September 2007

The surge of defective imports from China in recent months reached a peak last week when toymaker Mattel Inc, recalled nearly a million Chinese-made toys coated with toxic lead paint. The move prompted governments and corporations all over the world to fix the problem quickly without slowing down the surging process of globalization or triggering a trade war between China and the rest of the world.

Consumer Confidence

China is facing a global crisis of consumer confidence as the country's food safety watchdog acknowledged this week that almost a fifth of the domestic products it inspects fail to reach minimum standards. Following a number of contamination scandals, the world's biggest exporter is struggling to prove that it can match quality with quantity.

Local Worries

According to the General Administration of Quality Supervision, Inspection and Quarantine (AQSIS), in the first half of 2007, 19.1% of products made for domestic consumption were found to be substandard. Among products made by small firms, the failure rate was nearly 30%. The main concern is that these are not isolated incidents. Officials have found hundreds of bottles of fake human blood protein in hospitals and excessive amounts of additives and preservatives detected in children's snacks. Mainland Chinese are becoming increasingly concerned about food safety in general and the trust deficit is enormous and growing.

Although with health and environment, consumer safety has been one of the biggest victims of the rush to get rich. The domestic market has probably been affected more than international trade because export standards are higher than for goods sold in China. Last month, food inspectors said paraffin wax, dyes, formaldehyde and cancer-causing compounds were detected in food produced by unlicensed and small producers.

Foreign Worries

While the worst violations are in the domestic market, the repercussions are felt beyond the country's borders. China fills the shelves of Wal-Mart, Tesco and Sainsbury's with low price products. But as its world presence has grown, so have concerns about safety.

In America there was a series of cat and dog deaths in the US that was attributed to tainted pet food from China. Next in American and Britain came the recall of more than 1 million Thomas and Friends toy trains coated with poisonous lead paint from China. Then, Independence Day fireworks were withdrawn from the US because of their dangerously unpredictable sense of direction. In the EU, European customs officers had seized fake birth control pills and HIV drugs from China. Foreign consumers have reached a point where "Made in China" is now a warning label.

Manufacturing concept of exporters in China

One of the problems facing China is that manufacturers continue to deliberately widen profit margins through a reduction in the quality of materials. Importers usually never notice what is happening because changes in quality are subtle but progressive. The initial production sample is fine, but with each successive production run, a bit more of the necessary inputs are missing.

Even when importers catch suppliers in reducing quality, they frequently do not do much apart from complain. Many quality problems are seen as too minor relative to the difficulties involved in rectifying them. Customers may not notice a product flaw, but they most certainly notice when a product is not delivered on time. The chance of a product failure is usually remote, but the penalty for late delivery is an almost certain loss of business.

Some importers do attempt to fight back against the poor quality by insisting a supplier replace substandard goods at the factory's expense. However some suppliers can respond to such demands by terminating the supplier relationship. Or the supplier can raise prices. Importers may then counter and say they will switch suppliers, however the existing suppliers knows this is an empty threat as finding new suppliers takes time and cultivating the relationship takes even longer.

Suppliers, generally, know where they stand with the customer. They have virtually nothing to lose and only margin to gain. And if they have gotten away with it once, they will do it again. As routine, suppliers apologize and promise with a handshake that it will not happen again, and generally importers accept and just hope for the best.

Responsibility for the Product Defects

The larger question is who is legally responsible when a chemical used in antifreeze ends up in a tube of toothpaste. Foreign companies are starting to find out as the lawsuits begin in that the tainted ingredients may come from China, but the liability is in the foreign country.

This lack of accountability has legal implications. When a product is recalled, the importer pays the cost of that recall. It remains next to impossible to take legal action in China, and only in the rarest case can an importer successfully sue the supplier responsible for the product failure. Since most suppliers are paid in full well before goods leave the factory, the importer doesn't even enjoy the leverage that comes with owing payment to the supplier. The average importer has far less leverage than imagined.

The importers can seek indemnification from their Chinese exporters, however generally few foreign lawyers in the foreign country contemplate suing Chinese entities in Chinese courts, where tiny damage awards and frequently hostile local judges often make litigation pointless. One way or another, if importers want to stay in business, Chinese exporters will have to become accountable for injuries to foreign consumers and businesses.

