June 15, 2007 (Vol. 27, No. 12)

The Risks and Opportunities in a Society Undergoing Explosive Change

Anyone working in Shanghai who returns after only three months will be amazed at the changes, both physically and in the socioeconomic environment. There is an attempt to create a hybrid system of a capitalist economy and the political monopoly of the Communist party. This has opened China to the world, creating wealth for tens of millions along the eastern seaboard while fostering inequality for many living in the interior. This report, focused on the buildup of the healthcare industry in China, is the third article in a three-part series on biotech in China.

The Communist system had provided healthcare to its citizens through each employment organization. This system is being rapidly dismantled with the privatization of the economy. Over the past 25 years, the government reduced its share of healthcare expenditures from 36% to 15%, with patients paying up to two thirds of their medical bills. State-owned hospitals are being changed into private nonprofit or for-profit entities. The vast majority, however, still remain state-owned with only some 1.6% of hospital beds being for-profit. The structure of hospital charges are dramatically different from those in the U.S. with a majority of it going to drugs (45–58%) and equipment and a small proportion to doctor and nursing fees.

To promote the privatization of the hospital system, the government is trying to attract foreign companies, which can own up to 70% of a hospital joint venture.

The establishment of private hospitals is crucial to foreign pharmaceutical companies, since China’s State Food and Drug Administration (SFDA) designates the hospitals that can carry out clinical trials, and most of the principal investigators are on the staff of those hospitals. Foreign-funded hospitals are likely to have more up-to-date facilities and trained staff and will have an increasingly important role in clinical trials.

Sales of Western-type pharmaceuticals were $19.2 billion in 2005. The Chinese market will be the world’s fifth largest by 2010. Currently, 97% of Chinese products are either generics or copies of new drugs. The market is highly fragmented, with the top 10 companies having only 15% of the business and established local or regional niches.

For Westerners, the designation of private companies is often confusing since many are owned by local or provincial governments or government-controlled entities such as hospitals, banks, or investment groups. Not only are most drug firms government-owned, in whole or in part, but they are also most likely to receive financing from the banks. A number of government policies are designed to consolidate and restructure the industry:

• The introduction of GMP standards. Over the past two years, this reduced the number of companies from 5,000 to 3,700. In turn, the revenues of the top 10 companies increased to an annual average of $560 million.

• Enforcement of intellectual property rights (IPR). The government closed 691 drug companies for violations of IPR.

• Traditional Chinese Medicine (TCM) Initiative. In 1996, the government launched the TCM Modernization and Technology Commercialization Action Plan.

A major challenge to pharmaceutical companies, both foreign and domestic, is the lack of an efficient distribution system. The Communist system was based on a local or regional distribution method. There are roughly 6,000–8,000 distributors that move 80% of drugs through the hospitals with the remaining 20% moving through pharmacies. Since the hospitals generate much of their revenue through drug sales, the tendency is to work out arrangements with local manufacturers and distributors.

Another aspect of government policy is to promote the growth of pharmacy chains. Over time, this can lead to the emergence of private pharmacy chains that will replace the hospitals as the main source of drugs to patients. Some Chinese pharmaceutical companies have been aggressive in establishing their own chains, e.g., Beijing Pharmaceutical has 900 pharmacies, about a third of them in the Beijing area. Now that the WTO allows foreign companies to establish their own distribution, this provides MNCs with the opportunity to set up independent distribution networks.

Risking IP

To most MNC executives, IPR represents the biggest risk to operating in China—bigger than cultural differences, a changing political landscape, or corrupt business practices. China put in place an IPR regime that is modeled on the U.S. and EU and is administered by the State Intellectual Property Office (SIPO). A real test of the system occurred with Pfizer’s (www.pfizer.com) Viagra, which received a Chinese patent in 2001. In 2004, a group of 12 Chinese companies sued to have the patent invalidated on the grounds of a lack of novelty. SIPO overturned the patent.

Soon afterward, GlaxoSmithKline (www.gsk.com) abandoned its patent for Avandia following a challenge by three Chinese companies. This raised serious concerns about the willingness of the Chinese government to enforce IPR. However, by the end of 2006, SIPO acted favorably on Pfizer’s appeal for Viagra.

The IPR situation in China will continue to change over time and has to be understood in the perspective of the society. First, IP is not a Chinese concept, but one that has been introduced from outside. Knowledge is most often perceived as belonging to the group rather than an individual. Administrative laws and regulations are not seen as being independent from government policy, and China still lacks a corps of professional examiners and judges to enforce these regulations.

