Just up the hill from the cove, past the tethered goats and the sweet-potato fields, are what Chinese investigators see as monuments to the smuggling of foreign cigarettes: five garish mansions rising incongruously on the edge of the old fishing village of Shadi. All the houses belong to the family of Cai Wanhe, a 51-year-old man with no fixed job and no shortage of disposable income. Besides building a three-story house that resembles a giant bird cage, Cai has donated his money–and his name–to the village’s new primary school, old folks’ home and basketball court. But his charity didn’t work on everyone. Earlier this year a team of police and Customs officials raided the family homes and found nearly 30 million Chinese and foreign-brand cigarettes hidden in their basements–a haul worth $1.8 million. Cai and his brothers escaped the initial dragnet, but the alleged kingpin was finally captured in late September.
The message now painted in large red characters on the front wall of Cai’s home seems menacing enough: “Crack down on illegal smuggling.” But it is a dubious threat. Large quantities of foreign-brand cigarettes continue to be smuggled into China through the back door for one basic reason: the front door is almost completely closed. The world’s leading tobacco giants–Philip Morris, British American Tobacco and Japan Tobacco International–have spent the past decade desperately trying to offset declining profits at home by edging their way into the world’s biggest market. China’s 320 million smokers account for a tantalizing 30 percent of the world total. But Big Tobacco has been stymied by something even bigger: a massive state-run monopoly that is not yet ready or willing to open up to outside competition. Even with China’s entry into the World Trade Organization, foreign tobacco companies don’t expect to increase their paltry 1 percent market share any time soon. “Our operations are just a drop in the ocean,” says Johannes-Gerhard Hesse, general manager for JTI in China. “Right now and for a time to come, international brands are not relevant.”
That may be true in the legal market. But the illegal trade in foreign cigarettes is flourishing in China–and it is moving in both directions. Out in the darkness off China’s vast eastern coast, smuggling mafias are bringing loads of genuine foreign-brand cigarettes into China. And in return, some of these same groups are moving massive quantities of counterfeit Marlboros, Salems and 555s out of the country. These ships passing in the night–real brands coming in, fake brands going out–reveal the contradictory challenges faced by foreign tobacco companies in a place they once viewed as their sure salvation. The flood of illegal imports, whether smuggled with the companies’ knowledge or not, has helped foreign brands gain access to and build brand awareness in a closed market. But the emergence of “export quality” Chinese counterfeits has just as surely eaten away market share elsewhere in the world, including the United States.
What happened to Big Tobacco’s dreams? Fifteen years ago the three leading tobacco giants, which control more than 60 percent of global market share, were all buzzing delightedly about imminent breakthroughs in China. British American Tobacco was eager to return to the country where it had built its empire before Mao and his communist troops gave the company the boot. When BAT left in 1952, its chairman predicted: “We will be back.” And in the early 1990s that seemed to be the case. Like the others, BAT established a limited joint venture for manufacturing cigarettes in China and then exploited the opening with an aggressive advertising blitz. With sales on the decline back home–and class-action lawsuits on the rise–the companies reveled in their access to smoking’s last great frontier. The Marlboro Man rode his horse on massive billboards on the busiest Shanghai streets. Salem lured the new middle class to tennis tournaments. And Chinese models in miniskirts handed out free 555 cigarettes at Beijing bars under signs that read: “Be free from worldly cares.”
The reverie, however, ended quickly. Foreign tobacco companies were spending a reported $20 million a year on advertising in the mid-1990s, but their market access was minimal. China’s state monopoly tightly controlled how many foreign cigarettes could be imported–and who could distribute them. (It also controlled the number that could be produced in joint-venture factories.) In 1994 Beijing signed an agreement with Washington promising to lift all import-licensing requirements on American cigarettes within the year–but nothing came of it. In 1995 Beijing suspended all new joint ventures with foreign tobacco companies, explaining that the market was saturated. Then it banned all public tobacco advertising. Public-health advocates applauded the move–China, after all, is facing a major epidemic (sidebar)–but the foreign companies felt targeted. Their ads and sponsorships vanished, but signs for local brands still blanket the streets of some cities. Even in Shanghai, the premium Zhonghua brand has massive billboards along the highways that read: “Ai wo Zhonghua.” The clever slogan can be translated as “Love my Zhonghua cigarettes”–or “Love my China.”
It wasn’t just the foreign ads that disappeared. Foreign cigarettes did, too, dwindling from nearly 3 percent to less than 1 percent of the legal market. (Many other foreign products, such as computers or refrigerators, have faced a similar decline as local Chinese competitors boost their quality and production.) “Ten years ago there were more foreign cigarettes consumed in China than there are today,” says Zhou Ruizeng, spokesman for China’s National Tobacco Co., brushing off suggestions that the monopoly keeps the amount of imports artificially low. “The main reason foreign companies have failed is not our control of the market, but Chinese tastes.” Chinese smokers, he says, lifting a Zhonghua cigarette to his mouth, simply don’t like the strong blended flavor of most foreign cigarettes. “In the future the market share of foreign cigarette manufacturers will not likely increase,” he says. “But over the years to come, as demand rises, we will loosen controls over import levels.”
