Risks and Rewards for Pharma in Post-WTO China

April 1, 2002
Feng Cai

Feng Cai, MSc/MBAis a contract scientist for Elan Pharmaceuticals in Princeton, NJ.

Pharmaceutical Executive

Pharmaceutical Executive, Pharmaceutical Executive-04-01-2002,

New markets are a pharmaceutical company's dream. And China, with a population of 1.3 billion-and new membership in the World Trade organization-could be the pharma industry's dream come true. The country's projected growth rate of 1.1 percent per year, which will increase its pharma market by at least $50 million annually, in addition to an increasingly prosperous population with a greater awareness of health-related issues, make the market extremely attractive. (See "People Power,")

New markets are a pharmaceutical company's dream. And China, with a population of 1.3 billion-and new membership in the World Trade organization-could be the pharma industry's dream come true. The country's projected growth rate of 1.1 percent per year, which will increase its pharma market by at least $50 million annually, in addition to an increasingly prosperous population with a greater awareness of health-related issues, make the market extremely attractive. (See "People Power,")

People Power

In its study, "Global Pharma Market Forecast 1998-2002," IMS Health found a growth potential of 11 percent or $20.1 billion in Southeast Asia and China. That trend shows no sign of abating. Moreover, China is now aging at a projected rate of 3 percent annually. According to China's fifth national census, conducted in 2000, the country had 88.1 million people age 65 and over, accounting for 7.4 percent of the population. (See "The Age Factor,") Those over 60 numbered 130 million, or 10 percent of the total. Taken together, those two segments alone represent a huge opportunity for Western pharma companies. (See "Five-Year Forecast,")

The Age Factor

Until now, however, the barriers to foreign companies marketing in China have been equally great. The State Drug Administration (SDA), the country's primary regulatory body, has discouraged imported products and technology transfer by

  • making it difficult to gain administrative protection for patents issued before 1993

  • delaying approval of new import drug license (IDL) applications by more than 30 months

  • refusing to maintain confidentiality during the application process.

Most discouraging to US pharma companies has been the rampant theft of their intellectual property through patent infringement and counterfeiting. All those factors undermined the competitive advantage that innovative pharma companies stood to gain from their marketing investments. As a result, US companies accounted for less than 10 percent of China's total pharma imports between 1998 and 2000.

Five-Year Forecast

The big question is: "Will the barriers come down now that China has joined the WTO?" This article describes the most significant characteristics of the Chinese market today, the obstacles Western companies face, and the possible effects of China's WTO membership.

Paving the Way

China's mass migration to urban areas, which began in the early 1980s and continues today, has brought increased awareness of Western medicine. From 1990 to 1995, the urban population grew at an average rate of 4.4 percent a year, leveled off from 1995 to 1999, then took another leap upward, accounting for 30.89 percent of the total population in 1999 and 35 percent in 2000. (See "The Urban Shift,")

The Urban Shift

Not only does urbanization generate life styles more conducive to pharmaceutical use, it also gives city dwellers greater access to medicines through retail pharmacies. And, despite strong competition from traditional Chinese medicine (TCM), acceptance of Western medicine in China has accelerated, particularly among the young, largely because of Western advertising. Thus, urban consumers are US pharma companies' primary targets.

The Chinese government's establishment of a single regulatory authority in Beijing in April 1998 was an important step toward foreign access, because it eliminated the conflicting standards that prevailed among provincial government agencies, centralized the Chinese healthcare regulatory system, and made it more transparent. SDA now oversees all medications-both Western and TCM-as well as advertising. Its new regulations are expected to follow FDA's model.

On 22 July 1999, as part of medical insurance reform, SDA finally released its first list of over-the-counter (OTC) medications, and in 2000, the state began to regulate OTC and prescription drugs separately. SDA did so to encourage patients to purchase OTC medicines for less serious diseases, thereby reducing government medication expenditures and hospital visits.

