Monday, August 27, 2007

China: Product Quality, Reform and the Rule of Law

Source: Stratfor
Stratfor's Free Intelligence Reports
August 27, 2007 13 43 GMT


The head of China's new Cabinet-level leading group on product quality and safety has launched a campaign against poor product safety and regulations. The drive comes as China faces a rash of negative attention over a series of highly publicized product safety cases. This campaign will have only a limited effect, however, given the weak rule of law in China. By contrast, the response of multinational corporations could have a more lasting impact.


Chinese Vice Premier Wu Yi, head of the recently created Cabinet-level national leading group that addresses product quality and safety issues, has launched a "special war" against poor product safety and regulations. The administrative assault focuses on eight sectors, covering a wide range of import and export products, toys, electric wires, food products, agricultural goods and drugs. The campaign sets 20 targets to be achieved before the end of the year, including requiring licenses, inspections and certifications of raw materials.

The drive comes as China faces a rash of negative attention over a series of highly publicized product safety cases. These have included lead paint in children's toys, poisons in pet food and toothpaste, and improperly manufactured tires, among other things. This sort of strike-hard campaign, typical of Chinese administrative responses, will be constrained by the underdeveloped rule of law in China. And though the international and domestic brouhaha over the issue may fade from the headlines, as have past crises, the response of multinational corporations to the quality crisis could have a more lasting impact.

Addressing the Symptoms

Beijing often does little substantive to address emerging problems until they have snowballed into national crises, at which point a series of symbolic steps is often followed by a sweeping campaign, complete with slogans, designed to remove the symptoms in a rapid and public manner. The underlying causes, however, often go unaddressed. In July, for example, amid the rising tide of Chinese product recalls globally, Beijing executed Zheng Xiaoyu, the head of the State Food and Drug Administration (SFDA) from 1998 to 2005. (Zheng was the highest-level Chinese official executed since 2000.)

Following the execution, the SFDA admitted its inspection regime was not sufficient and vowed to redouble its efforts to ensure product safety. The pledge was insufficient -- and too late. Recalls of Chinese products in the U.S. market had been on the rise from a low of 99 products in 2002 to 221 in 2006, according to the Consumer Product Safety Commission. Nearly half of all product recalls in the United States in 2002 were of Chinese origin, compared to a quarter of the total recalls in 2002.

Rather than diverting attention and reducing pressure, following the execution Beijing actually saw many more public complaints and accusations of low Chinese quality standards. With the problem not going away but actually growing more acute, Beijing launched its highly visible special war.

Placing Wu in charge could aid Beijing in convincing foreign states that China is really serious this time around. Wu, known sometimes as China's "Iron Lady," has built a strong reputation abroad and at home for her ability to deal with crises and foreign pressures, and is called in when others fail. A critical component of her problem-solving style is relative transparency and her no-nonsense approach. Wu served as vice minister and then minister of the Ministry of Foreign Affairs and Economic Cooperation from 1991 to 1998. She helped negotiate China's entry into the World Trade Organization, was named minister of health to deal with the Severe Acute Respiratory Syndrome (SARS) crisis in 2003, and heads the new strategic dialogue between the United States and China.

Wu dealt quickly with the SARS issue by first addressing public criticism of the Chinese government, which was accused of covering up and thereby hindering efforts to prevent the further spread of the illness. She then tackled the medical system and some elements of sanitation and crisis management. She appears to be following a similar pattern in dealing with the product safety crisis: Deal with public relations and make enough operational changes to reduce the crisis without triggering other problems.

To address the current crisis, Wu has set a target of 20 discrete goals; but in typical Chinese fashion, the swiftness of the crash campaign means it deals primarily with the most obvious and overt symptoms of the product safety issue. The administrative top-down approach probably will show rapid and numerous results, primarily manifested in fines and shutdowns of many smaller enterprises. But there are much deeper structural issues that cannot be so easily addressed.

The Rule of Relationships

Chinese business, particularly at the lower levels, is not governed by the rule of law but by the rule of relationships. Businesses are formed, loans taken, investments made and contracts arranged based frequently on relationships and personalities -- from knowing which local official to bribe to making to sure one's brother-in-law's small factory has a place to sell its cheap lead paint. Inspections exist, but are infrequent and easily dealt with either by cleaning up the day inspectors arrive or by bribing inspectors.

Without a fundamental overhaul, Chinese business will continue operating in an environment where regulations are unevenly enforced, there is little effective oversight of local political and business leaders, and personal relationships and bribery quickly fracture legal boundaries. Thin margins for suppliers to the international markets only exacerbate the problems. Chinese products are widespread because they are so cheap. Raise the price, and buyers will go elsewhere. For the small factory operators, this is not an option. Neither is giving up their share of revenues. So instead, they cut corners in raw materials and hire underage employees or require excessive hours, leading to a decline in quality and consistency.

Addressing these deeper problems runs into three walls. First, stricter regulations could shut down many small operations, adding to unemployment issues and attendant social tensions. Second, as with many central government edicts, local officials have little incentive to crack down on these businesses. They have personal relations that allowed many to start or operate, and hold a personal stake in their revenues; moreover, the more the local area can export or attract foreign dollars, the better the political and financial future for officials. Because of the size of the bureaucracy, the central government can no longer simply issue an edict and hope it is obeyed. Enforcement travels down through several layers, and in the end power and relationships usurp state authority and legal structures.

