Chinese Milk Production Predicament

During the last decade China's dairy industry was often described breathlessly as a major success story with endless potential, but the melamine milk adulteration crisis in 2008 revealed the industry's weak foundation of scattered farmers milking poorly-nourish cattle. Reports posted this week reveal that the industry still has not recovered and is in a serious predicament. Dairy farmers are squeezed between rising feed costs and downward pressure on milk prices, Meanwhile, processing companies are still preoccupied with marketing and have little inclination to develop reliable supplies of raw milk.

A survey report from Hohhot, Inner Mongolia--the home base of two of China's biggest dairy companies--notes that small farmers with a few cows who benefited from the industry's frenetic growth in past years are now caught in a trap. They borrowed money with high interest loans to buy cows during the industry's flush years, but now they are losing money after several years of stagnant milk prices and rising feed prices. Many farmers are inclined to sell off their cattle but they can't get a good price for them. 

Another report from 21st Century Business Herald reports similar struggles of dairy farmers across the northeast region--the source of 70-80% of China's domestic raw milk output. The fundamental problem is that imported milk powder from New Zealand and Europe is about 30-percent cheaper than domestically-produced milk. One company in Heilongjiang Province is buying milk at about 4 yuan per kg, which translates to a cost of milk powder of 34,000 yuan per metric ton, assuming it takes 8.2 kg of raw milk to make 1 kg of milk powder and adding processing costs. 

According to a source in a dairy company based in Heilongjiang Province, companies lose 6000-8000 yuan on every ton of domestic milk they process. Farmers in northwestern Heilongjiang are having trouble selling their milk. Heilongjiang has a system for setting milk prices which forbids companies from paying more than 10% less than the reference price of 3.27 yuan/kg set during the fourth quarter of 2011. Unable to lower their purchase prices, many of the milk processors have cut back on the volume of milk they procure. During the peak production season in July-August, companies often declined to buy milk on the pretext of purported quality concerns.

Chart from 21st Century Business Herald shows imported milk powder cost is 22,000-24,000 yuan/mt, compared with cost of 30,000 yuan/mt for powder produced from Chinese milk.

Instead, companies are processing imported milk powder. China's milk powder imports totaled 400,000 mt through August 2012 and are expected to reach 600,000 mt this year. That's nearly half of domestic milk powder production in 2011 (1.25 mmt).

It is reported that milk processors have "reported the situation to the Ministry of Commerce." One Chinese dairy analyst recommends that the government start up a milk powder reserve. Two others recommend Chinese people switch from UHT milk (that can be stored for long periods and transported long distances without spoiling) to pasteurized milk (which could not be easily imported).

The Hohhot report complains that big dairy companies have been slow to develop stronger relations with milk suppliers by building their own farms, investing in cattle-raising communities (known as "cow hotels"), and developing fixed supplier relations with farmer cooperatives. 

Post-melamine-crisis, companies have been under pressure to gain more control over their source of raw milk to improve quality and safety, but the Hohhot report says companies have invested minimal funds in farms. The report criticizes milk companies for building just a few symbolic big farms as showcases or museums that have high operating costs while continuing to procure most of their milk from scattered farmers. The companies' attention is still occupied with marketing and developing new products. 

The government has reportedly not put much money into building farms either. In some instances companies commissioned construction of farms, but the company operating the farm had to come up with the investment capital or borrow it from the processor. The provincial government budgets only 70 million yuan for support of farm construction per year. In 2009, the Inner Mongolia government formulated a plan to construct 33 new 20,000-head farms and expand others over four years, but only 28% of the planned construction has been completed.

At the end of 2011, Hohhot had 700,000 dairy cattle, but only 359 "scale" farms: 271 farms with 100 head, eighty-four farms with 1000 head, and four with 10,000 head. These "scale" farms accounted for two-thirds of the dairy cattle in Hohhot. The Mengniu company has 6 large farms with 18,000 cows and Yili Company has one farm with 10,000 cows.

The report says a 100-cow farm requires investment of 3 million yuan which is hard to raise. It says banks don't lend much to dairy farms. Loans have strict collateral requirements, high interest, short payback periods. Investments in collectively-owned land can't be used as collateral since it can't be sold or transferred. 

The Hohhot report calls for measures to reduce the monopsony power of processors and put farmers and processors on an equal footing. The main recommendation is to develop farmer cooperatives. It calls for setting "fair" prices--perhaps they have in mind a reference-price-setting system like Heilongjiang has. It also calls for improving the availability and quality of forage by planting corn for silage and alfalfa.

This seems to be another example of the unraveling of China's model of low-productivity micro-farming with minimal investment. One sector after another faces cost pressures from rising raw material prices. Cost increases can't be passed on by increasing final product prices since cheaper imported products (milk powder, vegetable oil, meat) are available. While banks lavish funds on space-age infrastructure in cities with seemingly no limit, food processors and farms in the countryside are unable to make fixed asset investments to upgrade quality due to lack of credit and vanishing profits.