Country Risk Analysis - Pharma firm entering China's market
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Transcript of Country Risk Analysis - Pharma firm entering China's market
Part 1 Socio-Political Situation in China
Fractionalization of the political spectrum
The Chinese Communist Party (CCP or Party) has been in power in China for 63 years a record that can put to shame almost any communist structure in world including the soviets. The politics of the People's Republic of China take place in a framework of the single-party socialist republic. The leadership of the Communist Party is stated in the Constitution of the People's Republic of China.
All power within the government of the People's Republic of China is divided among several
bodies:
the legislative branch, the National People's Congress.
the executive branch, the State Council
the judicial branch, the Supreme People's Court and the Supreme People's Procuratorate
the military branch, People's Liberation Army (PLA) via the Central Military Commission
Most positions of significant power in the state structure and in the military are occupied by members of the Communist Party of China which is controlled by the Politburo Standing Committee of the Communist Party of China, a group of 4 to 9 people, the paramount leader being Xi Jinping. The executive body i.e. the State Council is tasked with running day-to-day affairs of the country. The State Council is the chief authority of the People's Republic of China. It is appointed by the National People's Congress and is chaired by the Premier (Li Keqiang) and includes the heads of each governmental department and agency. Exploring the possibilities of a rift Often sever competition exists among the members of the Communist Party’s Politburo & its Standing Committee - China’s highest decision-making bodies. As part of a trend of very modest political pluralization, moreover, other political actors are increasingly able to influence policy debates. One test of a political system is its ability to manage political transitions. In the run-up to a once in a decade change in the Communist Party’s leadership in November 2012, Communist Party Politburo member and Chongqing Municipality Party Secretary Bo Xilai fell from grace, exposing at least one serious rift in the leadership, raising questions about the tenacity of the one-party command structure opening room for factionalism. Many analysts, both in China and abroad, have questioned the long-term viability of China’s current political system, in which the politburo remains above the constitution, leadership politics is a black box, & right to free speech and association are severely restrained Maintaining domestic stability is one the prime mandates of the 2.5m strong PLA and 800,000 strong police forces. However, the current domestic issues are getting more complex to control:
a) Among the Chinese political system’s governance difficulties is the phenomenon known as “stove-piping,” in which individual ministries and other hierarchies share information up and down the chain of command, but not horizontally with each other.
b) A related governance issue is unproductive competition among official entities. It is not uncommon in China for multiple entities to attempt to assert jurisdiction over the same issue, competing with each other for scarce budget resources, power, and recognition from higher government officials.
c) Although China is effectively a one party state, multiple coalitions, factions, and constituencies exist within the political system. Political mentorship, place of birth, the affiliations of one’s parents, and common educational or work history may lead individuals to form political alliances.
We believe that in the next ten years the Chinese political system may be quite different. There is a chance that the basic game shall change significantly by 2017, and even a chance that there won’t be the same kind of Party Congress by 2022. Instead, we could witness transparent political process, more accountable and representative government, and increasingly democratic elections both within the Party and in the country. And it’s possible that very abrupt (yet largely non-violent) change could happen. Some intellectuals in China argue that cultural change takes 60 years, economic change takes 6 years, but political change takes 6 days, or even a weekend.
Fractionalization by language, race, religion
Today China's population is over 1344 million, the largest of any country in the world. As per
last consensus in 2010, PRC officially recognizes 56 distinct ethnic groups, the largest of which
are Han, who constitute 91.51% of the total population with 8.49% being minorities. The Han
Chinese – the world's largest single ethnic group – outnumber other ethnic groups in every
provincial-level division except Tibet and Xinjiang
The official spoken standard in the People's Republic of China is Putonghua. Its pronunciation is
based on the Beijing dialect of Mandarin, which was traditionally the formal version of the
Mandarin or Chinese language. Mandarin and its various dialects are spoken by more than 70%
of the population.
The Chinese government has implemented state atheism since 1949, making it difficult to
ascertain the data on the religious diversity. Different surveys undertaken over smaller samples
over the years have thrown up divergent results to establish any specific trend. Today, according
to different surveys, Taoism is being practiced by over 30% of the Chinese population while
Buddhism is practiced by between 11 - 18% of the Chinese. Christianity is practiced by 3 - 5%
& Islam by 2% of the population.
Thus religion, race, nor language has any major role to play in igniting any factionalist tensions.
However in light of the recent and rising disparity due to the widening income gap across the
social strata and also the glaring disparity in the economic growth of various parts of the country
may lead to some fractionalization along the regional lines.
As per BMI’s recent forecast, separatist movements will remain weak, but unrest will
occasionally erupt in the ethnic-minority regions of Tibet and Xinjiang, and related incidents of
terrorist violence elsewhere are possible. There is a small risk that separatism in Xinjiang will
escalate into a full-blown insurgency; a series of security incidents there so far in 2013 have
resulted in numerous deaths. The Tibetan separatist movement could grow more violent when
the exiled Tibetan spiritual leader, the Dalai Lama, dies. As yet, China’s government shows no
signs of moderating its harsh approach to dealing with separatist and ethnic unrest. However,
there are some signs of new policy strategies being discussed in official think-tanks that may
eventually lead to a change.
Restrictive measures to retain power
The Chinese government is famed for using all forms of restrictive practices ranging from
legitimate constitutional provisions to use of force in order to suppress any anti-party
commentary. The PLA is often touted to be the military arm of the CCP. The primary mandate
of the 2.5m-strong PLA along with 800,000 strong police force is to ensure domestic stability i.e
to prevent any social uprising.
In the words of Tanner during his testimony before the U.S.-China Economic and Security Review Commission, that aptly summarizes the popular practices adopted by Chinese Authorities:
“Despite the historic success of Beijing’s 30-year economic growth strategy, the available data from Chinese law enforcement sources indicates that unrest in China has continued rising for nearly two decades with little or no break. The list of government and managerial abuses that spark the great majority of these protests has changed little over the past decade, notwithstanding innumerable directives and laws from Beijing to stanch them. Beijing continues to struggle to find institutional responses that will check these abuses and predations by local officials. But over the past decade it has been far more ambivalent in promoting some of the legal and political institutional reforms first inaugurated in the late 1980s and 1990s that once promised to strengthen citizen access, oversight, and influence. Western analysts would be justified in asking themselves to what extent the promotion of political or legal structural reform can still be described as major priority of the Chinese Communist Party. Shortly after the onset of the 2008 economic crisis, China’s public security forces issued new regulations aimed at forging a more sophisticated response to unrest. As with previous efforts to develop more effective police containment and management of unrest, the question remains whether China’s law enforcement forces can develop the discipline and professionalism to carry out the new strategy—and whether or not local Party authorities will let them.” Besides physical force on the street the Chinese govt. has banned the use of twitter, google, Youtube, FB or any such mass medium of information sharing as part of the internet censorship drive. The govt. employees an army of tech sleuths to constantly monitor and track the web traffic flowing in and out of the country to check for any inflammatory/anti-institution rhetoric. Such heavy restraining measures cast a severe doubt the ability of any multi-national firm to seek
grievance redressal through public campaigns. As the new firms contemplate investing in China,
the informational barriers would have to come down sooner rather than later to ensure a healthy,
conducive environment to carry out their businesses.
Xenophobia, nationalism, corruption
Corruption in China is widespread. The roots of the corruption lie in the extremely bureaucratic
and rigid framework of the Chinese government. Given that everything falls under the aegis of
just one party with minimal counter-vigilance to check existing structures. Given that most
regimes have chosen to bring about only evolutionary changes in the govt. machinery – mal
practices and bribery have now been entrenched into the system. Among its forms are lavish
gifts and expensive meals bestowed on officials by those seeking favors; bribes explicitly
provided in exchange for permits, approvals, and jobs; privileged opportunities offered to
officials or their extended families to acquire corporate shares, stock, and real estate;
embezzlement of state funds; and exemption of friends, relatives, and business associates from
enforcement of laws and regulations. As China’s economy has expanded over the last 30 years,
the scale of corruption has grown dramatically. 2011 report released by China’s central bank
estimated that from the mid-1990s to 2008, corrupt officials who fled overseas took with them
$120 billion in stolen funds.46 Estimates of illicit financial flows out of China are many times
higher. In a 2012 report, Global Financial Integrity, a Washington, DC-based research and
advocacy organization, estimated that total illicit financial flows out of China in the decade from
2001 through 2010 amounted to $2.74 trillion, with $420 billion leaving China illicitly in 2010
alone.47 The international non-governmental organization Transparency International ranks
China 80th on its Corruption Perceptions Index, with the top ranking countries being the least
corrupt. China ranks just below Sri Lanka and above Serbia.
However, given the increased vigilante activism by a more vibrant civil society armed with social
media and other internet based resources, the government has gone into a counter-offensive
crackdown on bribery. The recent Bo-Xilai indiction openly demonstrated the entrenchement of
the endemic. Thus, immediately following his appointment as Communist Party General
Secretary in November 2012, Xi Jinping identified corruption and graft within the Party as
“pressing problems.” He pledged to “work with all comrades in the party, to make sure the party
supervises its own conduct and enforces strict discipline.” Many observers believe, however, that
the Party’s insistence on supervising its own conduct, rather than accepting supervision from
outside, has been part of the reason that corruption has flourished. Critics charge, moreover, that
when the Party’s corruption-fighting agency, the Central Discipline Inspection Commission,
conducts investigations; they are frequently politically motivated, even if they uncover real
wrongdoing. Officials who keep on the right side of their superiors and colleagues may engage in
large-scale corruption, while other officials may be investigated for lesser infractions because
they have fallen afoul of powerful officials.
Media commentators and academics have suggested a variety of measures to tackle corruption,
including allowing the media to play more of a watchdog role and requiring officials to make
their family assets public. So far, neither proposal has advanced significantly. Journalists who
expose wrongdoing do so at their peril. In recent years, however, microbloggers have
successfully exposed a string of corrupt officials. In one high-profile case, microbloggers drew
attention to photographs of a local official showing him wearing at least 11 different luxury
wristwatches on various occasions. Just one of the timepieces was worth more than twice the
man’s annual salary. Going forward, the virtual monitoring done by informed netizens shall play
a decisive role in further governmental reforms.
Managing corruption is a difficult but a mandatory art to be mastered for MNC seeking
successful operations in D&E markets. However, the increasingly complex landscape due the
recent crack-down both by the govt. and also the citizens have alerted the entire country that a
mild revolution is on the anvil.
Social conditions (population density and wealth distribution)
The population density also shows significant diversity with most sparse in the mountainous,
desert, and grassland regions of the northwest and southwest. The Inner Mongolia, Xinjiang,
and Tibet autonomous regions and Qinghai and Gansu provinces comprise 55% of the country's
land area but in 1985 contained only 5.7% of its population. Accordingly the economic disparity
is distributed along the regional lines with wealth being disproportionately held up in wealthy
centres such as Beijing, Guanzhou etc.
Over the last twenty years, China has growth at phenomenal rates raising the per caputa standard
of living but has also widened the gap between the rich and the poor. Results of a wide-ranging
survey of Chinese family wealth and living habits released this week by Peking University show a
wide gap in income between the nation’s top earners and those at the bottom, and a vast
difference between earners in top-tier coastal cities and those in interior provinces. The top 5%
account for 23% of China’s total HHI. The lowest 5 % accounted for just 0.1 % of total income.
