Milk Product Safety: The New Market Winner in China?

China’s latest food safety scandal involving local milk manufacturer China Mengniu Dairy Co Ltd underlines the importance of investing in proper procedures to ensure the full implementation of regulations in this fast growing market. As Chinese consumers become more demanding about food safety, the competitive advantage of international manufacturers, and their ability to charge higher prices, can only increase.

Toxic levels of flavacin M1 found in China Mengniu Dairy’s milk

The Chinese General Administration of Quality Supervision reported on 24 December 2010 that it had detected above-average levels of the toxin flavacin M1, which is listed by the World Health Organization as a class-A carcinogen, in a batch of Mengniu milk products, specifically 250ml cartons of milk produced at its Meishan factory.

The firm’s website was immediately attacked by Chinese hackers, who posted a message stating: ‘Mengniu once made the Chinese people strong and proud, but now it’s doing harm to its own people’.

March 2010: China introduces new regulatory framework

The new scandal comes more than one year after a new regulatory framework to improve national food safety was announced by the Chinese health authorities. The new framework, introduced in mid-March 2010, highlighted 11 action points to amend existing laws on adding non-food substances to food. The new regulation also aims to achieve better enforcement of tests for pesticide residues on fresh produce and seafood. The authorities in Beijing also want to “increase testing for high-risk foods, especially dairy products” and set up a national risk monitoring system.

The need to improve food safety standards came in the wake of repeated food crises that dented China’s credibility both domestically and abroad. The scandal with the biggest impact was the revelation in mid-2008 that compounds commonly used in the plastics industry, namely melamine, were added to milk and baby milk formula to boost its apparent protein content. Infant formula made from this milk led to almost 300,000 infants becoming ill, with six officially confirmed deaths.

Since then, the Chinese government has sought to restore trust in China’s dairy industry, cracking down hard on the perpetrators of the melamine scandal and implementing new safety regulations. Despite these measures, batches of melamine-tainted products have continued to appear over the past two years.

Demand for milk picks up in 2011

Drinking milk products in China have recovered from the downturn caused by the melamine scandal thanks to contributions made by both the government and corporations. Since the melamine crisis, consumers have increasingly opted for products from renowned manufacturers – typically international – which are perceived to offer better quality.

As a result, the competitive landscape became even more consolidated in 2010, with small producers’ share of total retail value sales declining from 21.9% in 2009 to 17.4% in 2010. Furthermore, due to the stricter quality control regulations implemented by the government, many medium and small-sized dairy companies, such as Qingdao Tianyou Dairy Co Ltd, could not compete, and were forced to scale back, or even end, their involvement in the dairy industry.

With a general recovery in consumer confidence in Chinese milk, demand has largely returned to pre-2008 levels. Constant retail value growth of drinking milk products reached 7% in 2011, a performance in line with that achieved in 2010.

Interestingly, children’s milk witnessed stronger growth in 2011 than adult milk products, contributing 5% to overall milk sales compared with 4% in 2010. This is mainly thanks to ongoing product innovation from key players.

The upgraded Future Star Milk range, which contains DHA algal oil, was launched by Inner Mongolia Mengniu Dairy Industry (Group) Co Ltd and is suitable for children of different ages. Bright Dairy & Food Co Ltd, another leading player, launched Bright Dudu flavoured milk for children in 2010. This new product features added beneficial ingredients such as xylitol and high fructose corn syrup, which can help prevent tooth decay, as well as the famous cartoon figure Xi Yang Yang on its packaging to make it more appealing to children.

Looking ahead: Challenges and opportunities

The most direct effect of the new scandal will likely be that Chinese consumers, particularly parents, will once again have doubts about locally produced/sourced milk brands, at least in the short to medium term. Back in 2008, the melamine scandal led to a drop in share for Chinese dairy and baby milk formula manufacturers, which lost ground to more expensive but more trusted international brands. Local milk formula brand Yili, for instance, owned by Chinese manufacturer Inner Mongolia Yili Industrial Group Co Ltd, lost around two percentage points in share in 2008 alone. Conversely, Dumex’s share, a milk formula brand owned by international manufacturer Danone, gained a similar percentage during the same year.

While product safety awareness in milk for adults is lower than in products intended for babies and children, it is nevertheless increasing. Mengniu Dairy is a leading player in the Chinese milk market, holding 31% of total retail value sales in 2010, whereas Nestlé accounted for less than 1% of category retail value. A significant worsening of the consumer perception of Mengniu’s milk brands following this latest food safety scandal could have a significant impact on consumer demand for locally sourced milk products as a whole.

As with baby food, large international dairy companies, many of which still have a relatively minor presence in China, stand to benefit the most from stricter production regulations. Local manufacturers failing to abide by the new rules will not only be subject to consumers’ ire – as reflected in the recent cyber attack on Mengniu’s web page – but also risk heavy penalties from public health authorities and the potential withdrawal of their products from the market for an indefinite period of time.

Regardless, abiding by the new rules is bound to have financial costs. This means that the higher production costs faced by Chinese dairy manufacturers to comply with new regulations are likely to reduce the price differential between imported and domestically-produced offerings across the market. Research suggests that this could represent an opportunity for international dairy manufacturers competing with mid-priced and semi-premium domestic lines, as the latter are likely to suffer the full cost impact of stricter production standards.

Bullish economic prospects for the Chinese economy might enable a significant number of Chinese consumers to bridge this narrowing price gap between cheaper but potentially less safe local brands and more expensive, but better trusted, international offerings. According to Euromonitor International’s Countries & Consumers database, China’s GDP is predicted to grow by 9% in 2012, far exceeding the economic headwinds currently affecting Western Europe and North America. In addition, international manufacturers anticipating the impact of newly introduced, as well as any forthcoming, regulations will gain a notable competitive edge over future entrants.

Looking ahead, new scandals affecting locally produced milk brands are unlikely to be forgotten by China’s increasingly sophisticated and savvy middle-class consumers, especially if they have sufficient purchasing power to trade up to more expensive – but safer – foreign sourced milk. If the economy keeps growing at its current rate and production costs between locally sourced and imported milk converge as a result of new regulations, new growth opportunities for international dairy companies will expand even further.