July 11, 2014
China's troubled but dynamic dairy industry
Demand keeps growing but domestic supply bottlenecks impact the world market as much as they do China itself
by Eric J. BROOKS
An eFeedLink Hot Topic
Despite the internationally publicised 2008 melamine scandal and countless food safety thereafter, China's dairy demand continues to grow at a near insatiable pace. A study by the Institute of Agriculture and Trade Policy (IATP) ("China's Dairy Dilemma", February 2014) estimates that from 2000 to 2013, China's dairy consumption (across all product lines) expanded at a 12.8% annual rate, projecting it to expand at a 4.1% annual average rate from now to 2022.
But the market has many challenges and supply-demand disparities. Rabobank reports that while 84% of China's fluid milk is produced in the northern provinces of Liaoning, Heliongjiang and Inner Mongolia, 67% of consumption takes place in southern China's high-income, modernized urban centers. Recent years however, have seen a large, widening gap between the country's milk supply and consumer demand.
Lots of pent up growth left
But the industry's current raft of formidable troubles distract critics from how rapidly it has grown or the progress it has made in such a short time. For example, an HSBC Study ("Infographic: China's Thirst for Milk", December 2013) points out that per capita fluid milk consumption jumped from 1kg in 2000 to 9.4kg in 2011. eFeedLink estimates China's per capita fluid milk consumption at 10.1kg this year, compared to Japan's 2011 per capita consumption of 31.8kg or the America's 78.2kg.
Hence, mere fluid milk consumption needs to triple before it approaches that of wealthy North Asian countries. Chinese dairy's potential is even greater when one considers that despite the rising popularity of cheese based fast foods (eg. pizza, cheese burgers, pasta) and health foods like yogurt, HSBC's study estimates that as of 2013, 80% of China's dairy consumption was still accounted for by fluid milk. Clearly, dairy is by far the most under-developed protein line with decades of rapid growth ahead of it.
Going forward, China's dairy consumption will be powered not just by further increases in fluid milk consumption but an even faster rise in value-added, highly processed dairy products. But to understand the challenges China faces in achieving the production to make such consumption changes possible, one must appreciate the past decades of dairy industry development created today's opportunities –and predicaments.
Industry structure, feed costs led to corruption
From thousands of small dairy processors and an industry growing 13% annually during the early 1990s, IATP estimates that by 2006, China's dairy market had a two-track structure: Four large dairy companies (Yili, Mengniu, Bright Dairy and Sanlu) collected and processed 50% of milk produced; with the other 50% of production divided up among approximately 700 dairy processors.
A major innovation was the introduction of UHT packaging in 1997, which made cold chain storage of milk unnecessary. This allowed dairy processors to easily expand beyond their geographic zones. The implicit supply boost created by the UHT milk's due date extension put downward pressure on prices. This had the impact of kick-starting a consolidation process that reached a major inflection point during Sanlu's 2008 melamine contamination scandal.
But while dairy processing had a half-consolidated structure, actual milk production remained a largely backyard farm operation. By 2008, 81% of dairy farmers were keeping fewer than 5 cows. By the mid 2000s, the following market dynamic resulted: The large dairy processors used their scale economies to drive down milk selling prices and minimize their milk procurement costs.
With raw milk prices capped by dairy processors and feed costs embarking on a decade of hyperinflationary increases, this put severe cost pressure on the countless backyard farms which supplied dairy processors. According to IATP, on the eve of the 2008 melamine contamination scandal, 40% of dairy farmers were not making any profits.
It was this unrelenting narrowing of dairy farming margins that led to China's milk safety problems. According to IATP's report, "when large processors exerted downward pressure on prices through the supply chain, problems with adulteration began. Initially, this took the form of extra water added to milk to increase the volume sold, but over time, other substances were added as well, culminating in the melamine scandal in 2008."
According to the USDA, this scandal incident caused China's 2009 fluid milk consumption to fall a whopping a 19.1% from the previous year. Although consumption of yogurts, imported foreign infant formula and milk powders used in fast food kept growing rapidly, fluid milk consumption only equaled its 2008 total last year.
Alongside importing record milk powder volumes and jacking up world dairy prices, the situation caused China's imports of US fluid milk to skyrocket 9,891% from 40 tonnes in 2008 to 3,658 tonnes in 2013. Even in 2013, five years after the scandal broke, its imports of fluid milk from the United States increased 33% on the previous year.