Smugglers and counterfeiters are the main beneficiaries of the closed market. In the late 1990s Beijing claimed that more than 90 percent of all foreign cigarettes sold in China were smuggled, costing the government more than $1 billion in lost revenue. (The United Nations estimated in July that cigarette smuggling around the world robs governments of $16 billion annually.) BAT and the other Big Tobacco companies say they deplore smuggling, but critics claim they benefit from its practice. In a tightly controlled market like China’s, smuggled cigarettes evade high tariffs and tight import controls–and reach Chinese smokers at reduced prices. Tobacco-control experts recently found that one third of all cigarettes exported by top tobacco companies are never imported into any country–meaning they are considered “lost.” What happens to that missing third? Experts say most of these cigarettes end up in the hands of smugglers, who move them into countries with closed markets like China, Colombia and Bangladesh.
Nobody has accused the foreign tobacco companies of direct involvement in smuggling. But some have come close. In 1995, at the height of a Hong Kong investigation into a $2.3 billion smuggling operation, the prosecution’s lead witness–a Chinese businessman named Tommy Chui–was murdered in Singapore. Chui had testified to the collusion between Chinese triads, or mafias, and high-level officials at BAT. Using the dead man’s testimony, the court sentenced BAT executive Jerry Liu to prison in 1998 for accepting a $3 million bribe and a $1.3 million soft loan from the triads in exchange for huge amounts of duty-free cigarettes to be smuggled into China. Judge Wally Yeung Chun-kuen laid the blame on BAT. “A leading international tobacco company sold large quantities of duty-not-paid cigarettes, worth billions and billions of dollars, with the knowledge those cigarettes would be smuggled into China,” he said. “Apparently the company turned a blind eye to the problem.” BAT strenuously denied any knowledge of the smuggling of its cigarettes into China.
The easiest way to see China’s impenetrable market is to drive through the heart of tobacco country in Yunnan, the southern province that relies on tobacco for two thirds of its revenue. From the dusty capital of Kunming, where boulevards are flanked by cigarette ads, you head south through the undulating tobacco fields to Yuxi, a town dominated by China’s biggest and most profitable cigarette manufacturer, Yuxi Hongta. The monstrous 500,000-square-meter factory complex only hints at the company’s clout: it presides over hotels, schools, housing complexes, biotech companies, a television station with channels named after its cigarette brands–and the lives of thousands of tobacco farmers. Even the exquisite six-lane highway to Kunming was built by Yuxi Hongta for a cool $169 million. Bao Yunhong, an official in the company’s foreign-affairs department, says: “Yuxi Hongta is like a small country unto itself.”
But that’s precisely the problem: China is a collection of fiefdoms, and each one is battling to protect its own tobacco industry. China’s entry into the WTO was supposed to open up the country to foreign competition and consolidate smaller players into large national firms that could compete with multinationals. But it will likely do neither. Sure, Beijing is dutifully reducing import tariffs on cigarettes (from 200 percent a few years ago to 65 percent today to 25 percent by 2004), and it promises to eliminate the straitjacketed licensing system for distributors by 2005. The national monopoly has even reduced the number of tobacco companies from a staggering 185 to 129. (In the United States, three tobacco companies control 90 percent of the market; in China, Yuxi Hongta claims barely more than 5 percent.) But executives admit that the fragmented industry is not ready for prime time. “China’s tobacco industry is ill prepared for life after entry into the WTO,” said Yuxi Hongta chairman Liu Wandong earlier this year. “Local protectionism, including closing the market to outside brands, limits the development of the national market.”
Despite the enormity of China’s tobacco industry–it accounts for nearly 10 percent of national revenues–it is still too weak to compete with foreign companies. So it’s doing the next best thing: retrenching. Earlier this year, the national monopoly forbade provinces to block out the competition. But several local governments simply ignored the edict and protected their cash cows. In fact, the most concerted push in China’s tobacco industry today is not to increase efficiency, productivity or transparency–those mantras of the WTO–but to get a stranglehold on distribution networks before the foreigners arrive. Fewer than 7,000 of the 3.5 million retail outlets in China are currently licensed to sell foreign cigarettes (many more sell smuggled cigarettes). By the time licenses are eliminated in 2004, officials say, the networks will be even more rigidly organized–and more slavishly loyal to their national suppliers. This distribution problem affects many other products as well, from soaps to soda pop: it is so costly for foreign companies to establish their own distribution networks, they become dependent on Chinese monopolies to distribute their goods. “Even with the WTO, we will still have a monopoly,” says one Chinese executive, taking a break from a conference of cigarette distributors in Shanghai whose main goal seems to be to lock out foreign cigarettes. Says JTI’s Hesse: “Some thought the WTO would bring us paradise. But we will not be so affected.”
