China 2020: Walled In No More

Aug. 16 marked a new milestone in China's history: After three decades of double-digit economic growth, China surpassed Japan to become the world's second-largest economy—outpaced only by the United States. More telling, however, is China's continued GDP growth amidst a harsh global economic downturn—a robust 11.9 percent in 2009 versus 1 percent in Asia's other market leader, Japan. China also last year overtook Germany to become the world's biggest exporter. Some economists predict that in another two decades, China will more than double its GDP to unseat the $14 trillion US economy as the world's largest.

Each of these trends underscore the growing influence of China on the world stage. For companies active in the life sciences sector, the message is simple: There will be less growth for your global market plan if it does not include China as a key priority.

GETTY IMAGES / DIGITAL VISION./IMAGEMORE CO, LTD.

Will China Be Tops in Pharma?

In the pharmaceutical industry, China currently ranks fourth in terms of sales but is expected to topple Germany to become the No. 3 market by next year. The most aggressive forecast puts China in the top spot in another 10 to 15 years.

Several key factors are driving these heady projections. First is the meteoric rise of China's "middle class" and its demand for better healthcare products and services. A recent Boston Consulting Group study estimates that the cohort of China's middle and affluent classes—defined as individuals with an annual household income above $9,000—will nearly triple, from 148 million currently to almost 415 million by 2020.

Most of the new growth is to come from consumers in smaller, second- and third-tier cities; it is not well known that, beyond the megacities along the coast, China has nearly 70 municipalities with populations of more than 1 million. The trend toward urbanization has significant implications for how medicines and healthcare are distributed. Anticipation of this change should be a key element in pharma's strategic planning for China, as it allows for closer contact with customers and a more targeted approach to building brand awareness.

"The key to success is recognizing that this is a different marketplace. We must pay close attention to the needs of physicians and patients in partnership with government, with the overall aim of improving health outcomes," Mervyn Turner, chief strategy officer for Merck in China, told Pharm Exec.

Another driver of the rosy outlook for China's pharmaceutical market is the epidemic of "diseases of affluence" (diabetes, heart disease, obesity, etc.), which require frequent and costly treatment. Due to this epidemiological transition, cardiovascular disease has now become the leading cause of death in China. This is a result of a combination of the 'Westernization' of Chinese lifestyle (high consumption of unhealthy diet, fast-paced work environment, lack of exercise), rapid urbanization (nearly 230 million "migrant rural workers" live and work in the cities), increased life expectancy, and accelerated growth of the aging population, which is projected to reach 11.2 percent by 2020 and 22 percent by 2040 for people 65 and older, according to the National Bureau of Statistics.

An extensive study conducted in 14 provinces and municipalities in China, published in the New England Journal of Medicine in March, concluded that over 92 million people are estimated to have diabetes, representing almost 10 percent of the Chinese population. Those with impaired fasting glucose or impaired glucose tolerance (defined as pre-diabetes) represent even higher figures—148 million, or 15.5 percent. Compared to previous national studies where the diabetes estimate was 2.5 percent in 1994 and 5.5 percent in 2001, the new result is alarming in demonstrating one major negative consequence of China's astonishing economic development, and highlights a substantial healthcare challenge for the Chinese government.

China realizes that in order to sustain its phenomenal economic growth, it has to shift the focus from historically export- and investment-driven outlays to one that is anchored by strong domestic consumption and indigenous innovation. According to data from Hong Kong University economist Lang Xianping, China's 2009 domestic consumption as a percent of GDP, at 29 percent, is one of the lowest in the world, compared to about 70 percent for the US and 50 percent for Africa. Aside from the high savings rate, a main reason for the low domestic consumption percentage is low wages: in terms of GDP distribution, it is only 8 percent for China, compared to 58 percent for the US, 33 percent for Mexico, and 20 percent for most of Africa.

