China food scandals: Will the government act against own companies?

Continuing food scandals in China do bring up a question, perhaps far more disturbing. If the government cannot protect babies or its people, how much protection do investors or markets get?

Regulations are usual supposed to protect ordinary citizens. There are regulations for food, professions, workers, products, banking, and most important, regulations for markets. But regulations are tricky things. Too many, and an economy gets bound in red tape. Too few and people start to get hurt. But it is not just the regulations themselves. They do not exist in a vacuum. They are part of a larger infrastructure. Without other laws, good courts, executive enforcement and information, regulations may not work at all. When regulations don’t work, they affect markets—often around the world.  
The Chinese have a problem with milk, actually infant formula. In 2008 Chinese companies were found to be mixing melamine into the formula. Melamine or more precisely melamine formaldehyde is an organic chemical commonly used in plastics, adhesives, countertops, dishware, and laminates. The Chinese companies had a profit motive. By mixing melamine into the milk powder or infant formula, they were able to make the product appear to have higher protein content. Sadly, it had another effect. It killed six babies and afflicted another 300,000 with kidney problems.    
The affect on the Chinese was dramatic. To this day, a food safety issue will create a firestorm of abuse on the internet. There were several prosecutions and two executions. The director of the regulator in charge of assuring food safety, Administration of Quality Supervision, Inspection and Quarantine (AQSIQ), was forced to resign. Chinese leaders vowed to enforce the law and prevent any subsequent lapse in standards. But there was a problem. 
Two of the companies involved in the scandal, Sanlu and Mengniu, are at least partially state-owned. It is always difficult for the state to enforce rules on itself. The issue became apparent when it was revealed that the companies involved in the scandal just recycled the milk rather than destroying it as they had been ordered by the central government. 
They simply flouted the law, because with the conflicts went corruption, so the problems continued. In April of 2011 Mengniu, the country’s largest dairy company, and Changfu, a smaller company, sold products that had excessive levels of flavacin M1, a substance that can cause liver cancer. Later that year in December, other milk products produced by Mengniu made 251 students sick and a batch of their cream was pulled from shelves when it was found to contain “alarming levels” of bacteria. Last June, another dairy, Yili, the largest by revenue and supposedly privately owned, sold baby formula contaminated by mercury. As recently as December 2012, five months ago, Mengniu had to destroy some of its products, because they contained aflatoxin, which can also cause liver damage. 
With the possibility of severe health problems for any baby drinking Chinese made formula, it is hardly surprising that Chinese parents are buying foreign brands. To fill the need they have turned to purchasing products from New Zealand, the world’s largest milk exporter. New Zealand alone produces 60% of the world’s supply of milk powder. New Zealand dairy farmers were able to profit enormously from the lax regulation in China, until they were hit by a drought, the worst in 30 years.
With their main source of infant formula restricted, Chinese parents and importers became more creative. The regulatory problems in China began to affect markets across the world. First it was Hong Kong where people attempting to travel to China with more than the two container limit are subject to arrest. This is difficult to enforce since smuggled cans can fetch premiums of between $35 and $50. 

With such a price differential, exports from Europe became profitable. Major retailers in Germany, Britain and the Netherlands began to ration purchases. As shortages mounted, local parents scrambled to find milk powder and began to stockpile the product. Even with the $80 shipping cost and import restrictions, the demand continued. 
The irony is that several large western companies that manufacture baby formula, like Abbott and Pfizer, also manufacture and sell their products in China. The companies maintain that their Chinese produced products are made to the exact same standards as their formula sold in the US or Europe. But the Chinese have reason to distrust even the western brands produced locally. In fact they distrust anything packaged in China. They are right to do so.
According to a recent report on Chinese television, most of the imported milk powder is fake. According to the reporters from CCTV, a search of several large supermarkets discovered that the majority of milk powder sold was labelled as imported. There are about 100 well-known foreign brands in the world. Of these, only 20 are sold in China. However, the supermarkets all sold over 100 products with foreign names and that many of the labels were falsified.
The CCTV report is no doubt biased. As many western companies in China know, there is always the possibility of brand slander. Luxury brands including Hermès, Hugo Boss and Tommy Hilfiger Chanel, Armani, Christian Dior, Zara and Burberry have been attacked as sub-standard. Coke, Heinz, Procter & Gamble General Mills, Lipton teas, Colgate-Palmolive all have been accused of selling adulterated products.
If regulation doesn’t work, the government can always try a publicity stunt. The Chinese Diary Industry Association recently commissioned a third party testing organization to conduct what it stated was an unbiased test of 25 brands of milk powder sold in Beijing. They tested 13 domestic brands, three foreign brands produced in China and nine imported brands. Predictably, everything produced in China passed with flying colours. 
But all the publicity in the world doesn’t help much when people continue to get sick from eating food in China. Recent problems include water-injected meat, fake beef and mutton made from rat and small mammal meat, excessive levels of hormones and antiviral drugs in chicken meat and thousands of dead pigs dumped in the river. These issues were followed by the usual admonition for “Local governments at all levels should strengthen their organization and leadership, to severely crack down on fake beef and mutton and other illegal and criminal activities.”
But any law or enforcing any law is doomed to fail in any system where information is suppressed and the government tries to regulate itself. The continuing food scandals do bring up another question, perhaps far more disturbing. If the government cannot protect babies, how much protection do investors or markets get?
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)
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