According to the first issue of "The China Pharmaceutical Business Information," 1990 OTC sales in China were almost $.25 billion. By the end of 1999, they had reached $.6 billion and $1.5 billion by the end of 2000. By 2005, total pharma OTC sales are expected to reach $7.3 billion, five times greater than in 2000. Experts predict the market will expand by up to 30 percent annually within the next five years. That represents a tremendous opportunity for US companies with large OTC lines.

No Local Competition

Although China has more than 6,000 domestic pharma companies that compete intensely with one another, they are no match for Western manufacturers' range of products, technological resources, and capital. (See "Top Ten Chinese Companies in 2000.") The largest, North China Pharmaceutical, is a state-owned entity that is transitioning to private ownership.

Top Ten Chinese Pharma Companies in 2000

Of the 3,000 pharmaceuticals-not including traditional medicines-manufactured in China since the 1950s, 99 percent are copies of foreign products, as are almost 90 percent of China's biotech products. Most Chinese companies-even joint ventures-compete with each other for the same generics. Many are struggling for survival; more than 32 percent recorded losses in 1999, according to the Pharmaceutical Department of State Economic and Trade Commission (SETC).

Moreover, compared with international pharma giants, Chinese companies are not only small, they are weak in technology and often lack capital. In fact, the total R&D expenditures for Chinese-owned pharma businesses amounted to less than that spent by a single major Western pharma company. SETC officials describe Chinese pharma companies as "numerous, small, scattered, disordered, and of poor quality."

Shadows

Despite the lack of competition, Western pharma companies have faced roadblocks in establishing a presence in China. Regulatory and bureaucratic obstacles include:

Lack of administrative protection. In 1992, the United States and China signed a memorandum of understanding (MOU) to allow administrative protection (AP) in China for US pharmaceutical patents granted between 1986 and 1992. The MOU provided seven-and-a-half years of market exclusivity, or AP rights, in China for pharma patents that were:

  • not protected by exclusive rights before the amendment of current Chinese laws

  • patent protected after 1 January 1986 and before 1 January 1993 in an MOU signatory country

  • not previously marketed in China.

Several Chinese government policies have prevented US industry from realizing the intended MOU benefits. Policies inconsistent with the 1992 MOU, such as the following two examples, have been the real nightmare:

Notice 72 has allowed local companies to submit and gain registration during a US company's evaluation period to market the US company's products free of infringement. That loophole often resulted in significant delays during the application process, allowing officials to share the patented information with domestic companies so they could copy and produce the product locally and cheaply. The upshot was that SDA frequently denied AP rights altogether.

Moreover, the Chinese government's unwritten "one drug, one indication" policy-its interpretation of the MOU-limited AP to the original indication listed in the pharma patent. That policy still conflicts with both the 1992 MOU and general patent law, which allows exclusive rights to the invention to encourage innovative uses for the product during its patent life. The US industry has lost significant revenue and market share in China because of inadequate AP rights.

Although the exact figures are unknown, the US pharma industry has lost roughly 10-15 percent of what it should have earned in annual revenue in China because of counterfeit products. In addition to lost revenue, counterfeiting has had serious implications for public health because the products have not been subject to the same safety standards as the originals. Few GMP standardized manufacturing facilities in China meet FDA requirements. Although SDA pushed for and got an administrative sanctions law and established a small office, it has allocated few resources for anticounterfeiting efforts.

Lack of patent protection. After a foreign company received patent protection in China, it often found that SDA had allowed local companies to apply for and receive permission to conduct clinical trials on the same compound, without the patent holder's permission.

Lengthy import license procedures. The average approval time to bring a new pharmaceutical import into China has been more than 30 months. That delay caused innovator companies to lose significant revenue because of the shortened exclusivity period in the Chinese market. It also burdened Chinese physicians and patients by delaying timely access to important new therapies. For off-patent products, IDLs were difficult to obtain, particularly if the government decided that enough locally produced generic equivalents were already available. Although pharma import licenses were valid for three years, renewal authority was by no means guaranteed and was often contingent on the availability and number of locally produced generics.

