still too big to ignore. In cars, it is the world’s largest market by unit sales.

If domestic demand picks up, China will return to becoming a top investment priority for multinationals again, said Allan Gabor, the chair of the American chamber in Shanghai.

“It’s about the economy. The demand side is the bigger factor. Companies are in China, for China," he said.

Write to Yoko Kubota at yoko.kubota@wsj.com and Liza Lin at liza.lin@wsj.com