One fly in the ointment is the fact that China's population is aging rapidly, which has convinced consumers to save more for the "rainy days" of old age and impaired health. The government is pursuing some modest experiments in subsidizing elder care services and long-term institutionalization. Currently, only 2 percent of the population is receiving any form of this care, and the cost burden suggests that any formal engagement to address the aging problem will have to follow on the heels of health reform—in other words, until well after 2020. In the interim, pharma companies should consider how to enhance their presence in the market with services and products that focus on prevention and the ability to live productively with chronic disease.

To stimulate domestic consumption, a major element in the government's 12th Five-Year Plan is raising personal incomes to allow all citizens to prosper in the new economy and to reduce the huge income gaps in Chinese society. This initiative will have a far-reaching global economic impact—as wages go up, the cost of Chinese goods and services will increase. For companies relying on inexpensive Chinese labor to outsource their manufacturing and services, the cost advantage will erode and eventually disappear over the next five to 10 years. This is true for the pharmaceutical industry in particular. Foreign companies need to anticipate the long-term change in China's economy and develop strategies that position themselves for participation in the next phase of innovation-driven growth. Low-cost labor should no longer serve as the rationale for investing in China's life sciences sector; rather, market size and potential as a high-value-added source of drug discovery and development should count most.

Pharma Reform: Gains and Losses

The short term will see significant changes in the way medicines are marketed, priced, and reimbursed. Like any structural change, there will be winners and losers—including foreign drug makers that fail to adjust their portfolio product mix to appeal to a range of new constituencies, from the rural poor to urban hospitals seeking new sources of funding, or to a vastly more consolidated distributor base.

A basic misalignment of incentives at China's public hospitals and other healthcare institutions has traditionally driven the preference—and overuse—of higher-priced proprietary foreign medicines rather than the generic drugs produced by domestic firms. In China, major government-owned hospitals nationwide are granted administrative monopoly power in pharmaceutical dispensing, accounting for about 75 percent of total drug retail sales and 60 percent to 80 percent of a hospital's annual revenue. Overall spending on pharmaceuticals accounts for about 43 percent of total healthcare expenditures, or 1.9 percent of GDP in China, compared to only 10 percent of healthcare spending on drugs in the US. The top 100 drugs account for a little over half of Chinese hospitals' drug retail sales.

Profit from a hospital's drug sales is routinely used to subsidize much of its medical services, pricing for which has been kept artificially low due to the low value placed on professional services. As a result, patients are often subject to unnecessary drugs and treatment. This perhaps explains Chinese patients' common mistrust of physicians and other medical professionals. The macroeconomic consequence of the mismatch between need and costs is that hospitals are incentivized to buy and dispense (by contracting in-house physicians) higher-priced imported drugs at larger quantities to patients because they make more profit this way. In turn, these profits are deployed to help defray the cost of medical care overall.

China's ambitious healthcare reform blueprint aims to change this misalignment. But the central government has met with severe resistance as the new policy only tries to eliminate the price differential between wholesale and retail. Under the reform, hospitals will no longer be allowed to add the price premiums to drugs at retail and there will be no replacement offered for this lost revenue stream that would compensate the hospitals in subsidizing care for the many new patients entering the healthcare system. The fundamental question is: How will hospitals maintain a reasonable revenue stream when government payments for core medical services remain artificially low?

One possible approach to plug the gap is to restructure the professional service fees and incentive mechanism of doctors and medical institutions by using a different provider payment system under public medical insurance, including adopting a capitation model in outpatient reimbursement covering one price for a package of services linked to a diagnosis. However, this will likely be a long and challenging process that requires consensus among all the stakeholders, including medical professionals, patients, administrators, and policymakers. Despite its authoritarian framework, China is essentially no different than other countries on the subject of health; interest group dynamics are still writ large, and foreign drug makers would be wise to devote adequate resources to influencing these stakeholders as a way to structure the reform debate.

It is inevitable as well that the government will seek to wrest more savings from the drugs bill, chiefly by reviewing the special price protections on innovative foreign medicines introduced before China became compliant with global standards of intellectual property (IP) protection. In effect, this makes the lower-priced categorizations of medicines placed on the public Essential Drugs List the benchmark for future pricing in China, regardless of whether the manufacturer deems it innovative or not. The logic is clear: In the years ahead, price and clinical value differentiation is going to become as important to patient access in China as in any other global market.