Price controls. Because pharmaceuticals are considered special commodities in China, they have been subject to price controls. In 1997, pharma price jurisdiction was turned over to the State Development Planning Commission. SDPC mandated that pharma companies base their drug prices on the following general guidelines:

  • innovative versus generic

  • GMP versus non-GMP

  • brand versus non-brand

  • equivalence to prices for locally manufactured products or to the prices in countries at roughly the same level of economic development as China.

The unintended consequence of that policy was to create higher operating costs for companies, which had to add pricing departments and personnel to enable them to negotiate with the many regional government pricing authorities. Also, SDPC reserved the right to order price cuts, discouraging companies from offering higher volume discounts that could result in a price reduction for the product nationwide. SDPC gave pricing jurisdiction for some products to the provincial and local governments, allowing them to maintain lower prices for locally produced products.

Provincial protectionism. Volume controls have effectively prevented provincial hospitals from increasing pharma expenditures by more than 15 percent over the 1999 level. In Guangdong, the provincial government issued a directive, known as the 70/30 rule, limiting the amount of imported and joint venture medicines that a hospital could purchase to 30 percent of total pharma purchases. In other words, at least 70 percent of its Rx purchases had to be applied to domestically produced products.

Difficulty in getting on formularies. Reimbursable drug lists, identifying pharma products that are subsidized under medical insurance, have posed another challenge. To get a product on the list and keep it there has been a long, fragmented, and negotiation-filled process, because both provincial and central authorities have had the power to select preferred products.

The State Drug List for Basic Medical Insurance is based on clinical need, safety and efficacy, reasonable pricing, ease of use, and the desire to maintain a balance between Western and TCM products. The SRL, compiled by the Ministry of Labor and Social Security in consultation with other relevant central-government departments, consists of more than 1,000 drugs and provides a framework for provinces to formulate their own reimbursement lists. Normally, 90 percent of the SRL formulary is included on local lists. By the end of 1998, following Shanghai's lead, 26 provinces had introduced reimbursement lists, but they included very few joint venture or imported drugs. Of the 885 drugs on the Shanghai list, for example, only 4 percent are imports.

Sales reps' lack of access to hospitals. Beginning in 1999, some Chinese provinces and cities began to bar pharma sales reps from entering local hospitals to promote their products to physicians and pharmacists. The regulations were adopted to curb improper behavior, such as bribing physicians and pharmacists to prescribe medicines and generally disrupting the physician-patient relationship. Recently, China's Ministry of Health included a similar provision (Article 10) to prohibit sales reps from entering hospitals that are bidding for pharma products. Although well intentioned, those policies are shortsighted and fail to consider the long-term interests of physicians and patients.

Diminishing Threats

China's membership in WTO will bring five important changes that should give foreign companies greater access to its market:

  • China has agreed to allow most products, including pharmaceuticals, to be imported into any part of the country and to phase out current distribution restrictions over a three-year period. Moreover, it is accelerating the formulation of new policies for foreign pharma investments to the extent that foreign companies will eventually control 70 percent of the Chinese pharma market, according to SDA.

  • China plans to encourage foreign investment in its distribution industry, giving US pharma companies control over their own distribution networks so they no longer have to rely on China's complex and costly one.

  • WTO membership will push China toward free-market pricing. Changes in SDPC pricing policy in the past two years reflect recommendations advocated by the global pharma industry, such as pharma representation by the European and American Chamber of Commerce in China.

  • In the sensitive area of better protection of intellectual property rights (IPR), China has agreed to implement the Trade-Related Intellectual Property Agreement of the Uruguay Round. To comply, Chinese companies will have to change their long-time practice of relying on counterfeit products. According to China's Securities Times, foreign companies will be able to file compensation claims ranging from $400 million to $1 billion against companies that copy patented medicines.

  • The Chinese government says it will reduce its tariff on pharmaceuticals from its current average of 9.6 percent to 4.2 percent. The reductions have begun and will be completed by January 2003.

