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China produces a staggering 190 billion counterfeit cigarettes each year. The Chinese government claimed that it dealt with 159,000 cases involving the manufacture and sale of counterfeit cigarettes in the first six months of 2002 alone. And it has destroyed more than 5,000 cigarette-making machines in recent years. Still, the government is at a loss to solve the problems posed by counterfeiting.

Counterfeit cigarettes cause harm in a number of ways. Consumers purchase a product that lacks quality standards:

Health experts in China say that the counterfeit cigarettes contain six times as much lead than legal ones, 160 per cent more tar, 80 per cent more nicotine and dangerously high levels of arsenic.

Also, legitimate workers lose work, and society suffers because profits from counterfeiting often support organized crime. The government naturally misses a fair amount of tax revenue, and one of the greatest harms is that counterfeit cigarettes are sold more cheaply. Cheap cigarettes provide a big incentive for people to smoke.

Counterfeiting in China has had a far-reaching impact with the contraband making its way to Europe, among other destinations. The British have reached out to the Chinese government for help in controlling the outflow of counterfeit cigarettes:

Investigators estimate a third of cigarettes smoked in Britain today are counterfeit — with 80 per cent of them now made in China.

While China has counterfeiting challenges, it also has the burden of dealing with cigarettes that are smuggled into the country. About 3% of all cigarettes sold in China are foreign-branded cigarettes, but 95% of this amount is said to have been brought in illegally.

Foreign tobacco companies have long regarded China as the “ultimate prize” and they have been shown to do whatever it takes to gain market share in the monopoly-controlled market. Big Tobacco’s approach has essentially been to use smuggling as a key marketing tool. Tobacco companies sell their product to agents who find their own ways of bringing the product into China. This is not mere speculation, but facts uncovered in legal actions taken against British American Tobacco. A surprising 25% of all profits at BAT were said to derive from so-called “transit trade” into China.

This is the third out of three posts on tobacco in China.

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More than 1.1 billion people smoke, and China is home to roughly 300 to 340 million of these smokers. The harmful effects are known, and World Health Organization (WHO) estimates that one-third of all Chinese males below the age of thirty today will eventually be killed by tobacco. China will undoubtedly face high economic costs down the road as a result of its high tobacco usage rates.

Tobacco’s origins can be traced to North America, actually, and when Christopher Columbus first saw natives smoking, he noted its addictive properties. In the centuries that followed, European physicians would claim that tobacco cured all sorts of ailments, and in the 17th century doctors would recommend smoking as a way to ward off the plague.

The Chinese took a different approach to tobacco around time time. Aware of its ill effects, the Ming Emperor in 1638 made smoking a crime punishable by decapitation. Today, the attitude is a positive one. One survey conducted revealed 61% of Chinese smokers believe smoking causes “little or no harm”, and a great many believe, quite the opposite, that cigarettes are healthful.

It’s a profitable business, tobacco - margins are much wider than for export-related products. The economy benefits, but the biggest beneficiary of tobacco is by far the government. Cigarettes generate more tax income for China’s central government than any other industry with an estimated 8-12% of national tax revenue coming in from the big leaf. A World Bank data sheet (below) suggests just how far this figure is from world averages.

China’s tobacco industry is a monopoly with one group, China National Tobacco, serving as the largest cigarette manufacturer in the world. It has some 130 cigarette factories producing 400-900 separate brands (the figure depends on who you ask, apparently, or what you call a brand). No trademark has more than 4% market share, and foreign brands together account for only 3% of the market. Cigarettes benefit the central government, but there are many fingers in the pie at the local levels also. Despite the long-term harm it is doing to China, it is not likely anyone in government will be discouraging the nasty habit anytime soon.

Country —– % of Gov’t Revenue From Tobacco Tax

United States — 0.4
Columbia — 0.7
Egypt — 0.8
Zimbabwe — 1.0
Estonia — 1.2
Costa Rica — 1.4
Denmark — 1.7
Finland — 1.7
India — 1.8
Spain — 2.2
Bulgaria — 2.80
United Kingdom — 3.0
Australia — 3.0
Chile — 3.4
Argentina — 4.0
Brazil — 4.9
Nepal — 5.4
Greece — 7.7
China — 9.1

Source: World Bank

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The Wall Street Journal printed a fun-to-read article yesterday on cigarette smoking in China by Hugo Restall of the Far Eastern Economic Review, who took up the habit of smoking apparently just weeks before writing the piece. His reasoning:

After years of resisting, a friend in Shanghai gave me the perfect excuse to start smoking. China has become so polluted, he told me, that it’s better to breathe through a cigarette filter than just take in the air on its own. And if your lungs are going to get shot to hell anyway, you might as well enjoy it. So, well into middle age, I figured that it was probably a good time to take up the smoking habit. The result? I enjoy it so much that I don’t know why I didn’t take it up earlier.