Still, foreign tobacco companies nurture a small flame of hope. With China’s entry into the WTO, there have been rumors about new joint ventures to manufacture foreign cigarettes. (There are only three right now: Camel, Winston, and Rothman and Black Cat.) Philip Morris executives have been assiduously courting Beijing this year. And in late July, BAT officials released a statement saying that in the next month they would announce a big deal in China. Published reports say BAT was going to build a $400 million joint-venture cigarette plant in Sichuan, putting it far ahead of its international competitors. A BAT spokes-woman was quoted as saying: “This deal took two years to negotiate and needed government approval.” But they may have spoken too soon. The next week Beijing denied the existence of any such deal. “BAT never talked with us about their joint venture,” says Zhou, the tobacco-monopoly spokesman. “I don’t know how they came up with that.”
Smugglers, of course, have their own sort of joint ventures. In the fishing village of Shadi, Cai Wanhe and his family allegedly worked for China’s most infamous smuggling kingpin, Lai Changxing. When cops busted Lai’s organization in 1999, it had smuggled more than $6 billion worth of oil, cars and cigarettes in a three-year period. According to Chinese investigators, Cai’s vertically integrated network soon included everyone from suppliers in the Philippines to black-market distributors in Zhejiang province. Nearly every Shadi resident has relatives in the Philippines, so it was no coincidence that Cai’s fleet of boats raced into the Taiwan Strait to meet container ships flying Philippine flags. The local cops, meanwhile, were so tainted by the trade that Customs officials brought in outsiders to carry out the raid. Now, on a point overlooking the smugglers’ cove, a cement guardhouse sits half built. “It’s for the police,” grumbles one local resident. “They’re just building it to impress their bosses.”
Nobody believes smuggling will stop any time soon. Last year Chinese authorities confiscated 810 million smuggled cigarettes (mostly foreign brands) and 5.3 billion counterfeit cigarettes (mostly domestic). Nice numbers, but just a fraction of the estimated 150 billion cigarettes coming on the market each year from smuggling, counterfeiting and “overproduction” (when factories deliberately produce beyond their official quota and sell to the black market). The sporadic crackdown seems to be simply pushing the illegal trade from one village to another, one province to the next. “Cigarette smuggling is still happening in a big way,” says Ewen Turner, a China specialist in the Guangzhou office of Pinkerton, the well-known security firm. “When it is no longer convenient or profitable, it will stop. But I don’t see that happening in the immediate future.”
The profits even trickle down to one vendor on Shanghai’s Maoming Road. Shifting his eyes nervously, he reveals the contents of his flat wooden briefcase: dozens of brands of cigarettes, including Marlboro, Salem and Camel, which cost $1.20 a pack. He never keeps his box open for long, spinning around and hiding the box when two cops stroll by. His most popular brand is Mild Sevens, purchased mostly by chic Shanghainese women in their 20s. For many young urban Chinese, smoking foreign cigarettes has a certain cachet. And smuggled goods do, too. Indeed, in southern China, most of the convenience stores carry smuggled cigarettes. At one shop in Guangzhou, which carries six brands of foreign cigarettes despite having no license, the owner says: “I can assure you that they are all real. We have professional smugglers as our sources.”
But it’s getting harder to tell the fakes from the real things. As counterfeiters invest more heavily in sophisticated packaging machines, the business has exploded. The number of cigarette brands counterfeited in China has risen from 30 in 1997 to more than 100 today. And they are moving rapidly into the export business. Although counterfeits cost Beijing serious money, foreign companies are getting hit, too. “Before, foreign tobacco companies happily ignored what was going on in counterfeiting within the China market,” says Samuel Porteous, a counterfeiting expert at Kroll and Associates in Shanghai. “They thought that counterfeits that stayed within China would only lift their brand recognition. But now that these counterfeits are being exported to other markets, they are starting to get real concerned.”
And well they should: China’s fake foreign cigarettes are landing on distant shores with increasing frequency. Last month three members of a Chinese family were arrested in New York after police found them with 1,265 cartons of fake cigarettes, mostly faux Marlboros, from China. In early October, Hong Kong pulled over a 24-ton truck carrying counterfeits from the mainland. Around the same time, Australian Customs officials seized a record 8.4 million packs of counterfeit cigarettes in a sea cargo container from China–more than six times the entire number netted two years ago. The packs were expertly made, with special Australian stamps and health warnings and a tag that read: “Made in the United States.” If you saw them on the street in Sydney, you’d never know that they contained the story of Big Tobacco’s battle for smoking’s final frontier–and the drama of some little smuggling cove on the coast of southeastern China.
