Hong Kong has had enough of mainland mothers emptying the region's shelves of imported baby formula. The government there will fine people up to US$64,000 and potentially throw them in jail for up to two years if they're caught carrying too much powder over the border into Shenzhen.
China is fed up with it too and wants mainlanders to start buying domestic dairy brands again after five years of scandals in the industry – some of them deadly.
That's why Beijing will offer five major dairy companies loans, subsidies and tax preferences worth nearly US$5 billion in support of consolidation throughout the sector. The government hopes the funds, which will come over a number of years, will help wean mainland parents off of foreign producers.
However, bigger, more powerful Chinese dairy enterprises won't necessarily produce safer milk. The fortunate recipients of this bout of government charity will need to do more than simply acquire market share if they want to win back consumers. That lofty goal will take time.
And the winners are...
The two largest companies expected to walk away with massive state subsidies are the very same ones that cast a huge shadow over China's dairy industry.
High levels of the chemical melamine found in Sanlu Group's baby formula in mid-2008 caused the death of six infants and made more than 100,000 seriously ill. The chemical was also found in China Mengniu and Inner Mongolia Yili Group's products. Ever since then Chinese consumers have stocked up on foreign baby milk despite the huge price premium over local brands.
Again, in late 2011, Mengniu's milk was pulled from the shelves and drained from cartons when aflatoxin, a cancer-causing agent, was found in products. Yili fell under the spotlight in June last year when it recalled baby formula with high levels of mercury.
Feihe International, Heilongjiang Wondersun Dairy and Treasure of Plateau, all of which have felt Chinese consumers' distrust ripple through revenues, will receive funds alongside the two industry leaders. Notably left off the list were New York-listed Synutra International and Zhejiang Beingmate. Both are major industry players but have been overlooked due to the level of foreign investment in the firms, according to insiders.
Foreign cows
International dairy brands have been on the offensive in China as of late.
After the National Development and Reform Commission, the country’s main price-setting body, accused France's Danone and Switzerland's Nestle of price fixing earlier this year, both brands agreed to slash prices. That will actually lead to lower prices and could hurt the competitiveness of domestic firms further. The intense scrutiny of multinationals hasn't stopped there.
On Monday, state-backed television CCTV said Dumex, a baby formula brand owned by Danone, handed out more than US$81,600 in bribes in April alone to doctors that recommended the product. This reinforced a similar report aired last week and complements months of similar attacks on the firm.
New Zealand's Fonterra, the world's biggest dairy exporter, had a safety scare of its own in August. Products were temporarily banned in China after tests revealed bacteria that cause botulism in its whey products.
If it's any indication of the strength of foreign dairy brands in China, Fonterra said this week that it was undeterred by the issue and would go ahead with plans to brand its own products in the mainland, adding to pressure on local producers.
More trouble
Boosting the size of China's dairy companies could help them compete with foreign brands on price. Mergers and acquisitions with smaller companies will increase companies' milk sourcing, lower costs and rapidly give the brands larger market share in the country.
Size, though, hasn't been the issue for China's dairy industry. By itself, consolidation won't bring reassurance to Chinese consumers still wary of Mengniu and Yili products. In fact, if the bigger players are unable to implement rigorous quality controls over their acquisitions, the industry could increase the risk of future safety scandals.
“Their expansion may bring more troubles rather than opportunities to the big five,” said Sun Xi, an analyst at Singapore-based consultancy Sustainalytics.
Stalling innovation
Reputation building will take a long time for the scandal-ridden brands, said Tracy Dan, a food and beverage analyst at investment firm First Shanghai. Consolidation in the industry could be a step in the right direction but even a good performance by the brands in the short term may never really back the trust of Chinese consumers.
Those five companies will need to use the special treatment to do more than just buyout the sector, Dan said. Competing with foreign brands will require innovation, not just bigger companies.
Unfortunately, heavy government support for favored industries in China hasn't always led to healthier business. The subsidies the solar power sector has received over the past four years created a supply glut and drove profits to the floor. State sponsorship has been known to wall productive companies out of key sectors while well-connected firms thrive regardless of their competitiveness.
The massive subsidies to dairy industry, Sun noted, could even hurt innovation. “In long run, [free competition] may be more sustainable than such administrative measure, which may create companies’ dependence on government support and discourage their real innovation.”
Given the track record of the current market leaders, maintaining the status quo in this industry is a dangerous prospect.
