By staff reporter Gong Jing and intern reporter Liu Jingjing

At the nascent stage of China’s dairy industry in the early 1980s, self-sufficient dairy companies owned farms as well as cows while managing a system that capped milk supplies and limited business expansions.

All that changed in 1986, when a Hebei Province dairy named Sanlu started giving away cows to local farmers.

Under Chairwoman Tian Wenhua, the company shifted its focus from farming to churning out and marketing products, building a new business model based on a division of farming and processing. Sanlu loaned cows to farmers, who later repaid their debts with milk deliveries.

Production jumped, farmers profited and new jobs were created. Dairies across China followed suit, making the Sanlu model an industry norm. Today, more than 80 percent of the country’s dairy cows are owned by individual farmers.

But in September, Sanlu’s business crashed – and Tian was stripped of power and detained by Communist Party authorities – after a contaminated milk crisis rocked China’s dairy industry.

Sanlu as well as market leaders Yili, Mengniu and Bright Dairy were among the 22 dairy companies that officials said sold foods laced with the industrial chemical melamine. Chinese health authorities blamed tainted milk powder for kidney stones and other ailments that sickened tens of thousands of babies across the country, killing four.

Its public image shattered, Sanlu is now on the verge of bankruptcy. The company faces huge expenses for victim medical care. It was ordered to recall more than 10,000 tons of tainted milk powder and compensate customers.

What went wrong? To find an answer, Caijing interviewed dairy farmers, industry sources and government officials. They described a system wracked by illegal business practices and lax supervision.

‘Just Call’

Hebei dairy farmers interviewed by Caijing said the practice of spiking fresh milk with additives such as melamine had been a “public secret” for the past two years.

“You just need to make a call, and then someone will send the stuff (melamine) to your home,” said one farmer.

Sanlu claimed it applied strict quality inspections to all the fresh milk it bought. However, Caijing found that the company’s inspection system went awry as early as 2005 and allowed milk collection stations to adopt unscrupulous business practices.

Some industry observers said the distorted development of the milk industry and vicious competition had forced Sanlu to loosen controls. But others wondered how a company that was China’s top milk powder producer for 11 years in a row could allow such widespread contamination in its products for at least two years.

An official investigation pointed to milk stations – middlemen in the chain that links farmers and big dairies -- as the major source of contaminated milk. City officials in Sanlu’s hometown Shijiazhuang announced the milk powder contamination September 12, saying milk station workers had added melamine to fresh milk to falsify protein-quality tests.

Police uncovered a melamine sales network in Hebei, a major dairy province, and arrested 12 milk station staff members along with six, illegal sellers of the chemical. Yang Changyong, Hebei’s vice governor, said suspects admitted that some stations had added melamine to milk sold to Sanlu as early as 2005.

A suspect surnamed Su told police he sold 200 bags of melamine powder to milk stations between February 2007 and last July for 218 yuan a bag.

But Sanlu wasn’t alone. A milk station source in Hebei’s Xingtang County told Caijing that buyers from dairies Mengniu and Yili approached local dairymen and offered to top Sanlu’s prices. But since their quality controls were stricter, most of the milk was rejected by Mengniu and Yili and instead sold to Sanlu.

When Sanlu started its new business model in the 1980s, quality control was not a problem. Newly formed milk stations were eager to sell and had every incentive to provide a clean product to Sanlu, one of the few dairy companies operating at the time. Sanlu could afford to refuse milk that failed quality tests, even pouring it out on the spot.

But more market players arrived, titling the balance to a seller’s market. By 2005, private and state-owned dairies had popped up like mushrooms across China. Hebei’s total production capacity that year exceeded the province’s milk supply.

Individual farmers lacked bargaining power, so milk stations, as the major suppliers, had an upper hand in the market. Quality control was diluted in a fierce scramble for milk. And government supervision was practically nonexistent.

Reporting Delays

China’s central government reacted quickly after learning of the milk crisis. Officials offered free medical treatment to the young victims, released comprehensive results of dairy product tests, and scrapped a national food inspection exemption system in place for the previous eight years.

Authorities also took into custody several responsible dairy employees, including top officials such as Sanlu’s Tian. Local government officials connected to the incident were ousted.

