Snapshot of China’s Pharmaceutical Market
China is projected to become one of the world’s largest pharmaceutical markets by 2020, second only to the United States. Healthcare expenditure more than doubled between 2006 and 2011, growing from $156 to $357 billion; by 2020, this number is anticipated to reach $1 trillion. China’s economy may be the second largest in the world, but healthcare expenditure per capita lags in the company of Swaziland and Albania. This disparity speaks to the enormous potential of the Chinese healthcare market. Home to the largest population on earth, China is also the fastest-growing pharmaceutical market with the potential for enormous gains as healthcare spending grows from 5% to a targeted 7% of the country’s GDP. Multinational pharmaceutical corporations have been flocking to China as sales languish in their traditional favorites, the USA, Japan, and Western Europe. The government has clearly established its position in support of the biomedical industry, boding even greater potential for China’s ability to become not only the largest market, but a pivotal leader in the pharmaceutical sector as well. Although China’s innovative capabilities have made significant strides, it remains to be seen whether domestic companies can overcome challenges such as governmental regulations and become true R&D leaders in the industry.
The forces behind the upsurge in healthcare demand are multifaceted, but the driving themes are economic and social trends. An expanding middle class with greater spending power has accompanied the spectacular climb of China’s economy over the past thirty years. In 2005, 29% of the population earned between $7,000 and $27,000 that is expected to increase to 75% of the population in 2020, while the upper class grows from 1% to 7%. Many conditions that were previously underdiagnosed and undertreated will compound the soaring number of patients as their access and ability to pay for treatments increases. The prevalence of chronic diseases such as hypertension and cancer is also surging, increasing the disease burden: in 2010, China registered 92 million diabetics and 150 million prediabetics compared to 27 million in the US. The planned urbanization of 250,000,000 people over the next twelve years will only augment these numbers as lifestyles change from agrarian to sedentary. The final major factor in this equation is China’s ageing population. The single child rule will contribute to a population shift from 122 million elderly over the age of 65 to 223 million in 2030, the largest number of elderly in any country.
The Chinese government has taken note of this evolution and has identified healthcare reform and expansion of the biomedical sector as top priorities for the nation. In 2009, the government unveiled an extensive plan to overhaul its healthcare system over the subsequent ten years. Li Keqiang reinforced China’s commitment to “establish universal health-care system providing safe, effective, convenient, and low-cost health-care services by 2020.” The response to these directives has been extensive: currently, 95% of the population enjoys basic medical coverage. The government has also made substantial investments in medical infrastructure in lower-tier cities and rural areas; the enduring goal is to equilibrate the quality of the healthcare framework, expand available services and develop community centers. The biomedical sector was also underscored as one of seven critical areas in China’s 12th 5-year plan. Historically, government support via these initiatives has translated into accelerated advancement for the target sectors, such as the automotive industry. Local governments have also followed suit, issuing their own 5-year plans aimed at improving China’s position in the biomedical industry, focusing this sector as a common target for a litany of Chinese institutions, including the Ministry of Health, Ministry of Science and Technology and the Ministry of Industry and Information Technology.
The synergism of skyrocketing demand for healthcare and pledged government support for the biomedical industry has the potential to create a synergistic environment for the pharmaceutical industry. Nearly all of the major multinational pharmaceutical corporations have established manufacturing and R&D centers in China, exploiting the sector’s growth from $27 billion in 2006 to $71 billion in 2011. For many key players, China is already the largest market not to mention the market with the obvious potential for continued expansion. Fueled by the government’s commitment, China has the capacity to become a leader in research and development. China’s universities and breadth of scientific research offer a talent pool to draw on to fuel innovation, and the sector’s relatively nascent nature creates a perfect blank slate on which to build a new drug pipeline. While all this evidence appears very auspicious, certain aspects of Chinese healthcare reform stand in direct opposition to the country’s ability to innovate and foster R&D.