Legal scholars have pointed out that the fact that groups of Chinese companies had taken legal action before SIPO was a clear sign of progress. In the past, such companies would just have manufactured and marketed the product in clear violation of the patent. This is the beginning of a sensibility that patent law is beneficial to Chinese industry.

In 2005, the number of IP cases in Chinese courts reached 13,424, most of which involved litigation between Chinese companies; only 268 involved foreign companies.

Cost, Time, and HR

For U.S. companies, China is a key component of their globalization strategy, particularly as it relates to manufacturing, R&D, and clinical trials. A major consideration is the increasing cost and diminishing productivity of new drug development.

China is estimated to have some 20,000 biologists with master’s degrees or higher. Their salary scales are one-third to one-fifth of that in the U.S. For managers, the cost of expatriates is as much as five times that of local managers. In the case of CROs, the FTE rate in China is from $50,000 to $60,000, compared to $200,000 in the U.S.

A second factor relates to time. It is estimated that a Phase III study in China could be six to seven months faster. Bio-Research (Beijing) is carrying out a study in collaboration with the American Epidemiology Society and the Chinese CDC involving 100,000 cancer patients. The study will examine environmental and dietary factors associated with GI cancer. Such a study would be impossible to conduct in the US.

Labor-intensive projects pursuing drug leads can also profit from the availability of multiple teams of skilled investigators.

While these two factors pertain to productivity, foreign companies are attracted to the Chinese market because of its high annual growth rate of up to 28%. To succeed, the companies would have to expand into the “innovator drugs” category, which currently make up only 3% of sales in China.

One group of companies is trying to do just that by acquiring existing drugs and developing them to meet Chinese medical needs. A number of MNCs (e.g., Novartis, Pfizer, and Servier) are trying to collaborate with Chinese institutes and companies by developing new drugs based on TCMs. Modernized forms of these medicines would be marketed differently than the traditional preparations, possibly as prescription drugs or OTC products.

It must not be forgotten that China is a developing country emerging from a Communist politico-economic system. The opportunities for MNCs lie in their abilities to establish a platform for their R&D, manufacturing, and clinical trials.

For the CROs, China can become the main center for their activities whether in preclinical or clinical studies. Perhaps more fascinatingly, new biotech companies can become virtual pharmaceutical companies through a network of alliances and subsidiaries in China. Certainly, few can ignore China in their path to the future.

Optimism about China should not blind anyone to the intrinsic difficulties of operating in there. The country has established scientific and clinical standards, such as GLP, GMP, and GCP, but most institutions still have to meet them. Foreign firms are best served by implementing their own standards.

Location poses another difficulty. Most foreign companies have located their facilities along the Eastern seaboard within 200 miles of Shanghai or Beijing. This places increasing pressure on facilities, property, and manpower in those areas and does not take full advantage of China.

Skilled manpower remains an intrinsic difficulty as well. Allusions to the large pool of scientific/engineering manpower beg the question in that only a minority are qualified to work for international firms as regards scientific and organizational skills. The Western press has highlighted the importance of Chinese expatriates who have returned from the West. This is in part true, but it is also true that those returning from long absences abroad either may find it difficult to work in the local business environment with its network of contacts or might fall back into the old ways clashing with international practices. The demand for appropriate staff is driving up salary costs and makes for rapid turnover.

Biotech companies and CROs are likely to need financing for their China operations. Investment in high-risk, technology-intensive ventures is still not frequent. Distribution and marketing also pose intrinsic difficulties. Foreign companies cannot just plug into existing distribution networks. This is perhaps one of the most compelling reasons for acquiring or establishing a joint venture with Chinese firms.

In the U.S., business is business and government is government. In China, the state plays a major role. At a minimum, government officials can lubricate many transactions. In many cases, however, the senior managers or officials of state enterprises or newly privatized firms or consortia have had a history as cadres in the Communist party. A banquet hosted by the chairman of a private conglomerate will have both government and party officials as honored guests. So Chinese partners in a commercial enterprise might come to it with a different ideology and mindset that will be consistent with that of the Party.

U.S. firms that wish to commit to China need to have a clear idea of their objectives. At present, there is little evidence of foreign companies using experimental technologies in China. This may change if the opportunities provided by cost effectiveness and productivity can be matched with efficacy, safety, and good management.

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