Asia Insight

September 2007

Made in China

As more foreign companies shift their production bases to China, the "Made in China" designation has begun to populate product markets around the world. Consumers have enjoyed several benefits from this shift, chief among them lower end prices. However, a number of recent scandals concerning product safety and quality have thrust China-made goods into an unfavorable spotlight. The recent barrage of media coverage regarding pet food tainted with melamine, faulty tires, toothpaste laden with diethylene glycol and toys made with lead-based paint highlight some of the recent issues associated with Chinese exports that have tarnished the image of China-made products. Product recalls by companies such as Menu Foods, Colgate-Palmolive, Gilchrist & Soames and Mattel¹ have led to safety scares among U.S. consumers, further straining the already tense relations between the United States and its second-largest trading partner, China.

Lesser known to many foreigners is that Chinese consumers have long struggled with defective and shoddy products. In 2004, phony infant formula caused the deaths of dozens of infants. In the same year, Chinese officials found a factory was using paraffin to make bean vermicelli. In 2006, a flawed antibiotic caused at least six deaths. Late in 2006, Chinese authorities found that some poultry farmers were using a cancer-causing industrial dye, Sudan Red, to feed ducks in order to achieve a desirable reddish tint in the eggs’ yolks. Based on examination results for the first half of 2007—which covered 6,300 companies and 114 products—China’s General Administration of Quality Supervision, Inspection and Quarantine candidly stated that about 20% of domestic products were substandard. Given that it is common to find counterfeit and poor-quality products in China, including shoes, computer disks, fertilizer, cigarettes, construction materials, household appliances and food, Chinese consumers often find it rather difficult to ensure the authenticity and quality of what they are buying. While imitation clothes and shoddy handbags tend to tarnish reputations and cause economic damage, tainted food and medicine can be harmful to consumers and may cost lives.

Recognizing that substandard products are harmful to the country and society, China faces a number of challenges in making its products conform to international standards. The product liability and recall system in China is still in its early stages and requires further development. Currently, companies that make counterfeit and defective products are often able to flout regulations and rarely face prosecution for product liability. Even in cases where companies are found liable, the penalties are typically not severe enough to deter others from following suit. Unfortunately, the problem is compounded because the market forces that would normally work in tandem with regulation—namely, brand and reputation—are only beginning to emerge in China. Numerous small- and medium-sized companies, with no brand reputation to lose, employ low product quality standards, placing greater emphasis on cutting costs in order to make a short-term profit. Furthermore, some of the offending companies may be critical to their local economies and are also a source of employment for area residents. Local governments are keen to foster job creation and economic expansion, and are willing to relax the enforcement of safety standards as part of the bargain.

The gap between China’s domestic standards and the standards it applies to exports is still quite wide and represents additional risk to Chinese consumers. Consumers in China have limited options when faced with the dangers of defective products. People who have the means are able to manage by shopping at large supermarkets and purchasing well-known brands, particularly goods produced by foreign manufacturers. However, the vast majority of Chinese consumers either cannot afford or are unwilling to pay the higher prices commanded by goods sold in large supermarkets. These consumers must instead rely on the government to regulate domestic producers and enforce product safety standards. The Chinese public has faced product quality and safety issues for more than two decades and they are frustrated by the state of product quality. Until recently, China’s focus has been on the economic benefits realized from its growing manufacturing sector rather than product safety and quality.

In general, products developed for export have higher quality levels compared to products intended for domestic consumption. While acknowledging that problems also exist in some export products, China stresses that the overall quality of its exports meets or exceeds international standards. The Chinese government’s statistics for the first half of the year showed that 99.1% to 99.8% of exported China-made food products passed foreign sample inspections (results varied by country and region), yet the protections and quality standards enforced on products bound for export do not carry over to domestic markets. Consumers have coped with scandals surrounding substandard food and pharmaceuticals, damaging the people’s confidence in the government’s ability to protect their well-being.

In response to growing concerns about product safety issues at home and abroad, the Chinese government has stepped up its efforts to control such problems and preserve the reputation of China-made products. In June 2007, the government announced that it had cracked down on about 180 food manufacturers who used industrial chemicals in food products. In July, the former head of the Chinese State Food and Drug Administration, Zheng Xiaoyu, was executed for accepting bribes from drug companies in exchange for approving flawed medicines. In August, the Chinese vice premier Wu Yi—famous for solving tough problems—was appointed to head a new safety and quality control agency charged with improving food and product safety. The Chinese government has also developed a five-year plan to improve quality standards, and it is working on establishing a food recall system. The government has also started to enforce more rigorous safety and quality inspections on all exported food shipments. While we haven’t observed a direct response by private Chinese companies to growing concerns over product safety, we have noticed some interesting trends. First, R&D spending by these companies has increased substantially. Second, we are seeing increased foreign investment in the private sector which is not only bringing in additional capital but also advanced technology and management capabilities which should help improve product quality.

As a result of recalls on certain China-made products, some Western companies have suffered significant expense and a few may be facing lawsuits from consumers. However, these recent incidents are unlikely to cause foreign companies to move their production out of China and into other developing nations—at least not in the short term. Over the last two decades, China has gradually become a dominant producer in industry sectors where few alternatives are available. For example, China currently produces more than 80% of the world’s toys. To build comparable production capacity in other countries would require significant time and resources. In addition, countries like Indonesia and Vietnam still lack the infrastructure to support this type of mass production. Even if production was shifted out of China, no one could guarantee that product quality issues won’t surface elsewhere. Thus, unless surging labor costs or dramatic appreciation in the Chinese currency undermine China’s cost advantages, the country is likely to continue as a major manufacturing base, but under heightened scrutiny, rigorous monitoring and thorough testing from foreign buyers.

At a time when trade tensions are high between China and the U.S., some Chinese officials believe that the "Made in China" safety issue has been blown out of proportion by the foreign media. This view is not without merit: rising protectionist sentiments in the U.S. are easily enflamed by such scandals. Interested political groups have opportunistically seized on the recent scandals as a "wedge issue" in trade relations—yet their underlying concerns cannot be dismissed. One can construct balanced arguments regarding the pros and cons of China’s currency policies, or global trade imbalances; but outright threats to the public’s health and safety are unacceptable. Regardless of the motivation behind the media coverage, the scandals related to China-made products have revealed some serious problems in China’s safety and quality standards. These events have brought both international and domestic attention to the issue and have put the Chinese government on center stage. However, it is important to note that the Chinese government has taken serious and immediate action toward correcting the flaws in its system. If China can move quickly to improve its product safety standards and regain the public’s confidence, both foreign and domestic consumers alike will benefit from the improved safety and quality of Chinese goods.

¹ As of 8/31/07, Matthews Asian Funds did not hold any positions in Menu Foods, Colgate-Palmolive, Gilchrist & Soames and Mattel.

September 4, 2007

The view and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.