Challenges for this Sector
The Chinese government’s mandate to provide universal low-cost healthcare creates perhaps the greatest barrier to innovation and new drug development. On average, first-in-class drugs—considered truly novel and the first of their kind—cost over $1 billion to develop and require 10 years before they come to market. Their originators typically have a very small window in which to recuperate the cost of development, explaining the exorbitant price tag on new therapies. Compared to best-in-class (drugs with similar mechanisms of action designed to offer advantages over existing therapies), first-in-class drugs are considerably more risky ventures: 9 out of 10 fail in clinical trials, adding to the expense of those that succeed. In an attempt to mitigate rising healthcare spending, the Chinese government has undertaken measures to control the price of drugs. It is easy to recognize the nobility of such action, but the unfortunate consequence of artificially suppressing the price of drugs will be the sacrifice of innovation and R&D. Although trying to reduce the burden of healthcare, the government policies do not address the cost of providing it; they are passing the buck. While this may protect the consumer, it annihilates a company’s ability to recover the cost of development, thus negatively influencing the incentive to create novel drugs. In the long run, such policies could actually deteriorate the quality of healthcare as well. Consequently, if margins are too low or even below the break-even point, some producers will be forced into bankruptcy, and some good inexpensive drugs will disappear from the market. Lastly, the sales and distribution channels in China absorb most of the margin in the value chain, passing on diminished benefits to the producers. One contributing element is the pervasion of corruption, as evidenced recently by the GlaxoSmithKline scandal. Pharmaceutical giants such as GSK have (and continue to) offer enormous bribes in exchange for increased prescription rates, and hospital employees have come to rely on this compensation to supplement their inadequate salaries. Combined, these practices foster improper drug dispensation, leading to over-prescription of some therapies and the unavailability of others.
Notorious among pharmaceutical companies operating in China, the Essential Drug List (EDL) and National Reimbursement Drug List (RDL) are distinct mechanisms that greatly affect the profitability of drugs. The RDL describes the drugs covered by reimbursement schemes of the three major health insurance providers. The EDL, on the other hand, includes all the drugs on the RDL, but covers them with a higher reimbursement rate for patients. These drugs are considered highly necessary for the population, and are subject to price regulation and limited mark-ups in hospitals. It is important to note that hospitals provide the main source of drug revenue, covering 75% of total drug sales in China. The lists provide something of a double-edged sword: while they increase market access, they are subject to intense price regulation, diminishing profits. Not long ago, hospitals were reluctant to promote drugs included on these lists as they offered little revenue benefit due to limited mark-up, and were too narrow to adequately address patients’ needs. The National Development and Reform Commission (NRDC) responded in 2013 by expanding the list to 520 drugs and requiring that 40-50% of second-tier hospital sales and 25-30% of third-tier hospitals sales be represented by EDL drugs. In addition, provinces were encouraged to adopt a tendering system for the bulk purchase of drugs that further diminishes the return to producers. Tendering fosters fierce bidding wars that often lead to drug sales below manufacture cost, leading to price erosion. The Guandong province is considered an indicator of national trends, and its recent adoption of a particularly aggressive tendering protocol is not promising for the pharmaceutical industry; the other provinces are expected to follow suit. It is unlikely that drug companies will be inspired to innovate in the face of curtailed abilities to cover the expense of developing new products.
The EDL and tendering system have the potential to greatly damage the Chinese pharmaceutical industry, and domestic companies may experience more severe effects than foreign entities. Obviously, companies with greater exposure to the EDL will suffer its consequences more severely. These include companies with a high percentage of their top-grossing products on the lists, as well as companies focused on manufacturing “me-too” or best-in-class drugs. Generics also incurred significantly greater losses compared to originators, and it’s important to recognize that Chinese companies make an asymmetrically high percentage of generic drugs. The lack of available alternatives for first-in-class drugs means that they will not be subject to the competition and price erosion as those drugs with alternates—at least until other players catch up with their technology. Additionally, the tendering process places a disproportionate importance on price over other factors such as quality or efficacy, thus grossly favoring any producer that comes in with a lower bid regardless of any sacrificed benefits. Because Chinese companies make mainly me-too drugs, they could be more susceptible to losses incurred by tendering. Although it has the potential, China currently lacks the R&D capability of its western counterparts, and these governmental regulations could slow its progress toward creating novel therapies.
One other problem standing in the way of China’s R&D capabilities are their abysmal intellectual property laws. IP laws are necessary safeguards to protect investments in scientific inquiry. They are also essential for communication and the dissemination of ideas and results, which in turn fuel innovation. Due to the extremely high cost of pharmaceutical development, they are also critical for protecting investments. On paper, Chinese IP laws are adequate but they are poorly enforced because of provincial fragmentation of the judicial system and the courts’ lack of sophistication in high-tech matters, compounded by slow decision making and minimal penalties for offenders. Chinese entrepreneurs see little advantage in investing the capital in high-risk first-in-class development when they can be imitated without recourse, nullifying their R&D spending. Job attrition is also high in China and creates another hurdle for developing a knowledge-intensive business propelled by self-developed knowhow. This factor may actually present another advantage to foreign conglomerates capable of developing drugs outside of China where intellectual property theft is less likely.
