East Providence, RI

Tuesday, December 09, 2008

China's regulatory agency failed to stop manufacturers from adulterating milk. This scandal has had impact all over the world. The most concerned should be investors. Investors like infants need protection too.

China's health and safety legal and regulatory environment is known for being rather lacks. This year we have had scandals involving poisoned toys, tooth paste, pet food, adulterated blood thinner heparin, frozen green beans, pesticide-laced dumplings, polluted drinking water and of course most recently, tainted milk.

The tainted mile not only sickened and killed children all across China, 290,000 at last count, it made its way into hundreds of dairy products that have been exported all over the world. The dangerous additive was melamine, a substance which is normally used in plastics, fertilizers and cleaning products. It was added to the milk to make the protein level appear higher than it is.

The story originally broke in September but it was discovered that the authorities knew about it much sooner. The Chinese regulator was notified that there was a problem in June, but reporting on the issue was suppressed during the Olympics so as not to put a bad light on China during the festivities.

Not surprisingly, the victims are trying to win legal damages in the courts without success. A collective suit in the Hebei Higher People's court brought on behalf of 63 victims was not accepted as were cases that plaintiffs tried to file in other courts. According to law professor He Weifang "This is a very serious problem. The courts should have accepted the case according to the law, and not make their decisions based on instructions from authorities or based on [official] documents. If even the courts are not abiding by the law, how can the people trust the law?"

So why should investors care? While the scandal is regrettable, problems like this occur all the time in less developed countries. The general idea is that China is reforming and that in time, it will be able to deal with these problems. This is incorrect. This scandal is about information. The information about the dairy products was known. It was just inconvenient and so it was suppressed. The one thing that investors need is information. If the Chinese authorities are willing to suppress information about adulterated milk, what else are they willing to suppress?

It's not only about information. Investors like to get a return on their investments, but they also like to get their investments returned. The only thing that any investor can ultimately rely on is the law. If the courts are making decisions based on instructions from authorities, then no investor, no matter how well connected, is safe. China is a relationship based system. In relationship based systems information is traded for relationship capital. It is impossible to know who knows what, who owes what to whom, or who has the power. Without the law that power can be unlimited as are the investor's risks.

Many commentators suppose that the recession enveloping China will be short and markets will rebound. The present credit crisis has a lot to do with trust. Without trust in the financial institutions, investors cannot be sure that they will see their money again. Until now, the government in China has had enormous credibility, but like the tainted milk, a lot of that credibility was base on suppressed information. As the economic situation worsens and the problems are revealed, the trust will be gone. Without the institutions, the trust and sustainable economic growth will not return any time soon.

William Gamble, Your Globalized Lawyer

Author: Freedom: America's Competitive Advantage in the Global Market

EMERGING MARKET STRATEGIES

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William Gamble

Emerging Market Strategies

East Providence, RI

401-272-8906

401-272-8139