Beijing seems perpetually unable to see how the market can make dairy safer.
At about this time six years ago, thousands of Chinese babies were falling ill and several were dying after consuming milk powder tainted with an industrial chemical. Recent weeks have seen further advances in Beijing’s ongoing effort to clean up a dairy industry whose faults were laid bare by that 2008 scandal. Don’t expect those governmental exertions to work as advertised.
Those infants were sickened, and in six cases killed, by melamine, a component in plastics that had been added to milk powder to trick quality tests into showing higher protein levels than the powder contained. The conventional wisdom holds that this happened because China’s dairy industry was highly fragmented. Financially strapped small farmers and middlemen supposedly conspired to cheat dairies with watered-down, chemical-laden milk, and the dairies weren’t able to discover the fraud because their quality controls were too easily fooled.
Beijing has responded to this scandal the way it responds to most economic challenges: by going big. The State Council recently released a new roadmap for the industry that focuses on consolidation, with a goal of forming 10 large milk-powder companies by the end of this year, and shrinking that further down to five by 2018. The theory is that massive scale, combined with vertical integration, will make quality and safety control easier to enforce.
Some of China’s new wave of big dairy firms are starting to list shares, including China Shengmu Organic Milk as early as this week in Hong Kong, saying they will use the proceeds to beef up their networks of dairy farms in China. Others are accepting private-equity investment for much the same reason; Jack Ma of Alibaba fame became one such investor when his PE firm Yunfeng Capital poured around 2 billion yuan ($322 million) into a unit of Inner Mongolia Yili last month.
In another classic China Inc. move, these newly enlarged dairy companies are going on overseas sprees. China’s Bright Food in May bought a 56% stake in Tnuva, one of Israel’s best-known dairy companies. Analysts hype the technology-transfer aspect of this deal. The Israelis will enlighten their Chinese bosses about safety best practices. Chinese baby-formula manufacturer Synutra, meanwhile, is investing €90 million ($122 million) in building a new dairy factory in Brittany in France from which it will export back to China.
This all sounds great, if you believe that a fragmented production system alone was responsible for the 2008 disaster and others. But plenty of other countries have fragmented dairy industries. None of those markets has experienced in living memory a safety scandal of the type and degree that afflicts China so frequently.
China’s failure lies not in the structure of its dairy industry but in the structure of its economy. Remember that Sanlu, the company at the heart of the 2008 scandal, was not a small family farm. It was one of the largest dairy companies in China, part-owned by New Zealand’s Fonterra, and its milk-powder brand was among the most popular.
That contamination incident happened partly because China’s safety regulatory apparatus remains weak and its unfree press can’t serve as a watchdog. Rule of law is too erratic—to put it kindly—to function as an effective check on bad behavior.
Contra the conventional wisdom about the ills of small farms, Sanlu’s size arguably exacerbated the problem. The company was owned by its local government, and had acquired a Communist Party secretary, as Chinese companies generally do. Whereas at other times this allowed the party to control politically sensitive price increases and the like, in the melamine case it allowed the party to conceal the contamination and avoid a general recall until after the 2008 Olympics.
If Beijing were serious about cleaning up its dairy industry it would hasten China’s transition to a market economy. Instead, Beijing is creating more Sanlus. Large firms fostered, if not outright owned, by the government may in theory make the companies easier for regulators to monitor, but Sanlu was such a company and turned out to be easier to manipulate for other ends, too.
Meanwhile, Beijing continues to evince ambivalence when it comes to the quickest and easiest way to import foreign safety know-how—importing foreign milk products. In recent years, the authorities have by turns hounded foreign milk-powder producers on spurious price-fixing charges and subjected them to burdensome registration requirements. Many have been deterred from further investing in Chinese dairies by a prohibition on majority ownership and the resulting lack of control.
A modern Chinese dairy industry might feature more large companies than have previously existed, or it might not. China has made some progress in allowing the market to decide. Witness a major cull of the cattle herd last year as economic factors such as falling milk prices and rising beef prices induced many marginal farmers to slaughter their cattle and exit the business. China’s food-safety regulators slowly but surely grow more astute.
But Beijing’s attempt to stage-manage the dairy industry’s development will short-circuit market responses. It is an old-style solution to a problem that was caused by the old style. Whatever other grand economic reforms President Xi Jinping promises, don’t expect consumers to trust Chinese milk any time soon.
Source: WSJ