Average annual income for a family in 2012 was $2,100. When broken down by geography, the
survey results showed that the average amount in Shanghai, a huge coastal city, was just over
$4,700, while the average in Gansu Province, far from the coast in northwest China, was just
under $2,000. Average family income in urban areas was about $2,600, while it was $1,600 in
rural areas. Ordinary Chinese are increasingly resentful of wealth being accumulated by a select
few — and in particular by people connected to party officials — and government censors often
try to limit discussion in public venues of the personal wealth of the richest Chinese and of the
families of China’s leaders.
The unemployment rate in China estimated to be in the range of 4.4 percent to 9.2 percent. It is
also estimated China’s Gini coefficient to be 0.49 in 2012, less than the 0.51 in 2010. The
Chinese government avoided releasing an official number for several years. Then in January
2013, the head of the National Bureau of Statistics, Ma Jiantang, said the Gini coefficient was
0.474 in 2012, down from a peak of 0.491 in 2008.
Strength of radical left
Though communism has governed China for the last 60 years, the recent & extra-ordinary
growth for the last 2 decades has introduced the Chinese to quasi free-market policies. While the
western media may laud China for its extraordinary economic success, some intellectuals, as well
as former military officials, workers, and farmers have raised serious concerns about the
downside of thirty years of unfettered economic growth. Crony capitalism, the failure to ensure
an adequate social welfare net, and growing environmental challenges are all seen as failures of
the current Chinese political economy.
These loopholes have now led to the emergence of "the New Left". These scholars are
suspicious of further market reforms and want a stronger state-hand in the market to ensure
social justice.
Some of China's recent reform initiatives, such as the drive to develop a "harmonious society",
derive from an element of the political spectrum that is concerned overwhelmingly with social
justice.
The nature of such a state in the political realm, however, is not as well defined. Scholars
associated with the New Left, such as Professor Wang Shaoguang at the Chinese University of
Hong Kong, express dissatisfaction with Western democracy as it is practiced. Yet they do not
have a clear alternative to propose. They seek a system that is accountable, responsive, and
responsible, but do not know precisely what political institutions will best bring such a system
about.4 In their concern over representative democracy, they pose a challenge to those who seek
more revolutionary reform.
Thus the chances of radicalism being re-introduced remain weak and only a theoretical
possibility. From the stand point of any Pharmaceutical firm planning to engage with China, the
left radicals should not be a major concern area.
Dependence on and/or importance to a hostile major power
The Chinese shares a historic bias against Japan and anti-Japanese sentiment, in particular, has
been a recurring theme among online Chinese nationalists. Periodically, Chinese nationalists use
Internet and the street to contest historical inaccuracies in Japanese textbooks calling for
retribution. Nationalists had also begun with anti-Japanese protests after recent territorial
disputes in the South China Sea, thereby providing the government an impetus to adopt a
tougher stance in its negotiations with Japan.
China’s traditional ties with erstwhile neighbor India has been rocky. While the two nations have
seen phenomenal increase in their mutual trade, the border conflicts have escalated over the
recent period. Repeated violation of border treaties has been observed with both parties
engaging in exchanging gun-fire keeping the foreign embassies busy for both countries. After
much and frantics visits by premiers from both does a peace accord seem to be have reached.
At a global level, China has fancied a head-on tussle with U.S of A. China’s hard-liner stance
with the U.S. on all key strategic issues such as exchange rates to environmental guidelines to
China’s domestic patent rights to the famed conflict over banning Google/FB have meant the
power politics of the world heavy weights is out in the open for everyone to see.
Thus, an American company entering into the Chinese markets may have to be wary of the
potential barriers it may face while it establishes its identity.
Negative influences of regional political forces
China may not have much regional diversity in political opinion given its one-party one
command structure – it is some to some of world’s most engaging separatist movements. The
on-going tiffs over the Mongolia, HK and Taiwan are fairly well documented but it is the far
flung & neglected regions of Tibet and Xinjiang that have seen heavy blood-shed and unrest
over the last few years. Both these regions are home to minority populace and are also equally
distant from main-stream Chinese economic hot-spots.
Also, both regions are fairly rich in term of its natural wealth in minerals and other extractive
materials and thus view the PRC with abundant suspicion of exploitation. The Chinese govt. on
the other hand has not restrained itself in exercising force to exert its control over the regions.
His Holiness Dalai Lama, the “keeper” for Tibet has been forced into political exile in Himachal
Pradesh, India and his well-being decided the future of peace in the region. Xinjiang on the other
hand is another offshoot of the fallen Qing empire inhabitated primarily by the Uighur muslims.
Beijing has used all its military might to stamp down any violence by perpetrators of secessionist
movements.
Societal conflict (demonstrations, strikes or street violence)
Growing disparity between the rich and the poor, opaque political transformations, rampant
corruption at levels of government has created significant resentment among the citizens thus
leading to often violent protests. According to Chinese law enforcement estimates on so-called
“mass incidents”—their official term for a wide variety of group social protest has increased every
year from 1993 to the late 2000s. Numerous police analysts report that official mass incident figures
rose from 74,000 in 2004, to 87,000 in 2005, and to “more than 90,000” in 2006. Official figures for
the year 2007, and at least one analyst asserts that incidents declined slightly that year, though the
number of persons participating “increased dramatically.” Despite Chinese government efforts to
keep protests down in the run-up to the 2008 Olympics, the spring and summer witnessed several
high profile or violent incidents. While the west focused on the March 14 riot in Lhasa, Tibet,
Chinese police were also fixated on major incidents such as those in Weng’an, Guizhou, and
Menglian, Yunnan. Protest numbers apparently spiked with the onset of the financial crisis soon
after the Summer Games, and by the end of 2008, total mass incidents had reportedly risen to
120,000 despite the pre- and post-Olympic security. Nationwide figures for 2009 and 2010 are not
yet available, although local data and reports by some prominent Chinese academics indicate
protests climbed greatly in 2009 in the wake of economic difficulties. Thus, the police and PLA are
finding their hands full trying to suppress a national uprising in the making.
In addition to the mass incidents, the increasing role of the Internet in Chinese political life
poses a significant challenge to the Party’s efforts to constrain political reform. While the
Internet is a important asset critical to the progress of the nation I also possesses significant
threats too. The Internet is, in fact, evolving into a virtual political system in China. The Chinese
people are increasingly using for information, organizing work, and co-ordinating online protests
online. As the blogger Qiu Xuebin writes, "When the interests of the people go unanswered long
term, the people light up in fury like sparks on brushwood. The internet is an exhaust pipe,
already spewing much public indignation. But if the people’s realistic means of making claims are
hindered, in the end we slip out of the make-believe world that is the internet and hit the streets
Instability (non-constitutional changes, assassination, civil war)
CCP maintains water tight control over all aspects of state, judicial or military matters make it to
be the supreme authority in the country. The rule of law is in its weak form in the country.
Scholars who have been privy to various models of government in the west now call upon
institutional reforms that transform the political structure in the country. For e.g. Political activist
and Nobel Peace Prize winner Liu Xiaobo represents the boldest of those who call for such
revolutionary reform with his online human rights manifesto, Charter 08, and his calls for
universal values, direct elections, constitutional democracy, separation of powers, and protection
of private property, among other elements of institutional reform.
Ex premier Wen, a vocal proponent of fundamental reforms, did conduct a small experiment on
political modernization in Shenzhen. The stated goal is strictly in line with the Party’s
constrained vision of political reform: to build a socialist democracy and a rule-of-law system, to
develop a clean, efficient and service-oriented government, and to construct a complete market
system, a socialist advanced culture, and a harmonious society. At the same time, the approach
has some potentially revolutionary reform elements: gradually expanding direct elections,
introducing more candidates than there are positions for heads of districts, and considering
allowing candidates to compete for positions of standing members of district or municipal Party
committees by organizing campaigns within certain boundaries.
Thus success of this reforms remains to seen. But in these trysts with democracy shall lay the
future course of Chinese civilizations that sits on the cusp of a new era.
References (for Part I)
Web Sources
Economic Intelligence Unit Reports
Business Monitor International periodical reports
CFR: Council on Foreign Relations
Online Links
New York Times - 2013/07/20 “Survey in China Shows a Wide Gap in Income”
Forbes.com - 2013/01/20 “The China Miracle: A Rising Wealth Gap”
bbc.co.uk “Xinjiang: China jails 20 for terrorism and separatism”
Wikipedia
Tibetan independence movement
East Turkestan independence movement
List of active separatist movements in Asia
Political Structure in China
Demographics of China
Literature
Elizabeth C. Economy. “Nobel Peace Laureate Liu Xiaobo and the Future of Political Reform in
China”
Murray Scot Tanner. “Unrest In China And The Chinese State’s Institutional Responses”
Susan V. Lawrence & Michael F. Martin. “Understanding China’s Political System”
Tyler Durden. “The Far More Important 'Election' Part 1: China's Political Process”
Part 2 The Economic Risk Rating
The overall aim of the Economic Risk Rating is to provide a means of assessing a country’s
current economic strengths and weaknesses. In general terms where its strengths outweigh its
weaknesses it will present a low economic risk and where its weaknesses outweigh its strengths it
will present a high economic risk.
These strengths and weaknesses are assessed by assigning risk points to a pre-set group of
factors, termed economic risk components. The minimum number of points that can be
assigned to each component is zero, while the maximum number of points depends on the fixed
weight that component is given in the overall economic risk assessment. In every case the lower
the risk point total, the higher the risk, and the higher the risk point total, the lower the risk.
The Economic Risk Components
GDP per Head
It is the estimated GDP per head for a given year, converted into US dollars at the average
exchange rate for that year, is expressed as a percentage of the average of the estimated total
GDP of all the countries covered by ICRG.
In world perspective China's performance has been exceptional. In 1300, it was the world's
leading economy in terms of per capita income. It outperformed Europe in levels of technology,
the intensity with which it used its natural resources, and capacity for administering a huge
territorial empire. By 1500, Western Europe had overtaken China in per capita real income,
technological and scientific capacity. From the 1840s to the middle of the twentieth century,
China's performance actually declined in a world where economic progress elsewhere was very
substantial. In the past quarter-century, China has had a rapid growth trajectory-a process of
catch-up which seems likely to continue well into the present century. By 2030 Chinese per
capita income will probably be above the world average, and it will again be the world's biggest
economy as it was from 1300 to 1890.1
Potential Risk: China's GDP per capita doubled to $6,100 from 2009 to 2012. However it does
not mean that this rapid growth has transformed the lives of the Chinese people. According to
Zhuang Jian “The fast-rising yuan value in recent years helped China achieve a higher GDP per
capita in this short span". This means the domestic growth is still not developed in China
For China,
GDP for 2012 is $ 83582
Average of the estimated total GDP of all the countries covered by ICRG is
GDP Per Head
(Billion) Country
1 China in the World Economy 1300 – 2030 by Angus Maddison
2 www.data.eiu.com
$1839 India
$11293
South
Korea
$878 Indonesia
$5959 Japan
$8358 China
3632.6 Average
Therefore GDP per head = 8358/3632.6 = 230%
Using the risk point table given by ICRG, the risk point assigned for this is 4.5.
GDP Country Percentage Risk Point
8358 CHINA 230 4.5
Real GDP Growth
It is the annual change in the estimated GDP, at constant 1990 prices, of a given country is
expressed as a percentage increase or decrease.