Funny stuff, and it reminded me of the story of one Westerner who returned to the US after many years in China. He was told by his doctor that his health seemed all right, but that maybe he should consider giving up smoking - his chest x-rays looked that bad. The thing was the guy had never smoked in the first place.

One of the points in the newspaper article that caught my attention was the idea that in China “real men” smoke:

Real men smoke, period. And when real men hang out together, they smoke a lot. The presence of women is appreciated, of course–if they are quick with a lighter.

I did research years ago on tobacco control policy and among the data was information on male/female smoking ratios in the world. Men smoked more than women in Asia (in China 63% of men, versus 4% of women), but smoking rates were nearly even between the sexes in the West (28% of American men smoke; American women, 23%). Sweden was the only country listed in the WHO survey where more women smoke than men. I asked a Swede about it, and he told me that real Swedish men don’t smoke – they chew tobacco. About the Vietnam rate differences, I recalled speaking with someone who believed that Vietnam was in some way “more Chinese than China”. Thinking of smoking habits, I wondered if that’s what he meant.

Smoking Rates (Men/Women)

Vietnam: 73% / 4%
China: 63% / 4%
Russian Federation: 63% / 30%
Japan: 59% / 15%
Sri Lanka: 55% / 1%
Israel: 45% / 30%
Thailand: 45% / 3%
India: 40% / 3%
France: 40% / 27%
Egypt: 40% / 1%
Norway: 36% / 36%
Singapore: 32% / 3%
Ireland: 30% / 28%
United Kingdom: 29% / 28%
United States: 28% / 23%
Australia: 27% / 23%
Sweden: 22% / 24%

Data: World Health Organization (1997)

This is mean to be the first part of a short series on tobacco in China…

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Hollywood will soon release In the Shadow of the Moon, a documentary presented by Ron Howard, the director of Apollo 13. The film will combine stunning footage from Apollo missions along with more recent astronaut interviews. The trailer suggests it will be an inspiring movie, but what struck me was how patriotism is downplayed. Discussing the world’s response to the achievement of landing on the moon, one astronaut reflected: “Instead of saying, ‘you Americans did it’, everywhere they said, ‘We did it, the human race.’”

Around the time this movie reaches theaters, China’s lunar probe will arrive at the moon. Far from a shared human experience, though, Beijing has made it clear – the purpose of the mission is to increase China’s prestige among nations. Back in the 1950s, Chairman Mao lamented that his country “couldn’t even launch a potato into space”. Not one to milk an opportunity, the Communist Party has invited citizens to request a song that might be broadcast from the moon. I always suspected that if the Chinese ever colonized space, it would somehow involve karaoke. Anyway, top choices include “My Motherland” and “Love Our China”, the sort of numbers meant to evoke deep nationalistic sentiments.

Re-imagined David Bowie lyrics might have been better…

This is ground control to Major Zhang
You’ve really made the grade
And the papers want to know whose shirts you wear
Now it’s time to leave the capsule if you dare

Coincidentally, this month it’s been fifty years since Sputnik, the event that kicked off our space race with the Soviets. The WSJ’s interpretation of the rocket launch is an odd twisting of perceptions - the paper has suggested China’s moon ambitions are directly related to an effort to settle its status relative to Japan. As if China were the sort of country to chase first runner-up prizes. No, I’m afraid the reason has everything to do with America, as some lesser publications have correctly hinted:

NASA’s top officials are clamoring about a new space race to help push the agency into the future. Their effort, expressed in speeches and interviews during the past several months, is fueled by a fear that unless something sparks a public outcry for an invigorated space-exploration program, the United States could lose its global leadership role in the quest for the stars.

China’s launch should be a wake-up call, but America will be hitting the snooze button. It may be a simple matter of “been there, done that”. We put men on the moon forty years ago already - and with less computing power than you’d find in a Sony PlayStation. About the only ones clamoring for a manned moon mission these days are conspiracy nuts who insist we never went to the moon in the first place [For a clip of Buzz Aldrin making his rebuttal, click here].

This week’s event is no Sputnik. A more like Sputnik might be seen at the China games, should China succeed in winning more gold medals than the United States. If China can pull it off – and there is every indication that they might – it would be a far more symbolic event than the broadcasting of some oversentimental serenades from deep space.

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Something is bothering me about Alibaba’s IPO and related market valuation. In case you haven’t heard, the company is looking to raise as much as $1.3bn in an initial public offering, making this the largest ever IPO for a tech company based in China. The IPO is going to give the company a valuation approximating $7.8bn. Believe it or not, some are saying that this value is low.