Although SDPC originally intended to set rigid margin controls at each stage of the distribution chain, a policy change implemented last year capped the upper limit on the price of prescriptions in hospital pharmacies while continuing to monitor margins at the distributor and hospital levels. Because Chinese hospitals derive their main profit from the sales of Rx medicines in their own pharmacies, the price policy has dealt a harsh blow to major hospitals, with negative effects on the entire pharma industry in China.

The Price of Pioneering

In July 2000, SDPC issued its Guidelines for Drug Price Administration. The new policy is encouraging, because it allows free-market pricing for some products and implies that free market use will expand, giving Western companies a better chance to have their products included on the provincial and municipal formularies.

Entry Decisions

For Western companies in pursuit of a dominant share of China's generics market, three factors are critical: timing, mode, and scale of entry. (See "The Price of Pioneering,")

Timing. Early entrants stand to gain more advantages than disadvantages. Advantages include:

  • first there gets first share

  • opportunity to build sales volume before competitors do

  • hands-on experience, leading to cost savings

  • avoid the high marketing costs necessary to get consumers to switch from one product to another

The disadvantages of being an early entrant-the high price of pioneering and the risk that the central government will change policies set by local governments-should now be offset by the advantages of getting there first.

Scale of entry. To maximize their early investment and increase the chance of succeeding, companies also should make a substantial commitment, in money, infrastructure, technology, and management skills. The decision to enter the market on a large scale, with a strategic commitment of five to ten years or more, will have a long-term impact and force potential rivals to think twice about entering the market at all.

Entry modes. Of the two main market entry modes-distributing products through joint ventures with local companies or manufacturing and distributing them locally through wholly owned subsidiaries-the second has the most promise. On the one hand, it's easier to just export products, because the technological superiority of Western pharma companies makes them appealing to Chinese joint venture partners. Moreover, Western companies benefit from the partnership's shared costs, reduced political risk, and the local partner's knowledge of competitive conditions, legal and social norms, and national idiosyncrasies. Yet, because most imported products are generics, foreign companies that take the joint venture route must compete with already available low-cost local products. Moreover, they must invest in local distribution systems, which are typically low in efficiency and high in cost. At the same time, they can't sell their products directly, and shared ownership and management keep each partner's profits to a minimum.

Western pharma companies that want to grow and maximize ROI in China should, instead, adopt wholly owned subsidiaries to produce generic drugs. The process is still complicated, time-consuming, and costly, and can involve host government and labor union objections and vulnerability to political risk, and the time required to establish a competitive position. But the advantages are obvious: maximum control and maximized potential for above-average return.

Because China's transition to a truly open market will be difficult, phasing in over a three-year period, it is advisable for Western pharma companies to wait until 2005 before launching innovative products there. Instead, they should launch only medications that have lost, or are about to lose, patent protection, with the modest goal of extending a product's life through a low-cost generics strategy-which China's cheap labor market makes possible.

Nevertheless, because Chinese companies can imitate those drugs and sell the same product at a much lower price, and because the government continues to give priority to domestic generics over expensive imported drugs when it issues reimbursement lists, Western companies need a contingent business strategy. At least two pharma giants-GlaxoSmithKline and Pfizer-have pursued a combined approach: mass production of generics through cost-reduction economies of scale and a differentiation strategy that creates unique products for which the company can charge high prices. Companies that receive a Class I new drug certificate in China receive 12-year manufacturing exclusivity, pricing freedom, and priority consideration for reimbursement. However, because of poor intellectual property rights in China, most Western companies should put that strategy on hold for now. Until the Chinese government continues its effort to improve IPR further, a low-cost strategy is the most prudent.

Strategic Decisions

When choosing a marketing strategy for China, Western pharma companies face two main considerations. First, a low-cost business strategy calls for reducing expenditures through tight global integration. But pressure for local responsiveness dictates the need for a transnational corporate strategy to achieve both global efficiency and local responsiveness. Realizing those goals is difficult because one requires close global coordination (cost reduction), while the other requires local flexibility. Thus, "flexible coordination" is required to implement a transnational strategy.

