China to Messenger: Off With Her Head!

"Alice began to feel very uneasy: to be sure, she had not as yet had any dispute with the Queen, but she knew that it might happen any minute, 'and then,' thought she, 'what would become of me? They're dreadfully fond of beheading people here; the great wonder is, that there's any one left alive!'" -- Alice's Adventures in Wonderland, by Lewis Carroll

Right now, Unilever (NYSE: UL  ) is wondering how it wound up next to Alice on the wrong side of the looking glass. In March, the company made a seemingly innocuous announcement: Inflation was hurting profit margins. Unilever planned to raise prices on some goods in April to compensate. Harmless, right? Except China's National Development and Reform Commission (NDRC) responded by fining Unilever $308,000 for the announcement.

As it turned out, in announcing a planned price increase, Unilever had accidentally violated at least three separate Chinese laws ... only one of which is written on paper.

Law No. 1: Don't yank the Cheshire Cat's tail
Unilever's first and primary mistake was to embarrass China's PR machine. Officially, you see, China has a 5.4% inflation rate. The government already isn't happy about that, as it's about 140 basis points above the goal. The last thing the government needs is companies like Unilever blabbing about price increases. Such public talk might get people wondering whether, if Unilever has to raise its prices 15%, the "official" 5% rate is really true. For that matter, I know a few consumers who might want to quiz Ben Bernanke about the dramatic rise in gasoline prices, and the recently announced hikes in diaper pricing at Procter & Gamble (NYSE: PG  ) and Kimberly Clark (NYSE: KMB  ) . P&G also was said to be planning price hikes in the Middle Kingdom.

Law No. 2: The Mad Hatter is an unstable fellow
In contrast to the U.S., China has a couple of tools it uses to keep such speculation under wraps. For some companies, such as Huaneng Power (NYSE: HNP  ) , overt price controls on electricity tariffs help to restrain inflation. Meanwhile, consumer goods companies like Unilever suffer under a quieter sort of pressure to minimize abrupt price hikes, so as not to spook consumers.

Why all the effort to prevent inflation when possible, and disguise its appearance when not? I'll tell you why. In fact, having lived in Russia in the 1990s, and in particular having lived through the dramatic inflation following Russia's 1998 debt default, I know firsthand what happens when consumers get really worried about inflation: They hoard.

In a front-page photo accompanying a story on Unilever's fine, the Wall Street Journal showed Chinese supermarket workers "fronting" a store shelf stripped mostly bare by consumers who have begun bulk-buying shampoo ahead of Unilever's price hike. China wants to make sure that no more pictures like that one get taken. And if it has to waggle a headsman's axe at Unilever to accomplish this, then that's exactly what China's going to do.

Law No. 3
It's important to note that Unilever isn't price-gouging here. It's not attempting to exploit the inflation situation to grab excess profits. To the contrary, just like P&G and Kimberly Clark here in the U.S. last month, Unilever was only trying to give customers a heads-up before raising prices. Unfortunately, if China's a place where putting antifreeze in the toothpaste and melamine in the baby formula are totally kosher, many other activities that businesses would like to engage in ... are not. Google (Nasdaq: GOOG  ) wants to spread knowledge to the four corners of the globe, and unlike Baidu (Nasdaq: BIDU  ) , refuses to censor its searches if that might "be evil." "Off with its head!" Coca-Cola (NYSE: KO  ) wants to buy a juice company in a simple arms-length transaction? "Off with its head, too!" Similarly, warning customers so they can begin budgeting for pricier shampoo and detergent may seem like the decent thing to do. But in China, it can be against the law.

Turns out, there's a "Price Law" over there, aimed at preventing anticompetitive price-fixing among producers. According to the law, producers aren't supposed to speak publicly about planned price increases, lest this make it easier to collude on pricing. That's the law's goal -- but it serves perfectly well as a tool to prevent Unilever informing its customers of price inflation. Despite Unilever's specifically citing commodities inflation as the reason for its rising prices, and despite NDRC not even suggesting that its motivations were otherwise, the axe came down.

"Thank you, sir. May I have another?"
And Unilever took it lying down. Hit with the fine, Unilever meekly submitted to chastisement, commenting: "As a company with a long-term commitment to China, we ... accept the decision of NDRC and Shanghai Price Bureau."

Now, whether this means Unilever's price hike must be rolled back isn't yet clear. Discussing the situation with the Journal, management hedged on the exact timing of the price hike (which, remember, was supposed to have happened last month.) What is clear is that China's monitoring this situation closely, and working actively to prevent companies from raising prices -- even if this means profit margins get hit. Bad news for Unilever ... and for anyone else investing in China's consumer goods markets today.

Fool contributor Rich Smith owns shares of Google. The Motley Fool has a disclosure policy.

Google and Coca-Cola are Motley Fool Inside Value choices. Baidu and Google are Motley Fool Rule Breakers recommendations. Unilever is a Motley Fool Global Gains pick. Kimberly Clark, Coca-Cola, Procter & Gamble, and Unilever are Motley Fool Income Investor selections. The Fool owns shares of Coca-Cola, and Google.

Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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