Key Points:

Call it brand dilution, China-style. Any company entering a joint venture as a minority partner is aware its brand could be damaged by events beyond its control.

Farmer shareholders would expect New Zealand's biggest multinational, Fonterra, to be acutely aware of the risks, with its global growth strategy heavily aligned to soaring demand for dairy products in Asia, South America, Africa and the Middle East.

These emerging markets promise infinite rewards; but you enter at your peril. They tend to lack infrastructure needed to ensure robust quality assurance; supply chains are often fragmented and subject to change; and central governments may exert little influence on behaviour in rural areas.

Such markets may be fledgling and remote, but scandals related to product safety or quality quickly reverberate around the world and damage the brand - no matter how diluted.

Fonterra's worst nightmare happened when milk destined for its Chinese partner San Lu was watered down by farmers and at rural collection points to increase volume, and melamine was added to disguise the low protein content.

Melamine, a chemical used in plastics manufacturing and in fertilisers, is not supposed to be in food at all, as one Chinese food science expert told the English language China Daily this week.

Its use to disguise protein levels was exposed last year when contaminated pet food from China was linked to kidney failure in cats and dogs in the United States.

BY yesterday the number of poisoned infants stood at 6244 including 158 with acute kidney failure and hundreds with kidney stones. Four babies have died.

The addition of melamine to Chinese milk appears to have begun late last year - the Geng brothers, the first two milk dealers arrested this week by Chinese authorities - reportedly began adding the chemical after San Lu rejected their supplies as not up to scratch, the China Daily reported.

San Lu is based in Shijiazhuang, 280km southwest of Beijing and the capital of Hebei province.

It is China's largest producer of powdered milk - used for infant formula and an ingredient in other dairy products, producing 6800 tonnes a day at 21 plants throughout China. Sold at a relatively modest US$2.60 a packet, San Lu infant formula is popular with China's rural poor.

The Geng siblings had had a supply contract with San Lu since 2004. They are residents of rural Zhenghing county, just north of Shijiazhuang.

Asked if he knew the consequences of adding the chemical to milk, the elder Geng replied: "I've never asked and never thought about it. I only know it's bad for health." He and his brother face the death penalty.

Another farmer arrested in Hebei on Monday, identified as Ma, confessed to buying about 200kg of melamine last November and mixing it with fresh milk from his 400 cows to artificially raise protein content. Police seized about 15kg of melamine from Ma's house.

Latest reports say a further 12 people have been arrested in China, bringing the total to 18. Six of those arrested reportedly sold melamine and the rest are accused of selling contaminated milk. Tian Wenhua, the sacked board chairwoman and general manager of San Lu, has been detained by police for questioning. The mayor of Shijiazhuang and four other city officials have also been dismissed because of the contamination.

When the news broke across China last Friday, it seemed the scandal was confined to San Lu infant formula. There were suggestions San Lu had been a victim of its products' rising popularity - having to source milk from non-contracted suppliers to keep pace with demand. But investigations by Chinese authorities found the rort far more widespread than a few rogue suppliers to San Lu.

Testing this week found melamine in 69 products from 22 dairy companies, including the Inner Mongolia-based industry giants Mengniu and Yili. All firms could offer the excuse that the chemical was not tested for in their quality control programmes - why would it be? But the highest concentration of melamine was found in San Lu products.

As Chinese authorities launched an industry-wide investigation, the number of victims soared apace - from an initial 650 infants to more than 6000. A roll call of some of the country's most backward rural-based economies were hardest hit - from remote western Gansu province through San Lu's heartland Hebei province to eastern Jiangsu and Guangdong in the south.

Hebei alone reported 861 infants with kidney stones, 61 of them hospitalised. The more remote areas are rife with discontent about official corruption, incompetence and indifference.

An opinion piece in the Zinhua newspaper said: "All the babies are from rural areas and are bottle-fed either because their mothers don't have enough milk for health reasons or because the parents are away working in cities and have left them under someone else's care."

It's a very different environment to the seamless contractual arrangements Fonterra is used to with Waikato cockies. San Lu suppliers are often smallholders with a few cows. Milk quality can be poor and supply chains fragmented.

Yet even the official Chinese media has been critical, with the China Daily questioning reaction speeds of San Lu and the state consumer safety agency AQSIQ. It carried expert comment that the scandal reflected poor management and supervision of milk products.

