Smoke signals

For the world's tobacco giants, China, home to 320 million smokers and accounting for a third of the planet's cigarette consumption, has long been viewed as the last frontier. Now it seems Philip Morris, maker of Marlboro cigarettes, the world's top seller, has scored the first deal to manufacture a major Western brand in China.

News organizations, including Bloomberg, quoted industry sources as saying the move followed a joint-venture agreement with the state-owned Longyan Cigarette Factory in Fujian province. The plant is expected to begin producing Marlboro before the end of the year, one report said.

"The State Tobacco Monopoly Administration appointed us to make cigarettes for Philip Morris," Bloomberg quoted an official at the factory as saying. "We will wait for Philip Morris's tobacco leaves to arrive and produce as many sticks as State Tobacco tells us to."

At writing, no confirmation had come from Philip Morris, its parent company, the Altria group – or Beijing, which jealously guards its monopoly on production, sale and distribution of tobacco.

To date the only big outside player to produce cigarettes in China has been Japan Tobacco (JT), but its experience does not seem to have been entirely happy. In early September state-run China Daily reported that JT was pulling out of its joint venture in the southeastern city of Xiamen following a difference of views over future development with its Chinese partner.

Despite such potential difficulties, with cigarette sales stagnating or slowing in the West, China has been seen as a tantalizing opportunity for manufacturers such as Philip Morris, British American Tobacco, RJ Reynolds and the like. For Philip Morris, for example, a modest 10% market share in China would eclipse its current revenues from US sales.

At present, foreign brands account for about 5% of Chinese tobacco sales – a market where a staggering 1.8 trillion cigarettes go, literally, up in smoke every year. A big factor has been price, with imported cigarettes burdened by import duties, severely cutting into sales prospects beyond the richer east-coast Chinese cities. Before they went down to 25% last year, some imports were hit with taxes as high as of 65%.

By producing in China, foreign manufacturers would avoid those levies and be more competitive against domestic brands. But the Chinese government has been playing it cautious, anxious to maintain control of its lucrative tobacco monopoly. It is already hurting from yielding to the WTO's lower duty limits. As it is, more than 10% of its tax revenue comes from tobacco – US$20.44 billion in 2003, making it the government's largest single tax source. Beijing also has to be concerned about state manufacturing revenue being siphoned off by foreigners as in the old days – as in 1937, when British American Tobacco (BAT) alone had a lock on 40% of the China smokes market.

It's a controversial subject, for a number of reasons. Health campaigners argue the tax earned from tobacco is offset by increased medical costs, lost productivity and the fact that more than a million Chinese died prematurely last year from smoking-related illnesses.

And there are myriad industry issues besides, from how tobacco gets traded to foreigners horning in on China's cigarette manufacturing equipment sector; that in itself opens up patent infringement issues because some equipment makers have reportedly played fast and loose with equipment design.

And it's not as if manufacturing in China suddenly yields up the whole country. The mainland is a battleground where local manufacturers have to fight to get their products distributed in other provinces. Complaining to US trade paper Tobacco Reporter, a top official in the Yunnan Provincial Tobacco Monopoly Administration revealed how "eastern provinces are hesitant to allow [in] Yunnan cigarettes."