China is the fastest-growing major economy in the world, which has lifted hundreds of millions
of people out of poverty over the past generation. Investors should not be unduly concerned
about GDP growth in China. The country’s dependency on exports to boost growth has made it
vulnerable to the global recession. Private consumption is weak at less than 40% of GDP.
Though the GDP growth in China is slowing however China can promote domestic
consumption in order to stabilize GDP growth which had previously driven by exports and
investments. Chinese consumption is currently much lower than other major economies at
35%~40% per capita compared to US on 71% which itself shows the domestic growth
opportunity in China. China’s economic growth is slowly becoming more broad-based, with
domestic consumption likely to rise in importance in relation to exports thanks to a middle class
of 200-300mn people. China’s ongoing urbanisation will be a major driver of growth and new
cities will emerge in less developed inland provinces. The UN forecasts China’s urban population
rising from 40% in 2005 to 73% in 2050: a gain of 500mn people. However it needs to be seen
that export oriented country like China which had policies to save and investment more in the
economy can drive up the domestic consumption. If the transition is done then the GDP growth
will stabilize.
According to Nueberger Berman product specialist Ria Nova, the other way was to introduce
more institutional investors into the Chinese mainland equity (A share) market through the
3 http://data.worldbank.org/indicator/NY.GDP.MKTP.CD
Qualified foreign institutional investors. According to her, returns in this market have dropped
30% or more in the last four years, partly because it is majority-owned by retail investors with a
vigorous trading mentality. The government wants to stabilise returns by giving access to longer-
term participants like insurance companies.
Thus we see that GDP growth in China will not be an issue in the long run if handled with care.
Also the growth rate for real GDP for last 5 years was at an average of 8.86%.
Potential Risk: In Nomura’s baseline scenario, China’s GDP growth slows to 6.7% in the first half
of 2014 and recovers slightly in the second half, bringing next year’s GDP forecast to 6.9%,
China’s slowest since 2008. Both cyclical and structural factors contribute to this slowdown.
Structurally, China’s potential growth is on a downtrend due to a dwindling and aging labour
force and a lack of reform. The government still runs the national and local economies, making
China slow and not very dynamic.4 In a higher risk scenario, GDP growth slows to 5.9% for full-
year 2014 and to 5% in the first half of next year and this could lead to China defaulting on its
loan payments.
For China, the real GDP growth for 2013 is estimated at 7.7%. Therefore using the real GDP
change risk table, the point assigned to China for this indicator is 10.
Annual Inflation Rate
It is the estimated annual inflation rate (the un-weighted average of the Consumer Price Index) is
calculated as a percentage change.
Not only worries over China's slowing growth trajectory may be greater concern but also
inflation could be a concern. Fears of stoking inflationary pressures will inhibit the new
administration from resorting to significant monetary easing. Slowing growth in agriculture
bodes ill both for price stability and Beijing's self-sufficiency goals. Rebalancing is inherently a
long-run process; progress in bringing it about will be slow. However for now inflation is not a
pressing concern. First-quarter results show a rise in CPI of 2.4%, or 1.4pp below that of the
same period in 2012 (and 0.2% below the annual figure for 2012). The only categories which
experienced price rises above the average were food and housing (up by 3.8% and 2.9%).
Producer prices for industrial products fell by 1.7% year-on-year.
Potential Risk: The inflation rate was higher than a median forecast of 2.9% in a Reuter’s poll and
August's 2.6%, but was still below the official target of 3.5% for 2013. If the inflation rate
increases in the coming months, then there will further policy tightening which might affect the
overall growth of the economy.
For China, the annual inflation rate is estimated at 2.6%. Therefore using the annual inflation
risk table, the point assigned to China for this indicator is 9.5.
Budget Balance as a Percentage of GDP
It is the estimated central government budget balance (including grants) for a given year in the
national currency is expressed as a percentage of the estimated GDP for that year in the national
currency.
4 http://www.forbes.com/sites/kenrapoza/2013/07/24/when-china-sneezes-everyone-gets-sick/
China's solid fiscal position is enough to make debt-ridden European and U.S. governments
green with envy. But turning strong public finances into a pro-growth fiscal policy won't be
straightforward. Economists focus on the budget balance – the difference between government
revenue and expenditure – as the main measure of the impact of fiscal policy on growth. In
2012, many expect China's Ministry of Finance to spend more than its income, run a budget
deficit and buoy domestic demand.
However in China, the budget balance doesn't tell the entire story on the government's impact
on growth. An enormous volume of gray revenue raised by local governments isn't included in
the Ministry of Finance's numbers. The most important omission is revenue from land sales –
effectively a tax on real-estate developers and home buyers. Land revenue of 2.9 trillion yuan
($457.3 billion) in 2010 was equal to 7.3% of gross domestic product. What matters for the
overall fiscal position isn't just how much gray revenue is raised but how much is spent.
Whatever be the case, the ministry of finance has to increase the budget deficit to increase
domestic consumption as the export demand is fading due to crisis in Europe and US.
Potential Risk: If the budget balance increases and if the GDP growth decreases, then there is
high chance of default on the loans. If there is a default, then the credit rating will be affected
and thus raising money will be difficult. Companies investing China must look at the growth rate
of Chinese economy before deciding whether to invest or not.
For China, the budget balance as a percentage of GDP is estimated at -2.0%. Therefore using the
budget balance risk table, the point assigned to China for this indicator is 6.5.
Current Account as a Percentage of GDP
It is the estimated balance on the current account of the balance of payments for a given year,
converted into US dollars at the average exchange rate for that year, is expressed as a percentage
of the estimated GDP of the country concerned, converted into US dollars at the average rate of
exchange for the period covered.
In the fourth quarter of 2012, there was a surplus of $65.8 billion in the current account.
According to the calculation of statistics requirements of international balance of payments,
there was a surplus of $107.4 billion in goods trade account in the fourth quarter, a deficit of
$19.6 billion in service trade account, a $21.8 billion deficit in income account and a $100 million
deficit in current transfer account.
In 2012, China had a surplus of $213.8 billion in its current account regarding its international
balance of payments, a deficit of $117.3 billion in the capital and financial account and an
increase of $96.5 in its international reserve assets. Last year, China's current account surplus
increased by 6% year-on-year, the ratio of which to GDP in the same period was 2.6%,
decreasing by 0.2% than that in 2011.
However it was the first time China's balance of payments transferred from "double surpluses"
to surplus in current account and deficit in capital and financial account since the Asian financial
crisis. Thus it also reveals that China has enhanced its ability in balancing its balance of payment
on its own. Also China’s massive trade surplus and huge foreign exchange reserve serves as a
major cushion against external shocks.
Potential Risk: Though China has able to manage the Asian financial crisis as it had double surplus
current account. However now it has reduced its current account and as the export demand is
lessening, the current account surplus may soon be over if domestic demand is not increased. If
the current account surplus goes down, then external shock will start affecting China’s economy.
For China, the current account as a percentage of GDP is estimated at 1.9%. Therefore using the
current account risk table, the point assigned to China for this indicator is 12.5.
Summary: Economic Risk Indicator
Economic Indicator Point
GDP per Head 4.5
Real GDP Growth 10
Annual Inflation Rate 9.5
Budget Balance as a percentage of GDP 6.5
Current Account as a percentage of GDP 12.5
The Financial Risk Rating
The overall aim of the Financial Risk Rating is to provide a means of assessing a country’s ability
to pay its way. In essence, this requires a system of measuring a country’s ability to finance its
official, commercial, and trade debt obligations.
This is done by assigning risk points to a pre-set group of factors, termed financial risk
components. The minimum number of points that can be assigned to each component is zero,
while the maximum number of points depends on the fixed weight that component is given in
the overall financial risk assessment. In every case the lower the risk point total, the higher the
risk, and the higher the risk point total the lower the risk.
Foreign Debt as a Percentage of GDP
It is the estimated gross foreign debt in a given year, converted into US dollars at the average
exchange rate for that year, is expressed as a percentage of the gross domestic product converted
into US dollars at the average exchange rate for that year.
As on 30th September 2013, the amount of debt China owes foreign lenders stood at 771.95
billion U.S. dollars. Of which, 403.31 billion U.S. dollars were international commercial loans
and 59.14 billion U.S. dollars were loans extended by foreign governments and international
financial organizations, according to data released by the State Administration of Foreign
Exchange. Meanwhile, 309.5 billion U.S. dollars were debts stemming from trade loans between
companies, the data showed.
Potential Risk: China has a high component of foreign debt. China economy policy is to borrow
heavily and invest in capacity building projects which return more than the cost of borrowing.
Due to recent crisis in US and Europe where US being one of the major export destinations for
China, export demand has fallen and China is lying with over capacity. If the Chinese are not
able to generate demand for their over-capacity, then growth rate will fall and probability of
default on loans will increase. Though China has state owned assets, land reserves in dealing with
local government debt but they won’t solve the fundamental problem. As long as the debt-
financed investments are not economically viable, there will be an unsustainable increase in debt
and if this continues forever, a debt crisis will take place
The majority or 80.79% of the nation's foreign debt was denominated in the U.S. dollar
Foreign Debt % of GDP = 1 – Public Debt % of GDP = 1 – 16.3% = 83.7%
Therefore using the foreign debt risk table, the point assigned to China for this indicator is 3.5.
Foreign Debt Service as a Percentage of Exports of Goods and Services
The estimated foreign debt service, for a given year, converted into US dollars at the average
exchange rate for that year, is expressed as a percentage of the sum of the estimated total exports
of goods and services for that year, converted into US dollars at the average exchange rate for
that year.
Potential Risk: The amount of debt China owes foreign lenders is approaching the $1 trillion
market. Outstanding short-term foreign debt, due within one year, rose to $565.68 billion from
$540.93 billion at the end of last year however the country has over $3 trillion in cash reserves.
More than enough to service its borrowing or wipe it out entirely and still have a few trillion left
over for a rainy day. Investors have been mildly concerned over China’s debt levels, from federal
to municipal to corporate debt. For the first time ever, a Chinese solar company Suntech Power
defaulted on a $531 million debt. Suntech Power is now in bankruptcy protection.
For China,
Total Exports for the year 2013 is $2224 billion
Total Foreign Debt = 83.7% * 9379 = $7850 billion
Short Term Debt = $565.68 billion (This amount is going to be serviced)
Foreign Debt as a percentage of Export = 565.68/2224 = 25.43%
Therefore using the foreign debt percentage of export risk table, the point assigned to China for
this indicator is 7.
Current Account as a Percentage of Exports of Goods and Services
The balance of the current account of the balance of payments for a given year, converted into
US dollars at the average exchange rate for that year, is expressed as a percentage of the sum of
the estimated total exports of goods and services for that year, converted into US dollars at the
average exchange rate for that year. For China,
Potential Risk: As discussed that export demand is falling and this is hampering the Chinese
economy, the current account surplus will come down. If the indicator falls, it shows that export
is not able to generate enough current account surpluses and China being an export oriented
economy, the GDP of the economy will go down. To counteract the effect of this indicator, the
Chinese government is looking to spur the domestic growth. So this indicator together with
domestic demand can tell us whether the economy will do well in the future or not. If the
current account goes negative, then the government won’t be able to service their foreign debts
through current account which will result in default and credit downgrade.
Total Exports for the year 2013 is $ 2224 billion.
Current Account for the year 2013 is $ 178.20 billion.