Opportunities and Future Trends
The Chinese pharmaceutical market is very fragmented: currently, there are nearly 4,000 participants. Inefficiency and opacity have been attributed to its splintered nature. It is likely, however, that the future will see a greater push toward consolidation in this sector, as smaller players are forced out of business and larger companies make acquisitions, enlarging their market share. The government is also interested in unification, and has introduced higher-level standards and additional entry barriers. One possible benefit of greater consolidation would be increases in revenue large enough to support more substantial R&D pursuits. Fierce bidding and price undercutting characteristic of the hawkish tendering systems might abate as competitors disappear. Aggressive government regulations may also compel multinationals to acquire smaller domestic firms, and increase their presence in China through partnerships. M&As could provide a greater avenue to access lower-tier segments of the industry and secure productivity gains. Pfizer has set the example here by creating partnerships with Hisun (API manufacturer) in an effort o access China’s generic drug market and low-cost manufacturing capabilities. Despite this, without meaningful hospital and procurement reforms, consolidation will certainly lead to greater concentration, but perhaps little increase in efficiency.
Many of the same quality control issues present in other industries also plague China’s pharmaceutical sector; the drug industry is not exempt from cultural paradigms that underlie workers’ attitudes. Not surprisingly, foreign drugs have a much more positive reputation among the Chinese and are frequently more desirable, but the government has taken an active role in correcting this view. By 2016, all drug manufacturers are required to comply with a new set of standards set in 2011. Contemporarily, the State Food and Drug Administration (SFDA) is undergoing reform to make its policies more transparent. The quality of drugs is thus expected to rise, and there are many indicators that the depth of R&D will expand as well. 2012 saw the highest number of submissions for clinical trials of new drugs (INDs) in China’s history, which grew steadily since 2009. More importantly, 220 class 1 drugs were undergoing clinical trials in 2012; Chinese pharmaceutical companies launched 5 first-in class drugs during the same time period. Complying with their most recent 5-year plan, the government has committed Rmb110 billion to R&D efforts between 2010 and 2020. Increased collaboration between domestic and foreign companies is also being encouraged, and incentives were created to encourage MNCs to establish research centers in China. Few Chinese companies have exported drugs to highly regulated foreign markets, but there are leaders, such as Nantong Novast, that have broken this barrier, setting the stage for the future. In the future, more Chinese companies could have capability to export their products to regulated markets. But generally speaking, there is still a long way to go until Chinese pharmaceutical companies will be able to fully rival their western counterparts.
Despite the many hazards potentially undermining the Chinese biomedical sector, there are many opportunities for growth. However, investments must be made judiciously, paying close attention to a company’s drug pipeline, current and upcoming submissions for clinical trials of new drugs (INDs). Well-positioned companies with a diversified drug portfolio including several first-in-class products should continue to benefit from the soaring demands of China’s population without suffering excessively from the government’s regulatory policies. New product launches and a high percentage of sales from exclusive drugs will allow companies to circumvent the price erosion expected from the EDL and tendering system. One standout example, Sihuan Pharmaceutical, has released four potential blockbusters in the past 18-24 months. All of these new compounds are in their nascent stages, and are positioned to cultivate large growth in the Chinese market. In addition, five of its other offerings are exclusive and protected from pricing constraints. Alternative sales models will also be critical to harness growth, as drug sales outside of hospitals are not subject to the same pricing schemes.
While the Chinese pharmaceutical sector has faltered in the first half of 2013, there are still many reasons to be optimistic, and analysts believe that the short-term volatility will give way to a long-term bull market. Not long ago many analysts hailed the biomedical sector in China, but changing circumstances—notably government intervention—have made it clear that the picture will be much more nebulous moving forward. Given the considerations discussed above, the key to the Chinese pharmaceutical market will be the ability to create novel, first-in-class drugs, focusing on R&D. The players that learn how to do this at reduced cost will win. As a whole, China has taken significant steps toward become an R&D powerhouse, increasing the number of first-in-class IND applications to 36 in 2012, the highest number on record. It could be a challenge to continue this trend with tendering protocols and EDL/RDL limits, and the better strategy could be to use the biomedical industry’s momentum to unearth completely novel ways of developing drugs. An investment here would be a boon for both consumers and pharmaceutical companies alike, achieving R&D goals at a lower cost and imparting the savings to patients.