The Role of Regulation

Meyer traces quality issues to another sort of decentralization: the traditional Chinese subcontracting system that has "multiple layers, with fourth- and fifth-tier subcontractors," making it difficult to control supply-chain networks. "Multiple tiers of subcontracting introduce lots of uncertainty into the system, and the costs in terms of quality can exceed those savings," he says.

Regulation can be effective if it is enforced nationally and locally, Meyer says. The overarching problem is that Beijing "cannot easily enforce regulations ... and the ability of the central government to impose regulations locally remains limited." Meyer attributes that to "centuries of [running a] decentralized economy." He notes, for instance, that China doesn't have national courts except for its Supreme Court. "Imagine trying to resolve an IP dispute with parties from different provinces."

Eager for redemption, China's regulators nevertheless are becoming more aggressive. In a recent statement, China's cabinet outlined plans to strengthen the food-monitoring system, for example. The effort includes representatives from government departments on health, agriculture, quality supervision, industry and commerce administration, and food and drug supervision, according to the Xinhua News Agency. That follows a global consumer backlash last year that forced the government to raise safety standards for toys. Regulators inspected the facilities of 3,000 toy-makers and revoked the export licenses of about 600, dramatically narrowing the playing field. Chinese toy companies worked with the government to strengthen their quality control, but the changes pushed up costs and forced many suppliers to close down. A total of 3,631 Chinese toy exporters -- 53% of the industry -- closed shop in the first seven months of 2008 because of a stronger yuan and increased production costs, Xinhua reports.

More generally, a groundswell of public concern over quality has catalyzed the government's reforms. Public sentiment inside the country -- aided by technology -- also is driving efforts to improve quality. "You have increasingly aware consumers in China," says David Michael, a senior partner and director of BCG's Beijing office. "For instance, the company which is at the center of the recent controversy around baby formula [Shijiazhuang Sanlu Group Co.] is being brutally attacked by bloggers within China on the Internet. It is being punished much more within China than it would have been five years ago, because of the Internet."

The scandal over baby formula tainted by the chemical melamine outraged many especially because it hurt a particularly vulnerable part of Chinese society. "It's not rich people in the big cities buying that baby powder, it's poor people in the rural areas being exploited by counterfeiters," Michael says. "Low-income people feel the most exploited," he adds, when quality is compromised in such a way. The government acknowledged the severity of quality issues. China's food industry still suffers from the use of dangerous illegal additives, Vice Health Minister Chen Xiaohong told Xinhua. He spoke of underground markets for additives that still exist in some regions, and "unspoken secrets" in the food industry.