Solutions

In an attempt to quell concerns, the government is drawing up new safety rules for oral care products. Beijing has promised to revise its inspection system for other products. Last month, the government published its first five year plan for improving food and drug safety. It closed 180 food factories in the first half of 2007 and seized large quantities of sweets, pickles, crackers and seafood tainted with formaldehyde, illegal dyes and industrial wax. In June, the former head of China's food and drug agency, Zheng Xiaoyu, was sentenced to death for accepting RMB 6.5 million in bribes from pharmaceutical companies to expedite the approval of new drugs.

In August 2007 the government announced a nationwide effort to monitor eight categories of products, including pork, farm produce, processed food, pharmaceuticals and toys. The government has drafted a plan to supervise the production process for industrial and food products across the country. In the next four months all food manufacturers will be registered; pigs shall only be slaughtered at designated places; agricultural wholesale markets and export zones will be inspected.

Concurrently China has blacklisted more than 400 of its exporters through the "Export Blacklist System". No details of the punishment have been given. Additionally police have detained a further 17 members of a gang in Heilongjiang province producing counterfeit medicines. In all, police have confiscated fake versions of 67 medicines produced by 53 companies.

Amid the rising concerns over food security, China's State Administration of Quality Supervision, Inspection and Quarantine (AQSIQ), now is trying to make things easier by introducing a new quality mark. The system began in 2001 and requires food companies to obtain production licenses and put the QS (Quality Safety) logo on their products. The labeling system now covers 16 categories of food products. Official statistics show that around 71,000 food production licenses have so far been issued in the 16 categories, accounting for 95 percent of the market in those sectors.

Action has also begun foreign imports as these products are failing the trust of Chinese consumers because of successive quality problems. Part of Beijing's strategy has been to portray tainted food exports as a worldwide problem. China has also banned imports of Indonesian seafood saying contaminated shipments have been found. In July, it suspended imports of chicken and pork from seven US companies, including Tyson Foods.

Product Certifications

ISO14000, HACCP, QS, CQC are examples of certificates that consumers can find on commodities, intended to demonstrate that manufacturers or products meet quality standards as certified by professional verification agencies.

In order to satisfy consumers, enterprises commonly get more than one certificate, from compulsory ones such as CCC to voluntary ones like ISO14000. In competitive markets companies seek certificates in order to increase the brand value.

China has developed into the second largest inspection and verification market in the world after the United States. By the end of June 2007, domestic and foreign verification agencies issued over 390,000 certificates on both system management and product quality. Professional certification laboratories, which are specifically used to test product quality and safety, have crossed 2,600 in China.

Consumers do have differing views on the reliability of the certificates and the government is strengthening supervision and punishment for both fraudulent certification institutes and companies that use illegal or unethical means to acquire certificates. In January 2007, Certification and Accreditation Administration of China (CAAC) declared five certification institutes as illegal and abolished them. Another 11 are under investigation.

Outsourcing Inspection Services

When sourcing in China, as with any country, quality should be of utmost concern, considering the rate of growth the country has realized in the past decade. However higher quality and safety does not happen by itself.

In the wake of quality problems, many are looking to third-party testing as a solution. Outsourcing the quality control division has become popular amongst companies expanding their operations. Quality control can be complicated, demanding and a costly exercise for every company doing it in-house. Outsourcing gives companies a choice of cost effective, yet professional and risk absorbing service providers.

When considering a quality control provider, a company must consider its own agenda and choose accordingly. Foremost is the intention of their quality control efforts and their budget available for these. One problem of outsourcing though, is that client firms often have somewhat unrealistic expectations of what can be expected for their budget.

When buying products in China companies must understand the price/value relationship - what one will get for what they pay for. This in combination with a more traditional approach of planning, design, technology transfer, supervision and control all effectively lead to quality success. That said companies should also think about conducting background checks, factory and social compliance audits before beginning to work with a new supplier.

Conclusion

With USD $546.7 billion worth of goods being exported in the first six months of 2007, the credibility of "made-in china" products must be restored. The government perceives that the "deep rooted" problems regarding food and product quality come particularly from a large number of small factories with substandard equipment and poor management. Local government protectionism needs to be dealt with, and weak enforcement must be shored up with more resources. However foreign companies should take the initiative to place control systems in their suppliers before shipment overseas.

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All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.