Fonterra out of its depth in a very murky sea

It looks bad for the Kiwi dairy co-op, but it may have handled China's milk formula alert as well as any foreign partner could

In a joke circulating in China, disgraced dairy company SanLu blames the farmer for adding the industrial chemical melamine to its milk, the farmer blames the cow and the cow blames the grass.

It's a piece of black humour that highlights the culture of lax regulation and buck-passing, seemingly endemic in the Chinese food industry, in which Fonterra has unwittingly been caught.

Four babies have died and more than 6000 have fallen ill from drinking melamine-tainted infant formula produced by SanLu, the Chinese firm 43 per cent-owned by Fonterra. SanLu general manager and chairwoman Tian Wenhua has been arrested and the scandal has engulfed more than 20 Chinese companies.

Questions remain as to why it took Sanlu four months to alert Fonterra after it started receiving customer complaints, why the problems were not made public for a further six weeks and what future Fonterra has in what was the world's fastest-growing dairy market.

There are also concerns that the three Fonterra employees on SanLu's board – New Zealander Bob Major, Briton Mark Wilson and Chinese national Patrick Kwok – could be arrested. The death penalty is commonplace in China. Last year the authorities executed a former head of the country's food and drug safety agency for taking bribes. Fonterra would not comment on the chances of arrests but a spokesman said: "The safety of our people is a priority."

Jamil Anderlini, a New Zealander who has reported on business in China for several years for the Financial Times, was present at the ceremony in 2005 when Fonterra announced its $153 million investment in SanLu. "I remember feeling uneasy," he says. "I've been to a lot of Chinese milk operations and I've seen how they work. I remember thinking Fonterra was a little bit out of its depth and didn't quite know what it was getting into at the time."

It is now clear that SanLu started receiving complaints about babies getting sick in March. According to Fonterra, SanLu went to the Hebei provincial health authorities with this information and, between March and July, the authorities carried out three tests that were all negative. SanLu then decided to do its own tests and, in early August, it detected the melamine, informed its board and started a trade recall.

Fonterra has admitted that it should have had better systems in place so that it knew what was going on earlier. "As SanLu's partner, Fonterra should have been informed of these earlier incidents and health complaint investigations," it told The Dominion Post. "It does raise governance and management issues."

Steve Dickinson, a partner at law firm Harris Moure, was surprised, however, that Fonterra learned what was going on as early as it did. Mr Dickinson, who has been based in China since the 1980s, is heavily involved in its food industry.

"If you're a 43 per cent shareholder in a joint venture in China, you don't have any power. And the fact that Fonterra even found out means that they're far more involved than a typical 43 per cent joint venture partner. It just shows you the problems of being a minority owner of a Chinese company. You're not really aware of what's going on."

Once Fonterra did find out about the problem, on August 2, there was a gap of about six weeks till the issue became public. Prime Minister Helen Clark says Fonterra expressed concern to the New Zealand embassy on August 14, and elaborated on this on August 22. The embassy informed Wellington on August 31, with Miss Clark being briefed on September 5, after which the Government contacted Beijing and the problem was made public on September 11.

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Fonterra chief executive Andrew Ferrier says that, during the six weeks, Fonterra staff kept asking themselves whether what was happening was effective, but had to work within the Chinese system.

Mr Anderlini says: "Fonterra has a point in that it would have been very hard for them to go to the [state- run Chinese] press. You just can't do that because the press wouldn't report it domestically.

"But I think Fonterra bungled this – because they knew about it for so long and on the surface did nothing. They could have come to the Financial Times or the Wall Street Journal or the New York Times. They are all read by senior leaders in Beijing.

"That's always an option to leak to the international press, because it often then gives the domestic papers cover to write about something. Maybe Fonterra wasn't familiar with the way things work in China."

SanLu is not expected to survive the scandal – at least in its current form – but Mr Ferrier says that is not what Fonterra is worried about at the moment. "This is such a tragic incident we are not worried about where we are going to be in China in six months' time. We are worried about doing the right thing."

David Oliver, a Beijing-based financial consultant who works with Chinese dairy companies, says the sector looks set for a big shake-up. "A lot of innocent small farmers will be ruined. Large-scale feedlot farming will become more common and there will be consolidation, with smaller firms going out of business."

What role Fonterra will have in the changing Chinese dairy industry remains to be seen. Expansion in China was one of the main planks of the co-op's global growth strategy, but this will have to be rethought.

Fonterra will still have a large business exporting New Zealand- sourced milk powder to China. But it had planned to integrate SanLu more closely with its Chinese ingredients and food services businesses to drive growth. That plan is now in tatters.

- © Fairfax NZ News