But even so, America only supplies a tiny proportion of China's fluid milk imports, which multiplied from 8,000 tonnes in 2008 to 300,000 tonnes this year, most of it sourced from Australia and New Zealand. Although such import volume growth turned the world dairy market upside down, it is less than 1% of this year's domestic milk production.
Indeed, the strength of China's dairy demand is such that even with fluid milk (which still accounts for 80% of consumption) flat, consumption continued to grow aggressively –but in a very uneven manner. The USDA estimates that from 2008 to 2013, consumption of whole milk powder (WMP) and skim milk powder (SMP) increased by 86.6% and 99.1% respectively, fluid milk consumption remained flat, 0.9% below 2008's level.
The problems is that 2008's milk scandal not only impacted the quantity of China's dairy supply, but brought to light serious quality control issues.
Although demand for powdered milk derivatives kept growing, after 2008, production could not keep pace. For example, domestic WMP output only increased 13%. As a result, imports had to fill the supply gap, skyrocketing 1,313%, from 46 tonnes in 2008 to a USDA estimated 650,000 tonnes this year. Similarly, with domestic non-fat dry milk (NFDM) output sagging from 2008's 53,000 tonnes to 2014's 51,000 tonnes, imports shot up 355% over this time, from 55 tonnes to an estimated 255,000 tonnes this year.
Moreover, top dairy producers such as Yili, Bright Dairy, and Mengniu all responded to the domestic supply crisis by acquiring western dairy processing facilities. Hence, the Chinese newspaper Heliongjiang Daily reports that in a six month period spanning late 2012 and early 2013, 200,000 tonnes of milk powders were processed at the foreign plants of top Chinese dairy companies and imported back to China. Earlier this year, China and Australia signed an agreement that allows the quantity of Australian fluid milk allowed into China to be greatly expanded and expedited.
With leading dairy companies and government policies overseeing much of the foreign dairy powder inflow, this implies that China's dependence on foreign dairy imports has become structural. It will not go away when China's domestic dairy production finally recovers.
But as we shall see, the problem's complexity was such that resorting to mass imports was really the only alternative.
Initial response a mixed success
China's government responded to Sanlu's melamine contamination scandal with draconian laws against adulterating milk, even executing some convicted offenders. But the problem was not at the supply chain's processing end; at worst, their collection agents turned a blind eye to known contamination or watering down of milk. The real problem was in the countless small farmers that lacked the scale economies to survive without watering down milk at a time when their profit margins were being relentlessly squeezed.
What most non-Chinese do not appreciate is that 2008's internationally publicized melamine contamination scandal was the opening bell of the industry's inability to make its milk supply to keep pace with dairy demand. Sanlu's 2008 melamine contamination scandal had a great short-term impact; curtailing domestic dairy purchases, depressing domestic output and boosting imports of WMP, SMP and infant formula.
Nevertheless, consumer demand for domestic dairy products would have probably recovered were it not for another half dozen major milk contamination scandals and a nearly a dozen other more minor incidents that occurred over the next five years. These incidents, some of which involved top five dairy companies, kept the problem of adulterated, contaminated milk in the Chinese consumer's mind long after the issue had disappeared from the western news media.
As hopeless as they made the industry seem, the post-2008 milk safety problems were symptomatic of one simple fact. While the government can easily monitor the behaviour of China's large, top five dairy processors, nobody could police the millions of backyard farms supplying them. With feed costs outracing raw milk selling prices even more after 2008 than before it, their incentive to water down or adulterate milk for commercial gain was, if anything, stronger than before.
Initially, there were government policies that encouraged dairy farmers to check their cows into so-called 'cow hotels', remote large scale facilities where milk quality could be monitored and adulteration avoided. It simultaneously provided incentives for large dairy processors to purchase their supplies from such facilities.
As evidenced by the slew of contamination incidents that kept occurring, the program was at best a mixed success: On one hand, the USDA reports that from 2007 to 2010, the number of farms with 500 or more dairy cows jumped 167% while those with fewer than 10 cows fell by 14.7%.
Moreover, these large companies did their best to boost the productivity of China's dairy farms too. From fewer than 15,000 head in 2008, the number of high quality dairy cows imported from countries such as Australia exceed 100,000 every year since 2011.
Hence, although domestic breed keep average cow productivity at 4.5 to 5.0 tonnes of milk per annum, companies that have invested in western breeds have much higher productivity levels. For example, through the importation of efficient breeds, better feed and farm management techniques, Modern Dairy increased its dairy cow productivity 28% in three years, from 6.1 tonnes of milk/year in 2008 to 7.8 tonnes of milk/year in 2011. The latter amount is higher than Australia or New Zealand's dairy cow productivity and 10% below productivity levels of dairy cattle in America and the EU.