Therefore Current account as a percentage of Export = 178.20/2224 = 8.01%
Therefore using the current account as a percentage to export risk table, the point assigned to
China for this indicator is 13.
Net International Liquidity as Months of Import Cover
The total estimated official reserves for a given year, converted into US dollars at the average
exchange rate for that year, including official holdings of gold, converted into US dollars at the
free market price for the period, but excluding the use of IMF credits and the foreign liabilities
of the monetary authorities, is divided by the average monthly merchandise import cost,
converted into US dollars at the average exchange rate for the period.
Potential Risk: The official reserves are used for various purposes like meeting loan obligation.
Also the reserves are increasing because of stable exchange rate maintained by the Central Bank
else appreciation of currency would have happened. If that happens in an export oriented
economy where export demand is low then the growth will be adversely affected and the
reserves will quickly dry up.
Total Import for the 2013 = $1772 billion
Average monthly import = $1772/12 = 148 billion
Official reserves = $3.66 trillion
Therefore Net International Liquidity as Months of Import Cover = 3660/148 = 24
Therefore using the Net International Liquidity as Months of Import Cover, the point assigned
to China for this indicator is 5.
Exchange Rate Stability
The appreciation or depreciation of a currency against the US dollar (against the euro in the case
of the USA) over a calendar year or the most recent 12-month period is calculated as a
percentage change.
China had been fixing its exchange rate at ¥2-US$1 until 1984, when the government changed its
policy and started Yuan depreciation, resulting in a drastic shift from ¥2 per US dollar in January
1984 to ¥8.7 per US dollar in January 1994. During the period from January 1994 to June 2005,
China pegged its currency to the US dollar at around ¥8.4 per US dollar. Around 2005, it started
to appreciate for a while before being re-pegged at around 7.0 in July 2008. World leaders expect
China to take actions by next year to adopt more flexible exchange rates. Facing such a strong
and consistent pressure from the USA along with other developed countries, China promised to
gradually move toward a market-oriented exchange rate, but still infuriates its major trading
partners recently for the pegged regime. Despite a recent halt to the appreciation of the yuan, the
recession is leading to job losses in China’s export sector and thus increasing social instability.
Potential Risk: If appreciation of currency happens then China will lose its competitiveness in
the export market and this will lead to lower growth rate. Till China is not able to spur domestic
demand, China should peg its currency. However this could lead to strain relationship with its
trading partner.
For China, the exchange rate stability is estimated at 6.2%. Therefore using the exchange rate
risk table, the point assigned to China for this indicator is 10.
Summary: Financial Risk Indicator
Economic Indicator Point
Foreign Debt as a Percentage of GDP 3.5
Foreign Debt Service as a Percentage of Exports of Goods and Services
7
Current Account as a Percentage of Exports of Goods and Services
13
Net International Liquidity as Months of Import Cover
5
Exchange Rate Stability 10
Part 3 Legal system in China: Basic structure
The legal system of the People's Republic of China (PRC) is based on the PRC Constitution,
which stipulates that political power is exercised by the people through people’s representation.
This is achieved bottom up, from the local level up to the provincial and national levels. In
practice, policymaking and administration are at times highly centralised and uniform in nature, and
at other times highly decentralised and diverse.5
Legislative function: The National People's Congress (NPC) and its Standing Committee have the
power to pass laws (enact and amend) on behalf of the state.
The Chinese Communist Party: It is technically separate from the government. The Party parallels,
overlaps with and controls the government at all levels. While this achieves a certain high degree of
national uniformity and cohesion, this arrangement tends to set the Party above the government.
Executive function: the State Council of the PRC (State Council) is the highest level of state executive
administration and has the power to enact administrative rules and regulations consistent with law.
The Ministry of Commerce (MOFCOM) is the administrative body that is responsible for approving
foreign investment. The State Administration of Industry and Commerce (SAIC) and Local AIC are
responsible for business registration and other legal/regulatory oversight functions.
Judicial function: the judicial power to apply the law in civil and criminal matters is vested in the
people's courts at various levels – central, provincial and municipal/local. Court cases do not act as
binding precedents.
The Party-controlled central legislative/executive/judicial structure is repeated at lower levels.
Laws and regulations made at lower levels generally only serve to implement central-level
enactments must not conflict with those made at higher levels. It is also important to note that
despite the uniformity attributable to centralisation, there is may be high variation in local practice
and interpretation wherever central policy is silent or unclear.
Direct foreign investment is not permitted across the board in China. It is important to first assess
under what conditions the contemplated activity is open to foreign investment. Investment activities
are classified into 4 broad groups – Permitted, Encouraged, Restricted and Prohibited.
Investment decisions are also largely taken considering the special investment zones available -
national level high-tech industrial development zones; regular economic and technology
development zones; free trade zones; and export processing zones.
Legal & Regulatory system for doing business in China6
5 http://www.out-law.com/en/topics/projects--construction/community-infrastructure1/doing-business-in-
china-part-1---overview/ 6 http://www.sixsmart.com/SSPapers/pmw10.htm
Before entering the Chinese market , the stability of the Chinese government, Chinese laws,
property rights, price controls, and business restrictions need to be analysed. The Chinese
government has in the past strongly controlled prices, markets, products, foreign assets, and
personal assets. However the Chinese government has progressively chosen to open markets to
foreign investors and to create laws and regulations more in line with the WTO guidelines. This
has encouraged more foreign investment in China in recent years.
Building Laws and Regulations for Investment
There is a general understanding that excessive approval delays, personal rivalries, dishonesty,
and graft exist in the mechanism. Other perceived problems are related to leadership succession,
nepotism, favoritism and increased corruption.
The Chinese government has been taking steps to create and enforce a stricter legal system,
support freer commerce, and embrace the global marketplace. The Sino-Foreign Equity Joint
Venture Law was passed in 1979 to build a legal structure governing foreign investment. Since
then, China has continued to build a legal system that will protect both their rights as well as the
rights of their foreign partners
Protection of Private Property Rights
Private firms have been one of the driving forces behind China's rapid economic growth in
recent years. Some systemic problems persist and need to be tackled in order to encourage
additional development; an important one being the need for additional legal protections for
private property rights.
Under the Communist regime, private firms were associated with capitalism. They were typically
forbidden or subjected to various restrictions. However China adopted an open-door strategy in
the 1970s and the situation has since improved. This significant shift in government policy,
however, has yet to be fully reflected in the provisions of Chinese laws. Insufficient protection of
private property rights can otherwise lead to a widespread hesitation to reinvest in the country
and expand businesses.
Protection of Foreign Assets
Since 1979, China has built a legal system that attempts to protect the rights of Chinese citizens
as well as the rights of their foreign partners. New Chinese legislation is regularly introduced in
an attempt to modernize their economic legal structure. China is also expected to increase the
creation and enforcement of laws protecting the property rights of foreign corporations.
However, there is a risk that this may not completely protect foreign assets.
Government Price Controls
The Chinese government retains the capability to impose strict wage-and-price controls, but this
practice in not currently enforced. The majority of prices in China are now dictated by market
rates. China lifted price controls on many items as part of entering the World Trade
Organization. The current policy of relaxed price controls is likely to continue as long as it
benefits the Chinese people.
Corporate Restrictions in China
There are several restrictions for firms operating in China. Certain firms may be blocked from
entering a particular field that is available only to state-owned companies. Certain firms face
difficult rules regarding technology, personnel, and financing. Also, certain firms may be forced
to shoulder an unreasonably large tax burden. Furthermore, financing may hinder access to
funds.
Recently, however, more and more foreign companies are doing business in China. The
government has realized that in addition to reinforcing the protection of property rights,
facilitating competitive and fair market conditions is necessary to allow further development of
the Chinese economy. As a major step in this direction, discriminative measures against foreign
firms are being gradually removed following China's WTO accession
China’s Accession to WTO
China joined the WTO in the process of transition from a planned economy to a ‘socialistic
market economy’. Access to the WTO promotes China’s policy to reform its economy and open
up to world competition. This meant that China was committed to reforming its laws,
regulations, decisions, etc in order to ensure the implementation of the WTO agreements. WTO
focuses on fair trade between members. The fields WTO encompasses have been extended to
investment, services, intellectual property rights and other issues beyond pure trade.
Changes in the Legal Climate for Foreign Investment after China’s WTO Accession7
i. Fields open to foreign investors have been further extended. For example, there are
351 industries specified as encouraged activities, an increase of 94 items over those
stipulated in the Guidance Catalogue of 2004. Encouraged industries account for 73 per
cent of the list, up from 69 per cent in 2004.
ii. Transparency of foreign investment polices is enhanced. The catalogue therefore
contributes to transparency by clearly indicating the group into which each industry will
fall, thereby clarifying which policies and regulations are relevant to them. This makes the
relevant instruments easy to ascertain and access, so facilitating foreign investment.
iii. Domestic innovation and upgrading of industrial structure are encouraged. In
order to promote domestic innovation and to upgrade the national industrial base,
foreign investment is encouraged in modern agriculture, high‐tech industries, modern
service industries, cutting‐edge manufacturing and infrastructure
iv. Energy‐saving and environmentally‐friendly industries are encouraged. In order to
promote the more effective use of resources, environmental management and sustainable
development, the Guidance Catalogue of 2007 encourages industries in the area of clean
production technology, recycling resources, ecological environment protection and the
comprehensive utilization of resources.
v. Coherent development across regions is encouraged. The eastern and coastal
regions of China were the first areas opened to the world, whereas the western, central
and northeastern regions are relatively underdeveloped. China particularly encourages
investment in underdeveloped regions. The government is determined to improve
7 Bond Law Review, Vol. 20, Issue 1 - January 2008: “The Legal Climate for Foreign Investment in China after its
WTO Accession”
infrastructure significantly, improve the investment climate, allow more market access for
foreign investment and attract expert personnel to western regions.
Establishing a business in China8
Foreign invested enterprises (FIEs) wishing to establish a presence to do business China must
establish one of the several different statutory forms of FIE. In general, only companies with
25% foreign equity or more can be considered as FIEs. Forms of FIE include:
1) “Wholly foreign-owned enterprise (WFOE): a limited liability company 100% owned by one or more
individual or corporate foreign investors. The liability of the investors is limited to their subscribed registered
capital. WFOEs are the most popular form of FIE.
2) “Equity joint venture (EJV): a legal person company invested in together by both foreign and domestic
corporate investors. The equity interests of the investors, and the division of profits, is strictly proportional to
their shares of contributed registered capital.
3) “Cooperative joint venture (CJV): normally established as legal person limited companies, but may also be
established as a non-incorporated contractual cooperation. The liability of the partners in an unincorporated
CJV is unlimited, and investors tend to have greater flexibility. Non-incorporated CJVs are typically only
established for specific limited purposes and activities such as collaboration in natural resources exploration
and venture capital investments.
4) “Foreign invested company limited by shares (FICLS): a joint Chinese and foreign-invested company, hence
a form of joint venture (JV), limited by shares. An investor's liability is limited to its individual
subscription. Companies seeking listing on the Chinese stock market must be in the form of a FICLS. A
WFOE, EJV or CJV may convert to an FICLS in accordance with PRC law.
5) “Holding company and regional headquarters: investors with major operations already in the country may
wish to consider establishing a holding company or a regional headquarters to help consolidate certain group
treasury, support services and trading functions. There are significant minimum investment thresholds, and
operations are limited to holding company functions.”