San Lu's first inkling something was wrong came in March, when customers complained that their babies' urine was discoloured and that some had been hospitalised. Fonterra CEO Andrew Ferrier says San Lu carried out thorough testing in three provinces - but melamine was not tested for.

"You can't test for every poison out there," he told a press conference this week. "To our knowledge, there isn't a dairy company in the world that tests for melamine."

Complaints continued through June and July, with hospital authorities in Guangdong linking kidney stone cases to the infant formula and notifying San Lu.

The first deaths were in Gansu - a 5-month-old boy on May 1 and an 8-month-old girl on July 22. Both died of kidney failure after their parents refused operations. A third infant died in Gansu 10 days ago.

A fourth death occurred on Thursday at a hospital in the Mongolian Autonomous Prefecture of Bayingolin.

Ferrier says San Lu's board of directors was not aware of melamine contamination until August 2, at which point it ordered a recall. Fonterra has three directors on San Lu's board of seven; Ferrier says they urged a full public recall but were ignored.

And in public, San Lu continued to deny and obfuscate. As late as September 10 - days before the scandal broke and five weeks after the board knew - the Gansu public health bureau announced it was investigating San Lu milk formula after the hospitalisation of 14 babies with kidney stones. A San Lu spokesman denied producing the questionable milk powder and maintained the packaging was fake, the Xinhua news agency reported.

Fonterra has to be unhappy at San Lu's crisis response - but how clean are Fonterra's hands? As Ferrier told Radio New Zealand, San Lu's quality assurance programme was developed by Fonterra. "We put in very rigorous testing - we helped San Lu build their testing."

Anne-Marie Brady, a specialist on Chinese politics at Canterbury University, says Fonterra's response was too slow. But, she told RNZ's Morning Report, the crisis coincided with the Olympics - and for two years leading up to the event the Chinese Government ran a "propaganda ban" on food safety issues.

A food safety crisis affecting babies just as the games began was the last thing Chinese officials were likely to promote. At the best of times, says Brady, China is a difficult environment for New Zealand companies that value their international reputation to work in.

New Zealand China Trade Association chairman Stuart Ferguson told the Herald's Owen Hembry that Fonterra probably acted as fast as it could but had been frustrated by local bureaucracy.

Companies that moved into China knew there were local traditions and action plans to be honoured, he said. "If that involves a degree of cloudiness, of obfuscation from local officials you have to live with that and you have to live with the frustration that that delivers."

Cultural factors - the need to save face - would also have played a part.

All of these - the Olympics, and the realities of doing business in China - go some way to explaining the 12 days it took Fonterra to notify the New Zealand Embassy and, perhaps, the further two weeks before the Embassy reported its findings to Wellington, on August 31.

Prime Minister Helen Clark learned of the issue on Friday September 5 and on Monday September 8 instructed officials to inform Beijing authorities.

Clark says Fonterra could not get local authorities to issue a public recall until New Zealand alerted the Chinese Government. Some commentators, including Herald columnist Fran O'Sullivan, say questions remain about what information was conveyed to the Government by Fonterra and why it took so long get action.

Ferrier says Fonterra was pushing San Lu for a public recall from day one but "had to make a call whether we could be more effective working with the Chinese Government or taking matters into our own hands". The latter would have meant going "outside the system", with no idea whether a proper recall would happen.

For China's food safety watchdog AQSIQ, the disaster is the first test of "landmark" new regulations designed to clamp down on unsafe food and toys.

The new recall system requires manufacturers to stop production and sales, notify vendors and customers and report to quality control authorities when product defects are found. Vendors should also stop sales and notify suppliers or producers when product safety issues arise.

The regulations, which follow scares ranging from ducks and hens fed with a cancer-causing dye to last year's melamine-tainted wheat protein, took effect on August 29 - too late for the tainted milk scandal and probably too late to rebound on San Lu punitively. But Chinese authorities are pursuing the case with apparent vigour.

Waikato University's international programme director, Ed Weymes, landed in the southern city of Guangzhou last Friday to find the tainted milk story headlining both English language papers.

Weymes, who lectures on international business management, says it's a reality of joint ventures anywhere that "when you're not in the driving seat you have to try and persuade and cajole as much as you possibly can".

He says Fonterra is dependent on the "integrity of the marketplace" in its joint venture partnerships in China - and elsewhere.

