- Published on Monday, 24 September 2012 09:49
China automakers Chery and Great Wall were recently forced to recall 23,000 autos exported to Australia. The reason for the recall is that the brake linings and engine gaskets in the cars contained asbestos. Asbestos is banned in Australia and 55 other countries. Due to the hazardous nature of the product, the cars had to be recalled back to China since remediation in Australia was not possible. It is assumed that all involved suffered substantial losses and that the Chinese move into the Australian auto market has been permanently damaged.
Chery and Great Wall have been on a push over the past several years to export their products overseas. Their efforts have been limited mostly to second and third tier markets. Entry into Australia was intended as the first move into first tier developed country markets. After Australia, the plan was to move strongly into North America and Europe. This recall suggests that the entry into Australia will be a failure. This bodes ill for any plans to enter the highly competitive North American/EU markets.
How can this monumental blunder be explained? In a recent WSJ blog post, China auto industry expert Michael Dunne attributes the catastrophe to “quality fade.” Quality fade occurs when initial production meets all applicable standards, but later production level deliveries are defective. The defects are in hidden components not easily discovered by surface inspections. Over time, the problem gets worse, hence the description “fade”.
The Chinese cars fit this description perfectly. The cars looked just fine; the defects were hidden in the brake linings and gaskets. Why the Chinese companies would destroy their entry into Australia merely to save small change on these cheap components is a mystery. However, the fact is they did it and foreign buyers of Chinese products should consider this lesson carefully. If a Chinese company will do this to themselves, what will they do to an unrelated importer? The answer is that it appears that Chinese companies will do virtually anything to save a few pennies. A big question with respect to Chery and Great Wall is whether they were victims or perpetrators as it is quite possible that they received the gaskets and brake linings from outside suppliers.
Foreign companies remain heavy buyers of manufactured goods from China. As these goods become more complex, the risk of hidden defects only increases. The China auto fiasco provides a number of lessons:
- You can never relent in constantly monitoring quality. Most foreign companies with whom we work assume that Chinese manufacturers will improve over time. The whole premise of quality fade/quality creep is that exactly the opposite is true. The first few deliveries are likely to be the best delivery. Without active intervention, the buyer should expect each subsequent delivery to be worse than the previous. Since this result is counter-intuitive, foreign buyers have to be constantly on guard. Active intervention is costly and mentally exhausting. Most foreign buyers eventually tire of the process. However, such active involvement is the price of purchasing from Chinese manufacturers. Buyers that do not want to incur the cost should avoid China.
- Do not take current success as an indicator of continued good performance. Many Chinese companies will perform well for several years, causing the foreign buyer to drop its guard. After the guard is down, a sudden drop in quality will occur, causing extreme damage. This is what happened in the lead content in toys issue that arose in Guangdong several years ago. The message is the same: a foreign buyer can never relax its vigilance on quality. The fact that a manufacturer has not had a problem for many years means very little in predicting future quality.
- Do not expect that a desire for a good commercial reputation will act to control the behavior of Chinese companies. Most manufacturers in the OEM world are privately owned. These companies operate under thin margins and are in a constant struggle to survive. Few of them are concerned about the long term. They are mostly only concerned with day-to-day survival. Most state owned enterprises are similarly weak financially. For those that are not, reputation also means nothing. The stronger state owned enterprises are protected by the state. A bad reputation with foreign entities is not important to their long-term survival.
- Do not assume that you know where problems will occur. Take the autos issue. Most buyers would assume that problems would appear in major systems like the engine or differential or steering. Instead, the problem appeared in break liners and gaskets, cheap components that would not normally raise attention. This is a very common occurrence in China. The Chinese manufacturer will make the primary and expensive component just fine and then ruin it with non-standard and defective accessories. This happens often in the home furnishings sector: an otherwise well made sink set is ruined with substandard faucet fittings.
What is the solution? The main point I want to make is that there IS a solution. The solution works as follows:
1. All purchases from China must be made under a well-drafted contract that is enforceable in China. Purchases under informal purchase orders simply do not work for China. For more on China OEM Agreements, check out the following:
2. The contract with the Chinese manufacturer must provide for a mechanism where the foreign buyer can exercise constant control over the quality of the Chinese product. Liability for defect must be made clear and it must fall hard on the Chinese side. If possible, no defective product should ever be permitted to even leave the Chinese factory. If defective product is discovered outside of China, the Chinese side must be absolutely liable for dealing with the problem. The standard procedure (in China, anyway) for dealing with defects through a discount on future purchases must not be used.
3. The foreign buyer must actually follow through and constantly monitor the quality of the product. The best contract with the best procedure is no good if the foreign side does not follow through by rigorously implementing the procedures outlined in it. As I mentioned above, this is an expensive and tiresome process. Parties that do not follow through are almost guaranteed to experience problems in China. These problems are an irritant to the Chinese side but can be fatal to the foreign side. For this reason, the only side that has any incentive to follow through is the foreign side.
Our clients often ask us whether China product quality is getting any better. My standard answer is no and yes. No, Chinese manufacturers are not doing a better job on their own at maintaining quality. In fact, if left on their own, much evidence suggests they are doing worse. But yes, the legal system and quality control systems have progressed to the point where aware and active foreign companies can force Chinese manufacturers to operate in a reasonably acceptable manner. However, they have to be forced to do it. They will not do it on their own. The Chery/Great Wall fiasco illustrates this final point.
Do you agree?
Dan Harris is founder of the Harris & Moure law firm, a boutique international law firm focusing on small and medium sized businesses that operate internationally. China is the fastest growing area for the firm. Dan writes ChinaLawBlog.com as a source of China legal and business information.