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.
In the meantime, Fonterra executives are said to have agonized over what to do. They studied the history of previous such incidents, in which the central government repeatedly tried to cover up the truth, including the deadly SARS epidemic and a spate of product safety scandals in which whistle-blowers got in trouble. They were not sure whether or not they would be backed up if they went over the heads of the local Chinese officials.
They decided to try to "work through the system" while they awaited clearer information from lab reports and word from the central government. "They were between a rock and a hard place," says the source.
But when more weeks passed by and the Chinese partner continued to refuse to tell the public about the risk—though it did pull the product from shop shelves—Fonterra sought help from the New Zealand government. Wellington went through diplomatic channels to inform senior central government officials of the problem on September 11, two weeks after the Olympics ended, and a little over five weeks after Fonterra was first notified.
At that point, Beijing jumped to action, going public with the story, ordering a recall, and arresting farmers and Sanlu and Shijiazhuang officials.
Fonterra has since come under heavy criticism for not going public sooner, but it has said that it behaved responsibly. Fonterra officials have expressed the view that had they gone public immediately, the central government might have reacted angrily and might even have denied there was a problem.
Critics say that Fonterra was naive about the China market. Although Sanlu told the company that it only learned about the problem in early August, there had been rumors of the problem going back to last December.
Many Chinese reporters were hearing stories of infants being afflicted with kidney stones, but the central government had last year ordered the media not to report on anything negative in the run-up to the Olympics. The media wouldn't touch the story. Journalists turned to their blogs and began putting information out, but censors eventually erased much of this.
"What this proves is that you can't be clueless in China," says McGregor. "You have to know what your partner and employers are doing."
Fonterra has been criticized for opting to work through the system while lives were at stake, and for doing so in an attempt to save face in China and to avoid ruffling Beijing's feathers.
"If you have a product that's making people sick, or that is killing them, you should not care about your business here," says McGregor. "You should care about human life."
In an article, Access Asia, a China-based consulting company, blamed the incident on what it called "China is somehow different excuse-mongering." Access Asia said this attitude created an environment where foreign companies feel "culturally obliged to turn a blind eye to corruption, nepotism, and outright criminality that can leave the tiny gap in concentration that is all that is required for a disaster like this to happen."
Access Asia said the Fonterra-Sanlu scandal was a model of why it's time for foreign companies to stop treating China as special and to behave responsibly, as they do in other countries.
With China still averse to negative news of any sort, the chances are that there will be further product safety scares. As soon as the news broke, the central government ordered that the Chinese media use only the official spin provided by state news organizations such as Xinhua News Agency and the People's Daily. Wwebsites began to erase any mention of the incident.
Officials from the two companies declined to be interviewed for this story. Another dairy company that says its products were not contaminated confirmed that the government had ordered it not to speak with any media.
McGregor says the Chinese were sincere in wanting to deal with product safety issues, but they still had a dangerous tendency to limit information. "The Communist Party likes to discuss problems in the context of how they are solving, or have solved, them, rather than in terms of being a problem," he says.
"This is how they do things," he says. "But it lets problems fester longer than they should."