"Dairy in China is a relatively new market but has been growing and expanding for a number of years. What the dairy industry doesn't have is a strong infrastructure in China. Some dairy companies run their own collection points, others rely on independent milk parlours and collect from there. It's a weak link."

Weymes says Fonterra's due diligence process would have examined San Lu's quality assurance systems and reputation before entering the joint venture in 2006. It's unlikely the process was lacking. "The tainting appears to be at independent collection points who aren't doing quality testing - it wasn't San Lu's fault directly.

"But Fonterra were pushing for a recall and San Lu have been ignoring that advice."

But it's not the first time San Lu has been linked to a food quality scare. In 2005, authorities in northern port city of Tianjin seized hundreds of cases of mislabelled San Lu yoghurt.

And Fonterra must have been aware of the risk of product-tampering in China. When the news reached New Zealand this week, a Venture Southland official, Steve Canny, recalled the concerns of a Chinese businessman negotiating to buy 1500 tonnes of baby formula in Southland earlier this year.

He insisted the formula be supplied in sealed 1kg containers to avoid the risk of contamination with materials like talcum powder or chalk once it reached China.

Even the Ministry of Foreign Affairs and Trade's website on the China free trade agreement alludes to the risks of operating in China. The site invites businesses to share their experiences of doing business there.

Among the familiar tales of needing to "do your time" and build relationships is this advice from Hayes International: "To protect intellectual property we manufacture only non-critical components in China."

Ferrier says he can "look myself in the mirror and say Fonterra acted absolutely responsibly in this one".

But entering a joint venture in China's regulatory and business environment without a secure supply line smacks of an accident waiting to happen. Perhaps for Fonterra in 2006, the potential of the burgeoning Chinese market outweighed the risks of a scandal damaging the brand worldwide.

Could Fonterra have done more to lessen those risks?

David Thorrold, chief executive of Hamilton-based Biovittoria, which manufactures a natural sweetener from the luo han fruit in southern China, says tampering is a risk anywhere and every company does supply chain risk assessment.

For other New Zealand businesses operating in China, the risks of a disaster like Fonterra's are well-known. Firms try to minimise these risks by building relationships of trust and confidence and having "people on the ground", says Brett Hewlett of nutraceutical and honey extract manufacturer Comvita.

"If you don't have complete control you are leaving yourself exposed - it doesn't matter whether it's in China or Africa or America. But at the end of the day you have to see China as an opportunity, not a threat."

Steven Dickinson, partner and China manager of US law firm HarrisMoure, says Chinese companies usually want three things only from their foreign joint venture partners: money, technology, and access to foreign markets. He says the sharing of management expertise is actively discouraged.

"There is a lesson here on how foreign investors get bound up in Chinese companies.

"It's a cautionary tale for all businesses in China - one thing they have to do is satisfy themselves that there are controls and measures in place to protect quality and their brands.

"There is the problem for Fonterra of how they're perceived and how their complicity is perceived. The fact that they felt they had to go through diplomatic channels says a lot about how they see the market here and how they see their place in it.

"Fonterra has to offer a better explanation of why it took so long for them to make the situation public.

"Why was their influence in the company not enough to force it to make this issue public?"

As for the long-term damage, Chinese media coverage has largely avoided focusing on San Lu's junior partner. Some business sources say this is linked to the recent signing of the China-New Zealand free trade agreement, with authorities alert to New Zealand's special status.

Internet blog criticism of Fonterra has softened as knowledge grew that our Government blew the whistle on the scandal. But as the first dairy firm exposed, San Lu's association with the scandal may linger longest in the minds of Chinese consumers.

It's likely Fonterra's name has been damaged by extensive news coverage in lucrative markets in Europe, Asia and America. What level of contamination occurs to Fonterra's brands remains to be seen. But one - Anmum Materna milk - has been affected.

Fonterra recalled a batch of Anmum Materna in China because it was manufactured under licence by San Lu using local raw milk that may have been contaminated.

That led to Fonterra Brands Malaysia having to assure customers that its milk products in Malaysia - using New Zealand milk - are safe and that the batch recalled was sold only in China.

Now, with Chinese lawyers and rights campaigners mobilising to support families stricken by the toxic milk, San Lu and its joint venture partner Fonterra may be facing compensation claims.

- John Macdonald