On the other hand, the policies encouraged large producers to expand output more than they encouraged marginal producers to exit the industry. As a result, by 2011, with new milk scandals still being uncovered, 50% of China's milk still came from farms with 10 or fewer dairy cows. While four dairy giants (Mengniu, Yili, Bright Dairy, and Sanyuan) process and distribute over half of China's dairy output, backyard farms still supply over 50% of the milk these and other dairies receive.
Consolidation at top, then bottom
The contamination problem's intractability forced the Chinese government to fine-tune its dairy industry policies. From 2008 to 2011, new regulations focused mostly on dairy processing and its consolidation into several, large scale, nationwide firms. When it became apparent that the incentive to adulterate milk persisted in the thin margins and low returns of backyard raw milk suppliers, China's government responded in two ways.
First, by encouraging small backyard dairy producers to exit the industry, or consolidate into much larger companies.
Secondly, by introducing policies, investment and tax incentives that encourage the country's top dairy processors to vertically integrate dairy milk production into their operations.
Mostly owned by Yili, Mengniu and Modern Dairy, China now has over 40 dairy farms with over 10,000 head of cattle. These three top Chinese dairy processors will continue substituting large, centralized dairy cattle facilities in place of their previous, widely dispersed backyard farm collection networks.
They are complimented by foreign dairy giants such as New Zealand's Fonterra and Switzerland's Nestle, which are building their own large-scale, vertically integrated facilities. Fonterra for example, intends to operate 30 integrated cow-to-milk powder dairy facilities in China by 2020.
Along with Chinese producers investing overseas, there is also considerable overseas investment in China's own domestic dairy giants. In February, France's Danone paid US$663 million to boost its equity in Mengniu from 4% to 9.9%. Similarly, RRJ Capital announced it would invest RMB1.5 billion (US$248 million) in a subsidiary of Bright Dairy.
Moreover, after spending five years overcoming the fallout caused by Sanlu's 2008 melamine incident,
all these changes are causing the industry to assume a new form. In June, China's government announced that it hoped to consolidate the country's dairy sector into 10 large scale dairy powder producers by the end of this year, reducing their number to five by 2018.
Second, seeing that small producers were still creating huge quality control problems, policies that encourage small dairy farms and milk processors to leave the industry have been in place for almost two years. They have been successful to the point that small players have left the industry even faster than large ones could compensate by increasing their output.
With imports of productive cattle helping to compensate, Taiwan's Want China Times reported that in 2013, the number of dairy cattle in China fell 20% to 25%. This left dairy output closer to 35 million tonnes rather than the 40 million that had been forecast for 2013 a few years earlier.
The situation was such that the USDA was forced to significantly revise its domestic fluid milk production estimate downwards in 2013. With less fluid milk, there is of course, less feedstock the milk powders which are foundation of processed dairy products. The resulting supply shortfall lead to an unusually large volume of imports last year, resulting in record high world dairy prices
Supply-side questions haunt road ahead
Going forward, there continues to be great opportunity and equally great uncertainty. When Sanlu's scandal broke out in 2008, nobody expected that it would have such a profound, long lasting impact. Record high world dairy prices, unforeseeable import growth and the prosperity of dairy farmers from Australia to New Zealand all have their origins in the melamine scandal's tremendous impact on the quality and quantity of Chinese milk production.
Going forward, neither private analysts nor China's government pretend that the domestic dairy supplies can keep pace with the expected 4.1% projected annual demand growth. Nevertheless, there is great disagreement on how quickly China's dairy market will grow over the next decade.
A great deal of the problem is the question of how well China will handle the transition to a high density, intensified production model. Without proper farm management techniques and supplement use, an intensified farming model may lead to everything from more disease outbreaks to perverse incentives for overuse of antibiotics and banned substances.
A joint OECD-UN FAO study expects China's fluid milk output to rise at a 3.3 % annual rate in the years between 2011 and 2020. This would leave plenty of room for growth in both Chinese dairy capacity and in the export prospects of foreign suppliers, be they western producers of dairy powders, dairy cattle supplements or processing equipment.
These uncertainties continue to cast a heavy pall over this protein line's otherwise bright prospects. On one hand, China's billion plus demographics and ultra-low consumption promises unlimited opportunities. On the other hand, how well it manages the transitions its dairy processors and milk producers are undergoing matters for a lot. It will determine just how much of China's dairy supply growth will come from China itself, and how much will be supplied by exporters in New Zealand, America and Australia.
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