Second, Chinese culture and its organizational, political, and social structures are vastly different from those in the West. The following factors have the most impact on Western pharma companies attempting to sell products in China:

Consumer tastes and preferences. Even though they regard injections as more effective than pills, Chinese consumers view one injection a day for a long period of time as intolerable. They also resist taking pills rather than their traditional tonics for long-term treatment.

Infrastructure and distribution channels. In 1997, China had more than 17,000 distributors channeling medicines to hospitals, retail pharmacies, and stores. But the distribution system, hampered by the lack of a national wholesale drugstore, the country's vast distances, and inadequate transportation infrastructure, is woefully inefficient.

Furthermore, because China's distributors are not exclusive agents, they do not promote products but simply take orders for hospitals and retailers. As more products flood the market, the distributors' powers increase and they tend to direct orders to drugs with the highest profit margins. Product prices are inflated by high distribution costs and hospital mark-ups. And the retail prices paid by hospitals can be up to ten times higher than the manufacturer's price.

Because of the system's closed nature, many companies believe that if they bypass their former distributors, those distributors are likely to retaliate by pressuring others to drop the manufacturer off their lists. Markets in China are highly regionalized, so companies may need to employ several unconnected networks.

Suppose an imported drug is approved by SDA for distribution throughout the country. If the chosen distributor is located in Shanghai, it may have trouble dispensing the drug in Beijing because of province protectionism. To survive, pharma companies must either generate a distributor-driven push by offering lucrative margins, or create market pull by generating consumer demand for their products.

Government demands. Because it wants to strengthen its ability to develop products, the Chinese government is in favor of joint foreign/domestic R&D ventures and even wholly owned subsidiaries of foreign companies. So it has numerous incentives, such as a dual-track tax policy that reduces foreign companies' income taxes from 33 to 17 percent and allows them to make unlimited investments in foreign exchange and priority purchasing in China to support their cooperative initiatives, particularly those involving genetic engineering, vaccine development, and biotechnology. However, traditional Chinese medicine R&D is still being done exclusively by local companies.

Organizational Structures

Most global corporations use a combination structure to implement a transnational strategy that emphasizes both multidomestic geographic and global product structures. In fact, to be locally responsive and globally efficient, companies must be both centralized and decentralized, integrated and nonintegrated, formalized and non-formalized.

Using that model, Unilever Group divided its operations into 14 business units, some framed around emerging geographic markets; others framed around the company's European food and drink products. Yet in China, such a structure is almost impossible to implement because of bureaucratic turf problems. So Johnson & Johnson chose a multidomestic geographic structure for its operations there.

Because most Western pharma companies do not send a great variety of products to China-and those are mostly generics-local responsiveness to foreign products is of greater concern than having to sell products at lower cost. Therefore, a decentralized operation that works like a federation is the most practical: The company's headquarters coordinates financial resources among independent subsidiaries, yet allows the differentiation needed to meet the local culture's demands.

Staffing Policy

To meet local needs, a polycentric staffing policy, using Chinese nationals to manage subsidiaries while Western nationals hold key positions at headquarters, is necessary. The advantages are twofold: It alleviates culture myopia and it is inexpensive to implement.

Nevertheless, all multinational companies face staffing challenges in China. The country lacks sufficient qualified local managers, and company loyalty is very hard to cultivate. The most notable example is Xian-Janssen, a J&J joint venture. Some in the Chinese pharma industry refer to it as "Janssen University" because many managers who moved beyond middle management received extensive training there. But because of large cultural differences and the need for local responsiveness, Western pharma companies should hire qualified Chinese nationals, especially those trained and educated in the United States or Europe. They will better serve as the bridge between Chinese subsidiaries and Western headquarters.

The Outlook

When the transition to the new policies that WTO membership promises is complete in 2005, the Chinese market should be much more favorable for Big Pharma. But to succeed there, the industry needs early, large-scale, and wholly owned subsidiary entries; low-cost and transnational strategies; global horizontal organizational structures; and polycentric staffing policies. The time to act is now.

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