China's baby food sector fed with harsher regulations

31 July 2014

Estella Tsai

Baby food, particularly infant formula, has been an increasing concern and heated topic in China since the 2008 infant formula scandal caused by Sanlu, a Chinese-foreign dairy products company, who tainted its products with illegal additives which caused illness in over a thousand infants and the death of two babies.

In response, the Chinese regulators have been working hard in the past five years to strengthen food regulations particularly in the sector of infant formula as well as nutritional additives.

As an immediate result of the Sanlu incident foreign infant formula brands benefited from that scandal by gaining substantially larger market shares.  The Chinese consumer confidence in domestic infant formula brands plummeted to zero and much preferred foreign alternatives; many young parents in China still prefer to source infant formula directly from overseas.

The Chinese government further reacted after the Sanlu scandal by strengthening enforcement of rules – governmental bodies including the Food and Drug Safety Administration, the Ministry of Industry and Information Technology, the Administration of Quality, Inspection and Quarantine ("AQISQ") and the Administration of Industry and Commerce ("AIC") carried out extensive food safety track surveys, random inspections and investigations of infant formula producers nationwide and a number of Chinese domestic brands turned out to have similar quality and safety issues as Sanlu.  Domestically produced infant formula became practically unsellable.

Baby milk powder became one of the most popular purchase for Chinese tourists overseas causing stock shortages.  Hong Kong even made the export of more than the permitted two canisters of infant formula a criminal offense.  Most of these purchases ended up as parallel imports on the internet, and sold very well even though they were sold for three to four times the retail price in the countries of origin.

Since 2013 the Chinese government has moved their focus from domestic to imported brands.  Partly to restore consumer confidence in Chinese products, the Chinese government carried out investigations of foreign brands, imposed purchase restrictions overseas and cracked down on parallel imports.

In the past two years the Chinese government has been looking into two aspects - food safety and unfair competition.  A provincial AIC investigation in 2013 looked at a number of foreign baby food and dairy brands which were alleged to have been provided with tainted raw materials by Fonterra, a New Zealand dairy products supplier.  Chinese distributors of these brands as well as supermarkets were also included in the investigations.

Since 2013 Chinese regulators have tightened the rules applicable to the overseas production and importation of infant formula and have banned the widely popular OEM models for infant food production.  In an OEM model a company, the commissioner, engages a manufacturer to produce usually customised products which will be supplied only under the commissioner’s names or marks instead of the manufacturer’s name.  Before the ban many foreign brands engaged local Chinese manufacturers to produce infant formula products for them while they retailed the products under their own brands.  It remains uncertain if Chinese infant formula brands can use the OEM model engaging overseas producers and regulations to ban this are expected to be issued.

In January 2013, the AQSIQ also issued the Imported and Exported Dairy Products Measures tightening the administration on the import of dairy products (including infant formula).  These measures require overseas producers and importers to complete conditional registration in China before they are qualified to import infant formula into China, prohibit bulk import of infant formula for repacking in China and require that Chinese marks and instructions are printed on the packaging of imported food products before customs clearance in China.  The bans on OEM models and bulk importation limit the options to invest in the infant formula sector, force foreign brands to change their models to self-produce the infant formula (including gain shareholding in infant formula producers) or import the canisters directly suitable for retail in China.  This may lead foreign players to restructure their investment strategy, recalculate their budget and recheck their compliance.

About the same time, the National Development and Reform Commission started to investigate alleged price fixing and unfair competition practices by infant formula producers, particularly foreign players.  In addition to the potentially substantial fines, reputational risks had to be managed and this may have, to an extent, damaged the 'clean and healthy' image of imported infant formula products.

The focus of dairy producers in China is now very much on a broad understanding of regulatory compliance.  Beyond this sector, however, the lesson to learn from this episode for foreign companies operating in China is applicable to many, if not all industry sectors: weak domestic compliance does not mean lower risk as a scandal and subsequent political reaction may result in a swift and unpredictable crackdown which can hit foreign businesses as much as domestic ones.

Authors

Estella Tsai

Estella Tsai

Associate
China and Hong Kong

Call me on: +86 21 2312 1288