Key challenges in the business & regulatory environment9
Some recent developments born out of friction between foreign companies and the Chinese
business environment are:
Coca-Cola's failed effort to take over Huiyuan Juice, 2009;
Google's exit from the market amid allegations of government hacking, 2010;
The arrest of Wal-mart employees over mislabeling of pork products, 2011;
Caterpillar's loss of $580 million after acquiring a Chinese construction equipment
company that had fraudulently inflated its revenues;
The bribery case involving GlaxoSmithKline.
According to the annual survey conducted by the American Chamber of Commerce in Shanghai,
the key business challenges in China faced by companies are as shown in the graph below.
8 http://www.out-law.com/en/topics/projects--construction/community-infrastructure1/doing-business-in-
china-part-2---establishing-a-business-in-china/ 9 The American Chamber of Commerce in Shanghai – China Business Report 2012-2013
Rising costs, HR constraints and preference for local firms and resultant competition were stated
by participant companies.
Challenges in business environment
The important regulatory challenges according to the survey are:
Bureaucracy (74%)
Unclear regulatory environment (72%)
Tax administration (66%)
Customs clearance delays (62%)
Customs and trade regulations (61%)
Difficulty enforcing contract terms (61%)
Obtaining required licenses (58%)
Difficulty in litigation (50%)
Domestic protectionism (between provinces) (49%)
Legal restrictions on market access (49%)
Regulatory Challenges
The environment for foreign companies in China has been getting tougher since 2006, when the
nation came to the end of a five-year schedule of market-opening measures it pledged as the
price of admission to the World Trade Organization. Soon after the WTO-mandated reforms
concluded, foreign firms began to complain of an increase in discriminatory practices, more
difficulty in getting licences and approvals, and a generally less friendly attitude from officialdom.
The wordings of the Chinese laws are often ambiguous and hence can be interpreted in many
ways. Laws on trade, intellectual property rights, labor and taxation are often refined which leads
to complexity in interpretation of the laws.
Antitrust laws
China's Anti-Monopoly law was adopted in 2007. Its provisions are partly consistent with
Western economies’ competition policy frameworks, in that they provide for a substantive test of
the impact on competition and consumers of the merger or anti-competitive conduct.
In contrast to the European law, however, the Chinese law leaves significant room for the use of
competition policy to further industrial policy objectives. The Chinese law explicitly allows the
inclusion of ‘economic development’ and ‘national interest’ in the assessment. The Chinese
antitrust law can therefore technically be used to pursue industrial policy objectives and protect
domestic industries.
Ministry of Commerce’s commitment decisions often aim to protect domestic competitors from
the potential increase in the competitiveness of merged companies. Companies are sometimes
prevented from pursuing a certain line of business (like Wal-Mart/NiuHai), or from reducing
their input costs.10
Finding a local partner
Finding a local partner to do business in China is crucial because has China has "gained a
reputation as a place where deals and contracts are often treated more like suggestions than
concrete agreements"11.
Having a Chinese partner does pose some risk. The partner company could infringe the foreign
company's intellectual property, so it's critical to vet potential partners thoroughly before making
any decisions. Ideally, a good partner is an incorporated company that is about the same size as
the entering firm, at least partly Chinese-owned, has a strong network and is well-connected in
the Chinese market. Partnering with massive state-owned enterprises is best avoided, according
to leading law consultants. It is advisable to retain a Chinese lawyer before attempting to enter
the Chinese market, as the paperwork and regulations, while not as opaque as in the past, are still
difficult for a foreigner to navigate.
Due diligence is required to reduce the risk of poor partnering to the entrant's business12. Below
are situations that careful due diligence can help avoid.
Fake companies - A company approaches and offers a big deal with very favourable
margins. This would involve paying a certain amount of “relationship building” fees to
clear the relationship with important local stakeholders. The company disappears soon
after you transmit the money to its account.
Paper tigers - A company promotes itself a leading company in its industry but fails to
present any strong and persuasive evidence to substantiate its claims.
Shell companies - A company with registration information but with no significant assets
or active business records.
Parasite companies – A company relying heavily on its relationship with local
government officials.
Intellectual Property – Infringement & Enforcement13
The legal framework for protecting intellectual property in China is built on three national laws
passed by the National People's Congress (NPC): the Patent Law, the Trademark Law and the
Copyright Law. The framework of regulations, rules, measures and policies have been made by
the NPC Standing Committee, the State Council and various ministries, bureaux and
commissions.
To enforce IPR protection, an administrative system has been established within the
government. To handle cases of infringement of IPRs more efficiently, special intellectual
property courts have been established in some cities and provinces.
10
http://www.voxeu.org/article/chinese-competition-policy 11
http://www.ibtimes.com/how-do-business-china-guide-entrepreneurs-investors-1378695 12
http://www.tradecommissioner.gc.ca/eng/document.jsp?did=132268 13
“Understanding China’s Business Risk Environment”, Marsh Risk Alert, Volume V Issue 3
The enforcement of protection of intellectual property rights is difficult in China. Without
adequate education with regard to IPRs, there is little awareness that infringement is a crime.
Strict laws and patents in economies of the West protect domestic and foreign businesses,
whereas in China, the legal system is designed in such a way that gives rise to ambiguity.
“Shanzhai” 14is an integral part of the Chinese tradition promotes individuals sharing what they
create with the society to promote greater harmony. Shanzhai in business today takes the form of
imitation of goods. Hence anything from shoes to cell phones are copied and sold openly in
markets across the country. China today is the world’s largest producer of counterfeit products.
Governments around the world continue to pressure Chinese authorities to do a better job of
enforcing IP laws, and there are signs of progress. In May 2006, President Hu made a speech in
the Political Bureau of the Chinese Communist Party calling for strengthening the country’s IP
system.
Some progress has also been seen in enforcement. In February 2006, the U.S. Department of
Justice obtained a conviction against a U.S. citizen for counterfeiting a popular pharmaceutical.
With the cooperation of Chinese law enforcement, the operation resulted in the seizure in China
of 600,000 labels, 440,000 tablets, and more than 500 pounds of raw pharmaceutical
manufacturing materials.
China’s State Administration of Industry and Commerce (SAIC) is the primary enforcer of IP
regulations. It has the authority to seize counterfeits from markets, warehouses, and factories.
Many companies find it helps to be proactive with the SAIC by using an independent
investigative firm to track counterfeiters, locate the warehouse or the factory where the
counterfeiters are producing the product, and then pass the information on to the SAIC along
with a formal letter of complaint. In theory, the SAIC should then raid the offending site. Brand
owners are well-advised to keep up the pressure on pirates through investigations and raid
actions. They should also practice thorough due diligence on employees and potential business
partners to see if they have a track record of IP theft or are currently involved in counterfeit
activities.
International Disputes Resolution15
China has several institutions for arbitration such as China International Economic and Trade
Arbitration Commission (CIETAC). Only litigations containing an "external element" can be
arbitrated outside China.
Dispute resolution in the commercial area is characterized by: (i) demonstrable overall progress;
(ii) considerable efforts to improve the regulatory framework and respond to investor needs,
14
Jayaraman, Karthik:"Doing business in China: A risk analysis", Journal of Emerging Knowledge on Emerging Markets, Fudan University & The Norwegian School of Management, November 2009 15
"Dispute Resolution in China: Patterns, Causes, and Prognosis": Randall Peerenboom and He Xin - The Foundation for Law, Justice and Society in collaboration with The Centre for Socio-Legal Studies,University of Oxford
thus reducing vertical disputes and tensions between businesses and the state; (iii) a rapid rise in
litigation to resolve horizontal commercial disputes among business operators through the late
1990s followed by relative stability; (iv) improvements in enforcement, particularly in more
developed urban areas; (v) notwithstanding considerable progress, ongoing problems with
litigation, including significant regional differences in the nature of the economy, the nature of
disputes and institutional capacity, and (vi) a renewed emphasis on judicial mediation in response
to ongoing problems
SWOT Analysis of General Business Environment
Strengths
Opening up various sectors of its economy to foreign investment.
China is the top destination for FDI with its vast supply of cheap labour.
Weaknesses
Foreign companies complain about the poor protection of intellectual property in China.
Chinese corporate governance is weak and non-transparent by Western standards.
Choice of right local partner is accompanied by considerable risk for foreign companies.
Opportunities
Urbanisation and infrastructure drive will provide major opportunities for foreign
investment in landlocked provinces as well as the transfer of skills and knowhow.
The Chinese government is giving more protection and encouragement to the private
sector, which is now the most dynamic in the economy and accounts for most of the
country's job growth.
Threats
China's government might block attempts by foreign firms to take over assets of national
importance.
China is experiencing rising labour costs, prompting some investors to turn to cheaper
destinations such as Vietnam.
Pharmaceutical Industry in China – legal & regulatory dimension
The domestic pharmaceutical market in China is highly fragmented. Traditional systems of
medicine have long had a major presence in China. The industry is still small-scale with a
scattered geographical layout, duplicated production processes, and outdated manufacturing
technology and management structures. The Chinese pharmaceutical industry also has a low
market concentration and weak international trading competitiveness, coupled with a lack of
patented domestically-developed pharmaceuticals.
Earlier, the industry had been riddled with problems such as: Poor IP rights protection, non-
transparency for drug approval procedures, ineffective governmental incentives, and poor
corporate support for drug research.
Accession to the WTO has brought a stronger patent system, medical insurance is now more
widespread, and pharmaceutical-related regulations have been tightened. Changes to the
patenting laws in full compliance with the requirement of the Agreement on Trade-Related
Aspects of Intellectual Property Rights (TRIPS Agreement) and the poorly developed
infrastructure of Chinese pharmaceutical R&D have created gaps in the market, which offer a
scope for foreign investments.
SWOT Analysis of the pharmaceuticals industry16
Strengths
Progressive healthcare Reform by Central government
Among the top five drug markets in the world in terms of overall size.
Large pool of highly skilled, low-cost scientists and general labour.
Rising per capita drug expenditure on the back of strong economic growth.
Weaknesses
Highly fragmented market.
Complex and protectionist (biased) drug pricing and reimbursement policy by the
government,
Lack of tight enforcement of domestic patent laws.
General focus on lower-cost pharmaceuticals and production overcapacity.
Government bureaucracy, non-transparency and corruption.
Opportunities
Rapid growth in generic drug sector.
Patented drug sector growth boosted by rising demand for hi-tech treatments.
The fastest growing over-the-counter drugs sector in Asia.
Modernisation of local manufacturing sector
Rising foreign direct investment (FDI) following increased intellectual property rights
Increased tax revenues, allowing the government to expand health insurance coverage.
New and improved drug registration process to place less emphasis on personal
connections.
Increasing research and development capacity.
Part 4 Chinese Pharmaceutical Market17
The Chinese Pharmaceutical market is currently the third greatest pharma market globally, after
the US and Japan, and in 2011 was worth $40 billion. It is forecast to increase dramatically to
$200 billion by 2020 and increase its dominance as a leading player in Asia. As the current third
market leader it is predicted that the Chinese pharma market will be the main competitor of the
US by 2020. The Chinese pharmaceutical market is the main driver of the countries healthcare
industry and in 2011 dominated with almost 90% share. Within the pharmaceutical industry
drugs and active pharmaceuticals (API) are the main revenue generators. Over the Counter
16
Business Monitor International: China – Pharmaceuticals & Healthcare Report, Q4, 2012 17
Deloitte: Opportunities in China's pharmaceuticals market, 2011
(OTC) medicines had a Chinese market figure of $9 billion in 2008 (18% of total market share)
and by 2013 will become the world’s second largest OTC market. In the same year prescription
medicines dominated the market place with 62% share, and traditional Chinese medicine (TCM)
made up almost 20%. Diabetes is one of the most successful therapeutic areas in the Chinese
market and will reach over $2 billion in annual sales in 2019, compared to $700 million in 2009.
