China Infant Formula Sector Today: Genesis

01

Early Optimism

When I first started analyzing Chinese trade policy, food regulations and China dairy sector market data back in 2013, I, like many others, could be forgiven for getting a little caught up in the hype. Billions of dollars up for grabs, a 300 million strong middle class with deep pockets and a penchant for imported products, extremely low breastfeeding rates, baby booms and a huge distrust of domestic product quality and safety.

As bad as this was for China it seemed like a golden opportunity for international dairy whose only competition was a domestic Chinese dairy sector still reeling from the impact of scandal and further hampered by a lack of technical capacity, animal husbandry and breeding, pasture management, processing technology etc. For international dairy facing global pricing pressures, it looked like a panacea to all that was ailing them. Let the good times roll....or... maybe not...fast forward 5 years and we see hundreds of SMEs forced from the market and multimillion-dollar losses for dairy giants like Fonterra and companies like Bellamy's caused almost exclusively by failures in China's IF market. How did this happen?

02

The Seeds of Destruction

After several months of analyzing China's dairy sector, I began to get a clearer picture of what was really happening. I looked at the government rhetoric expounded in 12th National People's Congress calling for the development and swift implementation of policies to foster the growth of the domestic dairy sector. In reality, this "rhetoric" marked the first official steps in setting China on a path to reestablishing parity between its domestic dairy sector and its international rivals in a war for the wallets of China's most important target demographic.

03

A Lack of Pedigree

In the months and years that followed, I witnessed the development of new legislation, new regulations and new product standards. My initial optimism about the opportunities regulatory changes offered to the international dairy industry was replaced by cynicism. At the same time, I started to meet and get inquiries from numerous would-be-investors without any solid pedigree in the infant formula sector. I saw a common theme amongst the vast majority of those that I met or spoke to on the phone... FOMU... or.... fear of missing out, dollar signs for eyes and a fairly damning lack of knowledge about China's dairy sector from almost every angle. China's IF frenzy had begun in earnest...

The problem was the vast majority were in way over their heads. They didn't understand distribution channels, they didn't understand their target market, they hadn't spent enough time on the ground, they didn't understand the regulations, the majority didn't even have someone on their team that could speak Chinese. Most costly for these people was the fact they failed to read the signs indicating where things were going and failed to foresee China's endgame. Sure I expected smaller SMEs to fail but I didn't expect the likes of Bellamy's and Fonterra to end up in the same hot water, companies that could absorb 5 million dollars annual consultancy fees but didn't get enough information to see the wood from the trees.

04

Context is Key

Failing to understand the context of China's large-scale dairy sector regulatory reform is by a large the single biggest mistake made by almost every investor that has suffered here in China's dairy markets. Despite China preaching a "win-win" international trade policy and business mantra, in practice, "win-win" in China should be always understood to really mean ...China wins first...then you can win.. if...(big if).... there is enough to go around.

Combine this understanding with an appreciation for that fact that China has always remained protectionist in its trade policies (unless it has other needs), then sift through all the rhetoric about improving the safety of products (improved product safety actually has been a beneficial side effect of realizing China's chief priority) and somewhere in between all that smoke you should start to see that China's main priority has and always will be reestablishing control of its domestic markets. The old journalism idiom of "follow the money" therefore, is particularly apt to aid in understanding China's dairy sector regulatory reforms starting in 2012 and moving forward to present day.

05

Fleshing out the skeleton...Paying attention to NPC Rhetoric is Key

China's successive implementation of regulatory changes over the last several years is often touted as an unavoidable and unforecastable scapegoat used to mask investment failures in China and more worryingly an obvious failure to conduct adequate due diligence and risk analysis. In actual fact the vast majority of China's major regulatory reforms like CNCA audit and registration, new product standards, CFDA product registration etc. were all basically blueprinted within the basic skeleton of NPC State Council policy rhetoric and then fleshed out through further announcements made by the State Council and expanded on by subordinate ministries like the CFDA,AQSIQ and NHFPC. Countless clues and hints can be found in dairy sector regulatory reform roadmaps and the slew of official legislative and regulatory documents released by Chinese authorities since 2012. But again it's not really necessary to get this complicated... let's go back to basics. China was never and is never going to be happy with a domestic infant formula sector dominated by international players..

06

Supply Chain Control...

Like I've said on numerous occasions (I think I should copyright it at this stage), China used and is using a very ingenious strategy to get its self into a position where it is finally starting to compete with international players... I've literally mentioned this in about ten of my articles but it still seems to be getting slept on so here you go ...again.

1) Use of legislative selective pressures and survival of the fittest regulations: Development of new legislation and associated regulation, standards etc. designed to cull from the weaker domestic manufacturers and ultimately consolidate supply chain control into China's larger manufacturers.

Phase 1 - Manufacturer orientated: Chinese domestic enterprise was subject to a host of new production hygiene standards and product standards. Hundreds of manufacturers failed to meet the cut and were forced to close..Leaving only a little more than 100 verified manufacturers......

Phase 2 - Brand orientated: Subject the remaining manufacturers to the second round of regulatory requirements designed to target products and further consolidate overall supply i.e CFDA product registration

2) Use of legislative and regulatory selective pressures at an international level: Designed to funnel overall supply into the hands of less enterprise. Supply chain consolidation means easier control, the better possibility for powerful partnerships. Same 2 phases as before. Phase 1 was manufacturer orientated and phase 2 focused on reducing the total number of products on the market.

3) M&A on a domestic front: Larger enterprise absorb smaller enterprise. Consolidating supply chain control and allowing a larger enterprise to be more competitive.

4) M&A on an international front: If you can't beat em ...buy em. China has been flexing its considerable financial muscle over the last several years. Buying production facilities, stakes in companies, pastures, new processing facilities, better genetics, etc. The technical gap between China and its major competitors pretty much underlies all of China's problems. This point is extremely important. Scandal and consumer distaste for domestic all basically boil down to China's historical technical shortcomings.

07

So the big question...where are we now and what next?

China is certainly going about its dairy sector reform plan in successive phases. I think a fairly good marker to use to track the genesis of all this is the aforementioned 12th national people's congress and not the Sanlu scandal as many people like to mention. The Sanlu crisis certainly helped precipitate the huge trade imbalance but overall I think the government's reaction to this wasn't finalized until 2012/2013 What happened after the 12th NPC ? We saw the formation of the CFDA and NHFPC. We saw the development of new legislation and thousands of pages of new regulations.

So when does the next phase of the plan begin? Well as coincidence would have it China's 1st session of the 13th NPC has just come and gone. What are the big takeaways? Well, China will once again implement large-scale institutional reform. Just 5 years after formation both CFDA and NHFPC (and AQSIQ) are set to be dissolved/amalgamated and their individual duties combined into a new super authority. Mmm sounds very familiar. In tandem with this change, we have a new dairy roadmap and new improved plans to uplift China's domestic industry. What we have seen so far in China's dairy sector is basically just the beginning of a much longer process. Over the next 5 years, I am sure we will see new legislation, new regulations, new standards all of which will impact market access requirements, trade balance and the health of China's domestic sector.

Source：LinkedIn

Author：Paul O'Brien

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