Last, but certainly not least, the very structure of China's political system -- the unquestionable authority of the Communist Party of China -- leaves little room for accountability or legal strictures. If rules cannot be enforced on the highest levels, how can they be incorporated into the lowest levels? And so Beijing turns back to the tried-and-true public campaign.

The Multinational Response

Though Wu's plan will bring some changes in regulatory processes, it will not address the deeper issue of Chinese business culture. This means that multinational consumer products companies with operations in China will need to find a way to obtain assurances to satisfy the increasing scrutiny from the Western public toward labels reading "Made in China." Though they could begin rejecting Chinese goods, as has begun to happen in the toy industry -- which cannot afford any more product safety recalls because the public's trust in their brand quality is beginning to erode -- other policy solutions are swirling around Washington, something that has much to do with an early U.S. presidential campaign season.

Such solutions include broadening the authority of the Consumer Product Safety Commission and other agencies to levy civil penalties in certain product recall cases and beefing up port inspections. Though these policy options are a start, multinational companies could decide to ensure their supply chain meets international third-party manufacturing- and food-quality standards such as those offered by the International Standards Organization and the Codex Alimentarius Commission. These well-respected nongovernmental process standards used by Western corporations are equipped with third-party auditing, and are designed to ensure safe manufacturing of products and food quality.

Multinational companies -- many of which are committed to China because of the large investments they have there, and which could lack viable alternatives to investing in China (at least not any that can be developed rapidly) -- are likely to begin to lead the way in reforming Chinese manufacturing, even if only in small steps. They have the power to select suppliers, and though it is difficult to audit a company's full supply chain, more scrutiny and selectivity placed on a company's suppliers is the only sure way for businesses to reduce product safety concerns regarding items manufactured in China.

Domestic Anger and Apathy

But the problem is not limited to foreign criticisms. Inside China, domestic consumer anger has risen notably over the last year as well, as wide foreign attention to product quality issues has helped draw the Chinese people's attention. Though substandard quality Chinese goods always have been around, the issue has never been so heatedly debated. Even so, most Chinese are still willing to risk product defects or even personal safety if it means they can buy something for half the price of a quality-controlled version.

Similarly, a Chinese consumer association exists, but does little. Chinese consumers would need to start caring enough to act in a group to confront Chinese producers -- and potentially Chinese government officials, since many industries are closely tied to political and party officials. U.S. producers reached their current standard of product quality largely because of U.S. consumer demands and activism. Poorer Chinese consumers, who cannot afford foreign brands, will sacrifice safety for cheaper prices; richer Chinese will simply buy foreign imports.

Though the process of addressing quality concerns could prove quite beneficial for China in the longer term, given that the quality assurance revolutions in the United States and Japan were expensive but paved the way for significant economic success, the fundamental structure of China's economy and business system is not likely to see a major overhaul. The core remains that Beijing can enact as many regulations as it wants, but in a state where the rule of law is secondary, such measures ultimately are unenforceable. This is why Beijing turns to highly public displays of power, dismissing, jailing and even executing officials. But without effective and regular oversight or accountability, even the execution of high-ranking cadres leaves most others unfazed -- the government is just too big, and the odds are slim that any single individual will get caught and punished.

Managing the Situation

The Chinese central government is once again striking hard at the crisis du jour, and has called in a fixer with a solid track record, Wu, to manage the situation. And "manage" is a critical distinction. Beijing recognizes the underlying problems, the impact on domestic trust and the effect on foreign investments. But at the same time, the Chinese central government fears the potential implications of the deeper reforms necessary. Most notably, this is because a wholesale change of Chinese governance from administrative fiat by an unchallenged single party to a more transparent, accountable rule-of-law society not only could cause chaos during the transition, it would likely end the Communist Party's monopoly on power.

For Beijing, then, previous experience with all manner of crises, from SARS to the yuan's valuation to trade imbalances to fear of a rising China have proven to be manageable, even without a fundamental change of the system. Investors brought their money back into China after the Tiananmen Square incident, even though there are still numerous lapses in human rights and individual freedoms. And Hong Kong, now a part of the motherland, went through a product quality crisis in the 1980s, but managed to pull through despite very vocal European attacks at the time. What Beijing is counting on, then, is both the political winds changing and that although foreign business margins will be affected in the short to medium term, provided foreign companies tighten monitoring of their Chinese suppliers, if history is any guide the international crisis should blow over before long.

Wu, who lends a face of respectability and transparency to Beijing's campaign, probably will oversee some short-term successes in addressing China's quality crisis, and could even make a dent in some of the regulatory lapses that have allowed the problems to expand so rapidly in the past few years. Even so, the structural aspects of China's economy remain untouchable so long as the central government fears the short-term impact and instability of reforms -- and the potential of losing control of reforms and seeing the Party slip from power -- and instead opts continuously to slap on Band-Aids and push the pain further and further out.

One day, however, Beijing will arrive at that further "out."

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