Vaccine production is a leading strength in China with the ability to produce almost 1 billion
doses each year according to the State Food and Drug Administration (SFDA). The country has
almost 40 (38 in 2011) companies with vaccine manufacturing capabilities and the vaccine
market was worth an estimated RMB1 billion in 2011. Over 40 different vaccines covering more
than 26 indications are currently being made in China. The main vaccines that are currently
exported are against hepatitis A, influenza and Japanese encephalitis. The oncology market in
China is forecast to grow steadily and reach $2.2 billion by 2017 from $830 million in 2009 with
a CAGR of 12.9%.
Growing and distinctive Chinese pharmaceutical market
1. Pharmaceutical sales grew at a CAGR of 25.9 percent from 2007 through 2010, and are
expected to continue strong but more modest growth from 2010 through 2015, at a
CAGR of 15.5 percent.
2. The aging population will generate higher demand for health care services. Currently, the
elderly population makes up 23 to 40 percent of the prescription drug market and 40 to
50 percent of the over-the-counter (OTC) drug market.
3. Out-of-pocket and private insurance healthcare payments rose steadily from 2007
through 2010, at a CAGR of 13.5 percent and expected to grow at a lower rate of 8.5
percent through 2015.
4. The CAGR for government healthcare payments was 17.9 percent from 2007 through
2010, and they are forecast to grow at 12.1 percent from 2010 through 2015
5. Although healthcare infrastructure expansion and the hiring of physicians have lagged,
the net income and private healthcare expenditure of rural households have grown
sharply over the past two decades.
6. Generics expected to continue to dominate the market, but patented drugs expected to
see significant growth.
Competition and changing Government health care policies
18National firms compete and cooperate with foreign companies that have a direct presence in
the market. The three major firms - one Chinese and two big Western multinationals - share only
10% of the market. Yangtze River Pharmaceutical Group is the leading player (3.6% of the
market’s value), AstraZeneca PLC controls 3.4% and Pfizer Inc. 3.0%. Bayern is gaining
importance, as well. China’s top three distributors - Sinopharm Group, Shanghai Pharmaceutical,
and Guangdong Jiuzhoutong Pharmaceutical - had in combination less than 20% of overall
market share in 2009. The number of firms has more than doubled from 2000 to 2010 and their
scale has been also increasing. State-owned enterprises, foreign enterprises and private
enterprises compete in the market. Even if the number of private firms has more than doubled
in only 6 years, their average size is much lower than SOEs and foreign firms. SOEs, on their
side, have been experiencing a period of reorganization and rationalization: their number
18
The rising Chinese pharmaceutical industry: local champions vs global players - Francesca Spigarelli, Hao Wei
decreased from 1.500 to 500, but their average size grew significantly, as well as their gross
domestic output.
In 2010, firms from abroad produced 27.01% of gross industrial output value. Anyway, despite
the importance of foreign companies, their share in the market is not overtaking national firms,
that are keeping their role and competitive position. Competition and rivalry among foreign
firms and Chinese companies is going to be strongly affected by the changing landscape in
proprietary technology. At the moment, foreigners hold the monopoly in many proprietary
technologies. In the insulin market only, Novo Nordisk, Eli Lilly and Sanofi controlled more
than 90% of the sales in 2010. This situation is going to change rapidly. In fact, more than 10 of
the world’s best-selling drugs, including Pfizer’s cholesterol-lowering Lipitor and Lilly’s
antipsychotic Zyprexa, lost patent protection in 2011. This is expected to directly result in a
nearly US$5 billion reduction in those global pharmaceutical companies’ revenue. Furthermore,
it is estimated that more drugs valued at about 77 billion $ in total are going off patent within the
next five years.
In March 2009, China's government revealed plans for a sweeping healthcare overhaul, and
committed RMB850 billion to develop the country's healthcare system between 2009 and 2011.
Among its provisions were to increase the Basic Medical Insurance (BMI) coverage from
approximately 65 percent of the population to 90 percent by 2011; to revise the national
Essential Drugs List (the "EDL", medicines reimbursable under BMI); and to allow the National
Development and Reform Commission (NDRC) to more strictly regulate pricing.
Domestic companies are mainly government owned and fraught with overproduction and losses. 19The Chinese government has begun consolidating and upgrading the industry in an effort to
compete with foreign corporations. It is estimated that most hospitals derive 25-60% of their
revenue from prescription sales, hospitals remain the main outlets for distributing
pharmaceuticals in China. This will change with the separation of hospital pharmacies from
healthcare services and with the growing numbers of retail pharmacy outlets. Retail pharmacy
outlets are expected to grow in number once the government finally introduces its system to
classify drugs as OTC. The government is now encouraging development of chain drug stores,
but the full effect might not be seen for several years. The central government has been playing a
significant role in pharmaceutical price readjustment. Future price reductions will originate from
hospital pharmaceutical retail shops. The rural pharmaceutical market will shift significantly. 80%
of counterfeit products are consumed in rural areas. This provides a huge opportunity for
pharmaceutical companies to develop the market in rural areas.
China Generic Drugs Situation
The wave of patented drug expirations will significantly boost manufacturing and sales of the
related generics. In fact, generic drugs are the mainstay of China's pharmaceutical industry, and
are likely to remain so for a long time. While the government encourages and relies upon
innovation to meet industry targets, China will probably continue to rely upon widespread
prescription of generics in the public insurance plan to hold down the overall healthcare
19
http://en.wikipedia.org/wiki/Pharmaceutical_industry_in_China#Governmental_policies
expenditures, and the current R&D capability also limits the possibility of launching domestic
patented drugs in the near term.
Traditional Chinese Medicine20
Traditional Chinese Medicine (TCM) is a more than 3,000-year-old medicinal practice whose
doctrines are rooted in ancient books such as the Yellow Emperor's Inner Canon and the
Treatise on Cold Damage, as well as in cosmological notions like yin-yang and the five phases.
Starting in the 1950s, these precepts were modernized in the People's Republic of China so as to
integrate many anatomical and pathological notions from scientific medicine. About 95 percent
of general hospitals in China have traditional medicine departments and formal TCM training is
an integral part of the national health program. There are more than 253,233 registered TCM
doctors and assistant doctors across the country. According to data published by the Shandong
University, hospitals practicing TCM treat more than 200 million out-patients and almost three
million in-patients annually. TCM has been growing at a pace faster than the average rate of the
entire Chinese pharmaceutical industry. The size of the TCM market is estimated to be close to
$30 billion. According to the Xinhua News Agency, the cumulative sales value of the TCM
industry is increasing at an annual rate of 23 percent.
OTC Market
China’s OTC market is growing quickly—around 17 percent per annum in recent years—
according to the China OTC Association's statistics, and faster than anywhere else in the Asia-
Pacific region. At this rate, observers at Espicom expect China to become the world's largest
OTC market by 2020. In 2009, the total OTC drug market was RMB121 billion, with a split of
RMB49 billion and RMB72 billion being sold in hospitals and retailers, respectively. Although
OTC drugs only account for a minority of the Chinese pharmaceuticals market, their sales are
growing in increasing proportion to sales of prescription drugs.
Regulatory regime and policy development
National authority & legislation
The China State Food and Drug Administration (SFDA) is the national supervising authority for
the pharmaceutical sector in China. It became operational in 1998 as the State Drug
Administration (SDA) and was renamed in 2004. The SFDA has a number of departments to
executive its different responsibilities, and the most industrial-related are the following three—
the Department for Drug Registration, the Department of Drug Safety & Inspection, and the
Department of Drug market Compliance. Pharmaceutical regulation in China is based around
the Drug Administration Law (DAL), first implemented in 1984, with the last major
amendments taking place in 2001, and coming into force in September 2002.
Drug registration, approval, and manufacturing
Drug registration in China is a complicated and time-consuming process, involving a number of regulatory
bodies at various levels of government, and at various regional levels. Drug approval applications
could be sent directly to the central SFDA prior to 2002, but the applications are now initially
reviewed by provincial and municipal authorities, and then passed to the SFDA for approval. The
20
http://www.biospectrumasia.com/biospectrum/analysis/2724/traditional-chinese-medicine-eats-pharma-market
entire approval procedure generally takes between 18 and 26 months. Domestic clinical trials are mandatory
for all drugs which are new to the Chinese market required by the Good Clinical Practice (GCP)
guidelines. If a drug has not been approved in China or anywhere else, permission for the trial
must be granted by the SFDA and the MOH, and it normally takes 12 months for the trial process.
Once the clinical trials have been completed, the product must undergo a quality test. The
manufacturer should provide enough product samples to conduct three complete tests.
Manufacturers should be prepared for unexpected questions and test results; a large number of
Chinese test laboratories are not rigorously controlled. The quality test should take around three months.
IP Protection
China's heretofore poor IP protection has been a countervailing factor in pharmaceutical
companies collective drive to carry out R&D in the country. In addition, China's patent law is
soon due to be revised, which should foster greater innovation and deter copycat drug makers.
In recent years, a growing number of companies have become increasingly attracted to the idea
of having an R&D center in China, as in-country research offers a general low cost base, a large
patient pool, increasing scientific capabilities, the local industry's knowledge in the field of
generic drugs, and insight into the country's growing drug markets. Moreover, manufacturers can
only receive regulatory authorisation for products based on clinical trials that have been carried
out in China
Pricing
Overall control of drug prices is the responsibility of the NDRC, whose pricing policy is based on
the control of profit levels and sales discounts within the industry. Prices of drugs on the EDL are set
by the government, while most other drug prices are set after negotiations between the
government and manufacturers. The NDRC's purpose is to diminish the reliance of hospitals on
drug prescriptions as a source of income by implementing the EDL. Some 300 drugs have been
identified as critical for common illnesses and diseases, and should be made available to all
patients. For drugs on the list, prices are fixed and no commission is paid for their prescription.
Prices for these drugs have come down by 30 percent to 50 percent, which has reduced the cost
of inpatient and outpatient care.
Entry Strategy
Based on analysis we have come out with suggestions where foreign firms can partner/make
their presence in China. Since China generic market has occupied a quite big share, entry to
generic market could provide access to huge market. However with the emergence of strict IP
protection norms it is possible for a firm to reap benefits by investing in R&D and
manufacturing facilities and come out with patented products.
Various Pathways to enter
Partnering
o R&D Collaboration
o Contract Manufacturing
• Presence
o Joint venture
o M&A
Partnering: regulatory considerations
Non-clinical studies/clinical studies:
The Chinese SFDA is very actively reforming the regulatory framework for conducting clinical
trials and will likely further adjust its policies in step with advances in the clinical environment. In
recent years, the agency has been striving to provide:
• Internationally Accepted Standards
• Normalization
• Greater Transparency
• Stronger Communication with Sponsors
• Closer Supervision of Clinical Trials.
• Traditionally, the approval timeline for Clinical Trial Applications (CTAs) has limited
China's participation in global trials. However, the time has been reduced to an average
of 7 months for NCEs and 12 months for biologics—a notable feat considering that the
number of approvals has also been increasing by 18-20 percent over the past two years.