Alibaba.com is a website that provides information on China manufacturers (Yahoo! owns a 39% stake). The website serves as a kind of directory. Consider it a Yellow Page for prospective importers. Those who say that website is a great business model emphasize the company’s first-mover advantage. Many also get excited about this being a “B2B play” - the phrase is so “2000”, but never mind that part. My lack of enthusiasm for the IPO has more to do with many uninspired experiences with the company’s website. To be frank, I just don’t get it. Aren’t the best China supplier relationships those where the supplier and buyer are known to each other, where the two have an on-going work relationship? Established players have little use for the website after the relationship is in play, and it’s hard to imagine that, for example, Mattel, ever used Alibaba.com (its supplier relationships predate the Internet).

If the website has any value at all, it’s in enabling fledgling factories to find would-be buyers. If you believe there is value in such a proposition, let’s reference all of those financial analysts reports that suggest the industry is rapidly consolidating. It would be one thing if factories were like single people - dating websites enjoy a steady stream of new single customers - but manufacturing is not the same. In the long run (or sooner?), all capable manufacturers are known to the market. The website works best in a world with murky market data. We are heading away from that world, not towards it. There are already websites that allow companies to list information for free and Chinese are using these sites with greater frequency.

I have no doubt that the IPO will come out strong. It’s going to get lots of attention because it’s both a tech play, and it’s a China play – call it “hype squared”. Not sure about Alibaba Group’s other businesses – it’s PayPal-style, or eBay-style, business models. It’s just that Alibaba.com as a business lacks what you want to see in an Internet offering. Just take a look at these five-year graphs pulled from Alexa. In terms of page views, as well as the site’s rank, both are down to where they were when Alibaba.com just started to take off in 2003. The company may be a rocket ship, but it’s one pointing in the wrong direction.

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A new website out there called NonInMyCart.org has promised to offer information on product recalls, drawing from three federal websites. The site happens to be sponsored by Consumers Union, the people who publish Consumer Reports. The splash page at the website displays a letter that a web surfer can write to congress.

The site combines recall notices from the three federal agencies that oversee food and product recalls, as well as recommendations from the organization and information about the organization’s stance on legislation being considered by Congress.

The reason why this development is so interesting is that Consumer Reports is famous for its objectivity. The magazine doesn’t take on any advertising revenue so that they don’t even have the appearance of taking sides. I can’t  remember Consumer Reports ever getting involved in anything political.

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A headline from today’s newspaper read: “Mattel Earnings Hit by Product Recalls”. It sounded serious and other news stories were even more dramatic, talking about how the company had been “knocked down” and “muzzled”. It had the feel of a moral tale. Was it the high price paid for poor quality control? Reading the stories in more detail, I felt misled. The primary point was that quarterly profits at Mattel were off by 0.9% (sales were actually up). I looked at the articles which I had printed out by then, and I laughed; they seemed so silly!

“Mattel Emerges from Quality Crisis Unscathed.” Put that in bold and you’d have a better headline - and a more accurate one. But then it would be a more difficult story to write, would require some explanation of how Mattel actually got through three massive recalls - and a resulting public relations mess - without any damage whatsoever.

I discussed the news stories with someone, and he suggested Mattel had survived on “the power of the brand.” That may have had something to do with it, but I thought of an easier explanation: Consumers simply didn’t give much of a goddamn. In surveys, you know, they all said they were finished with “Made in China”, and they vowed to purchase products made anywhere else. They were flakes. They said one thing, but then they did something else.

“Wait until the fourth quarter,” was a suggestion. Since roughly two-thirds of toy sales come from fourth quarter sales, that made sense. Maybe Mattel would suffer a supply chain delay, or else it would face another product recall - not likely. My prediction is that Mattel will see a solid Christmas, and, not only that, when fourth quarter results come in, the toy giant is going to be held up as an shining example, a case study in crisis management. No one will recall that Mattel delayed its reporting of lead-tainted products to the Consumer Product Safety Commission; there will be no memory of an uninspired, impassive speech made by the company’s chief executive officer; and no one will think of Mattel’s awkward kowtow in Beijing.

For Mattel shareholders, the lack of bad news on the income statement is good news, but on the whole it’s a disappointing result. Where is the incentive to avoid product failures if no one suffers? Executives are actually being patted on the back for their handling of the crisis. Everyone in China will be all right, also, naturally. With orders now stable, anyone who lost his job as a result of a factory shut-down has since been redeployed somewhere else. The best part is that the media prepared the American public to expect price increases for (ostensibly) higher quality, so there is now the opportunity for better margins in the U.S., China, or possibly both. For toy companies and their suppliers, it’s nothing but upside.

A few class-action lawsuits have been filed, which looked promising as a motivator, but it is not likely that lead poisoning will be proven in any case related to Mattel, and without significant harm (read: death) it will be tough to achieve the kind of punitive damages that encourage industry to higher levels of corporate responsibility. The media often provides a meaningful check in the U.S., but in this case the press has done little more than make flat quarterly growth seem like some kind of punishment for operational negligence. I don’t know what to make of Mattel’s quarterly report results, but it’s most certainly not that.

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