But lower level officials apparently were aware of a problem long before the news reached central authorities in Beijing. An investigation team sent by the State Council said September 11 that Sanlu had received its first customer complaint in December 2007.

The company claimed it received the first complaint no earlier than March 2008 – the same month that, according to a Sanlu source who spoke with Caijing – a company quality inspection department started taking action. Sanlu later confirmed that melamine was found in its products in June 2008. State Council investigators confirmed that claim.

However, the company waited until August 2 to report the contamination to the Shijianzhuan city government. Afterward, Hebei provincial investigators got involved.

A source told Caijing that investigators have tried to recover melamine purchase records at Sanlu. So far, they have found no evidence that the dairy actually added the chemical to its formula during production.

However, investigators faulted Sanlu for failing to report the problem sooner. Apparently, the company tried to resolve the incident alone before reporting to the government, even halting production of the baby formula July 1 and starting to test for melamine in raw milk August 6. Sanlu also sent sales representatives to visit victims who drank tainted formula, but refused to link the illness to Sanlu’s products. Instead, the representatives claimed the milk powder was safe.

“Sanlu management attempted to cover up the incident and hoped the crisis would disappear after awhile,” a source said.

As the situation worsened, Sanlu found it could no longer cover its tracks. Finally, company officials reported the case to the government August 2.

The State Council investigation team later said Sanlu’s delayed report violated government regulations, which require organizations and government agencies to report any emergency situation within two hours to their superiors at a higher government level. The State Council also criticized the Shijianzhuang city and Hebei provincial governments for late responses.

But higher authorities may have sensed danger as early as June, when the media in Jiangsu Province reported a two-month surge in the number of babies diagnosed with kidney disease. And in July, other reports said, a parent of a sick baby in Hunan Province questioned Sanlu’s milk powder and complained to the central government’s Administration of Quality Supervision, Inspection and Quarantine (AQSIQ).

The first official report suggesting kidney illnesses among babies may have been tied to Sanlu milk powder reached the Ministry of Heath in July. The report came July 16 from Gansu Province where, Caijing learned, a local health department received a report from a hospital saying cases of kidney ailments among babies had surged this year, and that most victims had consumed Sanlu’s baby formula. The health ministry sent investigators to Gansu in early August.

But the direct connection between Sanlu milk powder and the illness was not confirmed until September 9 when the New Zealand Embassy in Beijing informed China’s Ministry of Foreign Affairs that Sanlu’s baby formula contained melamine.

Holes in Supervision

The crisis has pointed a powerful spotlight on inadequate government supervision of the dairy industry and food security conditions in China. The incident struck a new blow to global confidence in Chinese food products and exposed flaws in the country’s private sector oversight.

National statistics show more than 54 percent of the milk stations that collect fresh milk from dairy farmers and sell it to dairy producers are private operations. However, government supervision of milk stations is virtually nonexistent. Minister of Agriculture Sun Zhengcai said China has neither a unified supervision system for milk stations nor a specific supervisory agency.

Meanwhile, critics have asked why AQSIQ failed to discover the tainted, and seemingly ubiquitous, milk products much earlier. Criticism led to the resignation of Li Changjiang as head of AQSIQ. Before stepping down September 22 amid the crisis, Li said China has neither a national standard nor a testing system for melamine in food products.

But Caijing learned that, since a global pet food scare in 2007 that revolved around melamine contamination in Chinese exports, tests for the chemical have been conducted on all food products exported by China.

China maintains a variety of standards for food products enforced by different government agencies. Some standards contradict, and the inter-agency communication gaps are common. These and other supervisory holes leave room for illegal operations.

Another problem revolved around the “inspection-free” status AQSIQ granted to certain companies, including several dairy producers such as Sanlu, Yili and Mengniu. Exemptions from government inspection controls were granted to “famous brand” companies for years before the milk crisis prompted Beijing to scrap the policy.

Until the regulatory vacuum is filled, dirty tricks in the food industry are likely to continue. One industry insider said that, unless government supervision can be implemented efficiently, another crisis is “inevitable.”

1 yuan = 14 U.S. cents