Contract Manufacturing
Building own R&D facilities
As most of the players are aware about the advantages of investing in R&D in China, foreign
drugs manufacturers are setting up facilities in Chinese market. Government has also introduced
dedicated parks which provide features ranging from proximity to suppliers and tax incentives.
Incentives are available to pharmaceutical companies carrying out R&D in China and they are
liable to get High/New Technology Enterprise incentive. HNTE incentive includes core
ownership of IPR and having products/services fall under the scope of “encouraged” domains.
However the pharmaceutical market is highly fragmented. Also, large parts of this layered market
continue to be flooded with low priced, low quality products. The market, however, is
undergoing major changes and becoming more mature. Two reasons are driving these changes –
first, a new regulatory system is forcing companies to focus on quality and safety; second,
companies themselves are becoming more sophisticated and gearing up to meet the stringent
regulatory requirements. Together this is driving the fundamental maturing of the life science
industry, the report points out.
Thus we can see that Chinese market has turned its focus towards strong IP laws and regulations
however still the registration and approval process is complex and cumbersome. Partnering
strategy should be in the field of generic or patents (considering strong protection to IPR).
Benefits Risks
Cost Savings Lack of Control
Mutual Benefit to Contract Quality concerns
Advanced Skills Outsourcing Risks
Quality Intellectual Property Loss
Focus Loss of Flexibility and Responsiveness
Economies of Scale
Mergers and Acquisitions/JVs:
1. Access to existing market.
2. The partnership would provide access of strengths of both partners, the foreign firm
expertise in developing innovative medicines and domestic players distribution network.
3. Quick access to fast-growing developer and producer of pharmaceutical products in
China.
4. Access to existing sales and marketing network
5. However, the road is not that strong, There is a risk of multinationals running into the
2008 PRC Anti-Monopoly Law that regulates all M&As-domestic as well as cross
borders
6. Another approach adopted by some pharmaceuticals is the research and sale of drugs
that tackle entire lifestyle issues rather than simply marketing medications for specific
diseases. This includes building a whole ecosystem to educate, train and benefit all the
stakeholders involved.
7. Prices are fixed by the government which could lower down the profit margins for the
firms
8. Complex deal structure is time consuming
Large multinational groups from North America, Western Europe, and Asia are attracted to
China, as a result of a more friendly and favourable business and institutional environment.
Operating in the Chinese market is still considered high-risky, time-consuming and expensive
compared to other emerging markets due to stringent regulations concerning safety and efficacy.
China is also strategic for Western companies to reach other nearby Asian emerging markets: as
operating in the country can offer a logistic and commercial platform to penetrate them. Second
factor, China is a market for delocalizing the production of high quality and price competitive
raw materials. In some specific market segment (antibiotics, cephalosporin), producing in China
is a necessity. In the West, in fact, environmental and safety rules make it impossible to set up
fermentation and chemical plants associated with pharmaceutical plants. Third aspect, China is
the frontier to develop applied research program
Part 5 Scenario Analysis
The firm has 2 options for making an investment decision:
1) Selling generic drugs
2) Selling patented drugs
Each of these options can have 3 scenarios for them:
a) The situation remains the same
b) The situation improves
c) The situation detoriates
Patented Drugs
China has altered its licensing laws to allow domestic pharmaceutical companies to make cheap
generic copies of patented drugs under certain circumstances. The move is part of the country’s
efforts to ensure it has the weapons to tackle health crises like AIDS, but there are concerns
about the effect these policies could have on innovative drug development.
The new measures allow the government to issue compulsory licenses to eligible companies to
produce generic drugs. A clause has been added to existing patent laws stating: ‘SIPO [China’s
State Intellectual Property Office] has the right to authorize compulsory licenses in emergencies,
extraordinary conditions or in the public interest.
Keeping all above point in mind, we proceed to with scenario analysis for patented drugs.
Patented Drugs – Situation remains same
1) Going by the current pharma policy framework and decision making process, to maintain
the same level of FDI in pharma sector, China might not tamper or make its pharma
policy more strict.
2) To provide access healthcare access to its population, China has set a maximum price for
all -category of drugs. This situation will continue to exist.
3) A change in government won’t cause drastic changes in current policy because most of
the current government policies are pro-people and in benefit of the population.
Patented drugs – Situation remains same
Key parameters 1) Amount of competition remains same
2) Government policy & regulations remains same
3) Government providing national treatment
4) Price Ceiling
Key Issues that will
arise
1) Same as existing scenarios. No drastic changes.
Action to be taken 1) Firm should continue with its current level of investments
in the either of its generic or patented drugs
2) Emphasis should be given on establishing distribution
network
3) Consult with government while setting prices since the
pricing mechanism is based upon three considerations
when setting the maximum retail price - production cost, a
wholesaler spread set by the government and the prices of
comparable products in the market. Any products priced
above this level will be cut.
Likelihood of situation
to occur
1) In short term (1-2 years) situation would remain same
Patented Drugs – Situation Improves
1) China entered the WTO in 2001 as a developing country. Due to this is gets various
benefits that are offered to developing countries. On another note, China has trained its
judges to understand WTO rules and regulations. It has also created a system to handle
the various patent issues that would arise after entering the WTO. China’s entry into the
WTO has been a win-win situation for China and the rest of the world.
2) Below is the list of China’s trading partners
1st trading partner of following countries: Australia, Chile, Japan, South Korea, Hong
Kong China, Malaysia, Russia, Brazil, South Africa, Saudi Arabia
2nd trading partner of following countries: Argentina, Canada, European Union, India,
Indonesia, Mexico, New Zealand, Singapore, United States
3) All these factors lead us to believe that China in future will increase its adherence to
WTO regulations and follow a stricter implementation when it comes to cracking down
on fake duplicates
4) Due to economic recession of 2008 and 2011-12 there is mounting pressure from US,
EU to further open up Chinese economy. This would create more private players in a
particular sector thus bringing in efficiency in the system.21
5) China houses world’s largest population. The Chinese health ministry has laid an
ambitious plan to provide healthcare access to every Chinese national by 2020. This
provides a huge opportunity for various pharma companies.
6) China's Ministry of Commerce (MOFCOM) has outlined its plans for the development
of the pharmaceutical sector from 2011 to 2015, focusing on the consolidation and
distribution of drugs.
Patented drugs – Situation Improves
Key parameters 1) Amount of competition decreases due to M&A activity
2) Consolidation seen among various local players to remain
competitive (Rate of consolidation)
3) Crackdown on duplicate drugs
4) Stricter implementation of TRIPS of the WTO
agreements
5) Pressure from US & EU for more open economy
6) Introduction of healthcare reforms undertaken by the
government
Key Issues that will
arise
1) Acquisition of local players by MNC majors
2) Higher amount of FDI in pharma sector allowing foreign
players to invest more in R&D
3) Increased healthcare expenditure
4) Price Ceiling by Government
Action to be taken 1) Increase R&D spend for more patents since overall cost
21 http://online.wsj.com/news/articles/SB10001424127887324577304579056191917697998
of R&D is lower in china
2) Setup factories in china
3) Collaborate with Chinese government to work on health
and insurance schemes
4) If the set prices are above the government ceiling prices
then there is likelihood of the government cancelling the
patent. This happened with the firm Viread’s patent for
HIV/AIDS being cancelled. The firm should work with
the government in coming with a suitable pricing strategy
for its patented drugs.
Likelihood of
situation to occur
1) China’s reform policy is geared towards consolidation and
swift developments are taking place in drug delivery and
distribution system22.
2) As per Chinese health ministry:- Chronic diseases like
cancer and respiratory and heart diseases are China’s
biggest problems
3) Due to all these factors consolidation is already observed
in some firms23
4) So the likelihood of this situation remains high
Patented Drugs – Situation Detoriates
1) Recent investigations of corruption in the pharmaceutical industry have focused solely on
foreign enterprises, said Bruno Gensburger, the European Chamber's pharmaceutical
chair. "To date, no single Chinese pharmaceutical company has been investigated," said
Mr. Gensburger.
2) China has world’s largest population and the benefits of China’s turnaround has not
reached the poor natives. Also, 26% of Chinese population suffers from hypertension.
This translates into 35.20 crore people having hypertension. A situation might arise where
firms selling patented drugs against hypertension might face patent cancellation, under the
pretext of national emergency.
3) Similar healthcare problems can be seen in other areas:
a) 30 crore people in China smoke
4) An outbreak like H1N1, will force Chinese government to cancel patents of companies
which come up with an antidote
5) As part of trade wars that is seen amongst countries, if US/EU bans some of the products
of china’s pharma industry, as a retaliatory measure China can ban or revoke licenses of
pharma companies.
6) Even today there is a wide state interference in the pharma sector. Majority of the firms
are state owned. The various pharma companies and the hospitals are closely associated
with each other, where the hospitals prescribe drugs of a certain pharma company. Due to
this there might be a high entry barrier for foreign firms.
22 http://www.swissnexchina.org/foryou/kpmg-china-pharmaceutical-201106.pdf 23 http://www.chinadaily.com.cn/business/2013-05/20/content_16510980.htm
7) Given the fact of China’s ambitious health plan of 2020 in which it wants to cover every
citizen under health cover, China may actually boast the production of generic drugs so
that the health plan comes to their citizen at an affordable price.
8) China has relatively strict foreign exchange regulations. Moving currency in or out of the
country often triggers a settlement, registration or approval requirement, depending on
the type of transaction.
9) Depending on the structure of the transaction, a U.S. company may incur tax liability
under Chinese law. For example, a U.S. company may be subject to China’s enterprise
income tax for certain China-sourced income such as interest, royalties, capital gains, etc.
10) An economic downturn will force Chinese government to aggressively pursue the option
of generic version of similar drugs thus directly threating the patented drugs. A recession
in US or Europe can cause such a downturn to occur.
Patented drugs – Situation Detoriates
Key parameters 1) Government bans patents and revokes licenses
2) Promotes local generics
3) Introduces TBT or volume restrictions
4) Provides ceiling prices on various drugs
5) Problem of duplicate drugs (manufactured via reverse
engineering processes)
6) Increases the price ceiling so that the patented drugs are
available at much cheaper cost
Key Issues that will
arise
1) Most MNC’s losing market share to domestic players
2) Government crackdown on MNC
3) Observation of TBT
4) Interference of the government in pricing strategy of the
firm
Action to be taken 1) China is a member of WTO. Approach WTO, since as per
clauses of WTO government can’t introduce TBT or
provide national treatment
2) In case of patent revocation, there has to be an extremely
solid case against the firm, the firm can again approach
WTO or the Chinese judicial procedure
3) Price its drug appropriately to avoid clashes with the
government and risk losing license
4) The firms may approach the government to crackdown on
duplicates
5) Another option would be to acquire the firm that has
duplicated the drug, since the acquiring firm has to cut
down on the losses
Likelihood of situation
to occur
1) Even though the likelihood of this scenario is less, there have
been an instance where China, has revoked patent of Gilead
Science Inc. for HIV/AIDS drug24
Generic Drugs
The generic market in China has high amount of competition. It is difficult for uncompetitive
firms to survive. Government is in favor of policies, which drives out uncompetitive firms forcing
them to be acquired by large multinational or domestic firms. Innovators have witnessed the
growth in the generic industry and struggle to cope with pending patent expiries, many of them
have turned to acquisitions and supply agreements to expand into generic drug markets as well.
