BEIJING—The crisis began August 2, when executives of the Fonterra Group, the world's largest trader of dairy products, arrived for a meeting at the headquarters of their Chinese joint venture company, Sanlu Group.
They were in for a shock. The Chinese company's powdered milk was found to contain melamine, a chemical used in producing plastics, and was sickening infants and young children around the country.
There is never a good time for that kind of news, of course, but the timing couldn't have been worse: It was just days before the start of the Beijing Olympics, just when Chinese authorities were hypersensitive to anything that might mar the nation's moment in the spotlight.
Over the next five weeks, according to a knowledgeable outside source, Fonterra and its Chinese partner engaged in a nerve-racking battle over what to do. All the while, unknowing parents went on giving their children the contaminated milk made by Sanlu, which is China's largest powdered-milk producer.
When the news eventually came out, parents rushed their ailing infants to hospitals: So far, some 54,000 children have been found to be suffering from kidney stones and four have died, according to official statistics.
Government testing soon discovered that the problem was not limited to Sanlu, which is headquartered in Shijiazhuang, the capital of China's Hebei province near Beijing. The products of 20 dairy companies around the country were found to be contaminated with melamine. Traces of melamine were found in one of China's most famous candies, White Rabbit, which is also sold abroad.
And if that wasn't bad enough, the chemical soon started turning up in the products of international companies, including giants such as Cadbury, Nestlé, and Unilever, leading to product recalls around the world.
How did this happen? Some say the source of the problem is farmers caught between rising costs and a government cap on prices. The farmers, these critics say, added the melamine to boost the tested protein level of watered-down milk. Farmers, in turn, are blaming the operators of the thousands of milk collection stations scattered across the country, which purchase raw milk with little regulatory oversight.
Wherever the blame ultimately rests, this episode is a textbook example of how things can go terribly wrong in the opaque world of Chinese business and politics.
Some say the growing scandal—which has seriously damaged the reputation and business of major domestic and international companies—could be a wakeup call for foreign companies here, who have long walked a fine line to avoid offending their Chinese partners and the authoritarian government.
"China is a very murky environment in which foreign companies are frightened of having politics turned against them," says James McGregor, the chief executive of JL McGregor & Co., a China research firm, and author of One Billion Customers: Lessons From the Front Lines of Doing Business in China. "So they are way too deferential to their partners."
Fonterra executives had immediately urged a total recall of the milk powder from homes, shop shelves, and warehouses, according to the source knowledgeable about the incident.
However, their Chinese business partner refused. "Sanlu was afraid of a crisis, angry parents and farmers, and the loss of jobs that would result from the scandal," says the source.
But there apparently was an even bigger issue: The central government had sent out an order that nothing was to negatively affect the Olympics, which was to begin just six days after Sanlu told its foreign partners about the problem.
Fonterra, a New Zealand company, came under intense pressure from its Chinese partner, and also from the local city government, which owned the remaining shares of the venture, to keep quiet. "You can't imagine the threats they faced from local officials," says the source.
In four different meetings, Fonterra repeated its demand and Sanlu deferred, insisting the information had been provided to the central government. Beijing later pleaded ignorance.