Generic Drugs – Situation remains same
Generic drugs – Situation remains same
Key parameters 1) Number of competitor remains same
2) Rate of consolidation
3) Number of new players in the market
Key Issues that will
arise
1) Level of competition would remain same
2) No significant change in government policy
Action to be taken 1) None
Likelihood of
situation to occur
1) The likelihood of this situation is MODERATE
Generic Drugs – Situation Improves
1) Consolidation seen amongst drug distributors brining in higher efficiency in the entire
value chain
2) OTC drugs will see higher consumption due to increased awareness and promotion of
self-medication.
3) The government 12th 5 year plan clearly lays emphasis on generic version of drugs
4) As one component of a broader set of national goals of 12th 5-year plan, to push industry
consolidation and industrial advancement, pharmaceutical companies are encouraged to
consolidate domestically, eliminating outdated and excessive capacity, solidifying market
share and technologies to build their businesses. This in turn would reduce the amount of
competition in market
5) Increased acceptance of generics among providers and patients—focusing first on
ensured quality
6) Initiatives such as the EDL, price-capping, the recent anti-corruption investigations, and
reform of the drug mark-up system will favor the use of generics
Generic drugs – Situation Improves
Key parameters 1) Number of competitors decrease in the market
24 http://www.bioworld.com/content/china-revokes-viread-patent-pricing-was-issue
2) Significant amount of consolidation activity seen in the
market. Rate of consolidation will be high
3) Migration of population from rural to urban areas
4) Higher spend by government on health reforms
5) Lesser amount of beauracracy
6) Rising population of middle class
Key Issues that will
arise
1) Spending on health per person will increase
2) Expected generic drug market size by 2015 is USD 82
billion4
3) Large number of patent cliffs will arise from year 2012
of many well-known drugs (631 drugs having patents to
expire between 2012-2016)
Action to be taken 1) Increase the number of generic drugs in market
2) To become immediately visible in market form joint
venture with local pharma firms
3) Acquire attractive local firms manufacturing generic
drugs
4) Work on establishing distribution network to reach
even rural areas
5) Take strategic initiatives to plan ahead and capture the
large pie of the generic market
Likelihood of
situation to occur
1) The likelihood of this situation is HIGH
Generic Drugs – Situation Detoriates
1) One of China’s visionary aims is to become self-reliant in pharma sector in the next
20-30 years. For this to happen a lot of domestic industries will be motivated for
R&D giving rise to huge competition to foreign players.
2) Medicine is a field where science maintains a sometimes uneasy coexistence with
personal belief systems. Every doctor knows that interactions with patients are not
simply about medical evidence, unambiguous diagnoses, and textbook prescription.
The healing process is influenced by seemingly ―irrational‖ factors, including
mysteries such as the placebo effect.
3) As part of policy, China may introduce hindrance in drug approval process for
foreign firms.
Generic drugs – Situation Detoriates
Key parameters 1) Increase in number of competitors
2) Bribery cases against MNC officials bringing criminal
charges against firms and individuals
Key Issues that will 1) Slowdown in expansions processes of firms
arise 2) Increased restriction of government on firms
3) Crackdown on MNC officials25
Action to be taken 1) Immediately settle bribery charges
2) Work with government to reduce political risks
3) Work in building infrastructure facilities like hospitals
and create goodwill amongst Chinese population
Likelihood of
situation to occur
1) The likelihood of this scenario remains MODERATE
Part 6 Analysis of the Entry Strategy
Based on the findings in part 4 of the report, the preferred entry strategy comes to be entering
the Chinese market through M&A or JV and utilize the benefits present in R&D sector in China
to come up with patented products. Though this seems to be the ideal and harmless way forward
but the scenarios considered in part 5 of the report are equally plausible and hence require prior
planning of actions. In this part we will be looking into various factors which may affect our
decision to enter the Chinese market through investment in patented products and the possible
plan of action which might be taken to negate the adverse situations.
A recent development
The Ministry of Health (MOH) of China has come up with the latest version of Good
Manufacturing Practices (GMP) 2010 on 12th February 2011. This move signifies Chinese
government’s resolve towards upgrading the quality of Chinese drug companies and increasing
their competitiveness in the international market. An implication of GMP 2010 will be the
consolidation of fragmented Chinese drug markets because of increased manufacturing costs due
to compliance requirements with the new guidelines. Some small-sized companies might get
eliminated from the market.
This presents an excellent opportunity for the MNCs to acquire these small-sized firms which is
the preferred entry strategy as per our research. But at the same time multinational drug
companies have to make sure that they comply with guidelines. In spite of the grace period of 5
years given to domestic drug firms to improve their manufacturing practices, MNCs need to
make sure that the prospective acquisition target should be in a position to comply with the new
guidelines. Besides elevated standards for manufacturing, there is additional requirement for
training the employees, implementing a drug recall system and having quality checks at each
level. The new norms could lead to shutting down of close to 500 small and medium firms.
These norms have clauses which are very different from US and European norms and hence
need a comprehensive review before investment.
Action Plan for Patented Drugs entry strategy
25 http://www.pharmalive.com/china-arrested-how-many-glaxo-employees-at-least-30-so-far
Scenario: Normal Conditions
The parameters which decide whether the conditions remain normal or not are the market
environment with respect to competition, government policy and regulation, and the continued
treatment of MNCs as foreign firms. Each of these factors working alone or in tandem can give
rise to a variety of risks and hence a variety of actions which the company might have to take.
Competition
The current Chinese drug market is highly fragmented with about 5000 companies producing
drugs and about 98% of them engaged in Generic drug manufacturing. This shows that though
the patented drug segment is very small but there is ample scope of growth. In the generic drugs
segment OTC medicine sector which is close to RMB 96.4 Billion in 2010 is set to grow at the
rate of modest 7.7%. The Chinese believe very highly in preventive medicine and tend to self-
medicate for minor ailments. This has led to bypassing of doctors especially in urban areas given
higher education and awareness levels about the health issues. MNCs occupy prominent position
in OTC medicines with leading JVs which are operational in China being Xiang-Janssen, Wyeth
OTC and Bayer-Beijing. Competition is expected to get fiercer as major global players seek to
enter this sector. The government discourages self-medication and hence it seems wiser at this
point in time to enter the patented drugs segment. If the government decides to take the OTC
drugs out of the list of medicines for which reimbursements are given then the OTC
manufacturers will be in huge disadvantage.
The right way forward might be the prescription drug market as China is set to become the third
largest market for prescription drugs. The continued efforts to increase the health sector
spending by China would propel it to overtake western markets. Almost half of the top ten
pharmaceuticals companies in China are foreign players but they control not more than 2.5%
market share each. If the condition remains same then we might see further consolidation on
expected lines and hence, if the normal competitive conditions continue we suggest holding on
to the investment made as more opportunities might arise in near future.
Government Policy and Regulation
The government controls the prices of Essential Drug List medicines and for other medicines
prices are set after negotiations between government and manufacturers. This suggests that
government control almost all aspects of pricing of medicines. The National Development and
Reform Commission (NDRC) plays an important role in deciding the prices of drugs included in
the essential drug list (EDL). The main purpose of NDRL here is to reduce the role played by
hospitals in prescription and make the essential medicines available to everybody. For drugs on
the list no commissions are paid and prices remain fixed. The current system works as a
deterrent for companies to invest in R&D and bring out new medicines. Given the clause about
compulsory licencing during emergency situations which remains very subjective, it is risky for a
company to venture into patented drugs segment.
At the same time the government’s intent to focus on improving the pharmaceutical industry
through creating standards and increasing the spending from $ 52.2 Billion in 2010 to a
forecasted figure of $ 85.1 Billion with CAGR of 15.5% presents an equally lucrative opportunity
to enter in to patented drug segment. Given the entry strategy of JV which will have lesser capital
expenditure as compared to acquisition, it seems like a moderate risk. For acquisition, more
reforms particularly in drug pricing and control regime should happen before one decides to
enter the country.
Treatment of MNCs as foreign firms
Recently the special pricing agreement which stood ground for almost 20 years between
government and pharmaceutical industry has been scraped off. This has resulted in elimination
of differential pricing for about 100 MNC drugs which will be demotivating for these firms. As
acquisitions lead to invigoration of nationalistic sentiments, it seems fair to assume that
continued focus on acquisition as the strategy to grow in the sector can attract more ire in terms
of policy. JVs can still be hopeful of support from the government.
Scenario: Favourable Conditions
The important factors which will determine whether the conditions are favourable in the
pharmaceutical sector in China or not are the rate of market consolidation, stricter
implementation of TRIPS, pressure by US and EU for greater market access, and health care
reforms in China. Taking a holistic view of these factors would give us the right plan of action in
due course.
Rate of Market Consolidation
With the GMP guidelines having an effect on the pharmaceutical sector, closure of close to 500
small sized firms is a definite possibility. If this rate of market consolidation further increases
because of government focus on improving quality standards or other external factors it gives
further opportunity to consolidate through acquisition of smaller companies. In this situation the
firm should invest in the generic sector as well as majority of the companies which will go
through consolidation will be in this sector given the presence of 5000 companies.
Stricter implementation of TRIPS
As pointed out in the earlier section national treatment of foreign firms is an issue in China.
One of the most important actions which would determine the favourability of conditions is the
crackdown on counterfeit drugs. Apart from effects on patients ranging from placebo effect and
other injuries and fatalities to the patients, there is also loss of Drug Company’s brand equity and
profits which is in the range of 10-15%. Recent reduction of benefits given to foreign firms has
led to apprehensions in the industry about the attitude of government towards these firms.
Continued benefits from the government’s side will further encourage the MNCs to come
forward. In case there are efforts towards stricter implementation of TRIPS the firm should try
to increase their investments further into R&D and bring out new drugs to cater to the market.
Pressure from US and EU for greater market access
Pressure from these developed countries will work towards further easing of restrictions and
help in FDI as majority of the FDI comes from these countries and some of the biggest
pharmaceutical companies come from these countries.
Healthcare reforms in China
The Chinese government has launched massive healthcare reforms in 2009 which is bound to
have impact on the industry landscape. The major focus areas being accessibility and
affordability of drugs. The government plans to build a network of network of health facilities,
expand the public medical insurance system to cover more than 90% of population and reform
of the drug supply system. As far as the reform in drug supply system is concerned there is intent
to consolidate the Reimbursement Drug List (RDL). These would further push down the price
of the drugs for the population. If there is support from the government’s side to encourage
drug companies to bring out novel drugs and making these drugs available to population, it
would lead more firms to invest in patented drugs sector which is currently only 2% of the total
pharmaceuticals sector. So, further healthcare reforms should be a good sign for the firm to
further increase investments in R&D.
Scenario: Adverse Conditions
In case of adverse conditions the government might take the actions ranging from banning of
patents and revoking of licences, promote local generic drug companies, introduce TBT or
volume restrictions, decreasing the ceiling prices of controlled drugs or putting up ceilings for
currently decontrolled drugs and not cracking down on counterfeit drugs. In all these cases the
actions taken by the firms would depend on the kind of business arrangement they are having in
China. In case of JVs firms could shift focus from patented drugs to generic drug manufacturing.
The greater risk which is present with the firms having R&D investments due to higher capital
investments leaves them with the only option of selling of their assets and leaving the country.