From 'Made in China' to 'Innovated in China'

Health reform has been coupled with an equally ambitious industrial strategy for the biopharm sector. In 2005, the Chinese government outlined a "Medium to Long-term Plan for National Science and Technology Development" geared to achieving status as an "innovation-driven" country by 2020. This was followed by 76 specific policies introduced at the end of 2008.

Without homegrown, high-caliber science and technology talent—many Chinese scientists have spent years overseas to obtain education, industry connections, experience, and know-how—China will not be able to realize its innovation policy. The government has responded by generating a variety of new incentives to persuade this China-born overseas talent to return and lead new discovery and development initiatives. The incentives include high salary adjustments, funding and resources, subsidized housing, tax breaks, and benefits sharing. Most importantly, the most talented returnees are given key positions with significant responsibilities and organizational impact that would not have been possible in their adopted countries.

Coupled with the lackluster economy and depressed job market in the big pharma centers of the US and Europe, this policy has been quite effective. Overall, about 80,000 Western-trained Chinese scientists have returned to the country to work in academia or industry during the past decade. A large number of the returnees are from the life science industry, due to the high percentage of graduate and post-doctoral researchers admitted to Western universities and research institutions in biomedical research fields.

Of course, there is some danger in this scenario for the Western-based Big Pharmas, particularly over the long-term. That is, will the emphasis on promoting technology transfers to Chinese companies result in an effective cannibalization of Big Pharma's key skill sets, leading to the creation of a China-based, globally competitive biosciences sector with the scale and reach to dominate the domestic market but also to seize the competitive advantage in multiple markets beyond China itself?

Where Does Innovation Come From?

In the past few decades, the Chinese pharmaceutical market has been dominated by generic drugs as well as traditional Chinese medicine (TCM). China has been weak in pharmaceutical R&D because the foundation for novel research was lacking and there was no infrastructure of venture capital (VC) investment and technology transfer to foster and support new biotech companies. This is in many ways still the case. But now China is eager to change that by pouring large amounts of government funding into key industries and establishing large-scale science and technology parks with incentives in top-tier and second-tier cities to attract talent and new technologies.

However, given that the US developed an efficient infrastructure to support new technology spinoff with venture capital, university licensing, and capital market expertise over many decades, it would be unrealistic to expect the same to be built in China in a matter of a few years. China does not yet have enough knowledgeable VC professionals with successful track records and experience in the life sciences industry to run government-owned quasi-VC funds, as most of the experienced ones work for US or European VC funds that happen to include a China operation.

Infrastructure is being supplied by contract research organizations (CROs)—both locally based firms as well as foreign players with operations in China. Many of the major drug makers are working in partnership with CROs to build their clinical trials and manufacturing presence for the Chinese market. Drug discovery services in China are expected to grow at an annual rate of 18 percent from 2008 to 2014, with preclinical and Phase I trials at a 7 percent rate during the same period.

The trend in the CRO industry is that pharma and biotech companies are moving away from the pure fee-for-service model when working with their CRO service providers. Instead, many are migrating toward the "strategic partnership" model with their preferred CRO companies, as the CROs continue to gain therapeutic-area expertise, operational excellence, and build positive relationships with their pharma/biotech clients. The strategic partnership model allows pharma companies to focus their resources and make bigger and hopefully smarter bets on "vetted" CRO partners with a proven track record of quality and deliverables who may also be willing to share part of the development risks because of their research insights from working on certain therapeutic targets and disease areas in the past.

The dozen or so leading Chinese CRO companies have blossomed in the past five to seven years thanks to the rapid demand for their services from multinational and Western biotech companies. Most of senior management at leading Chinese CROs are "sea turtles" (overseas returnees) who not only manage the day-to-day operation and growth of the companies, but also train a vast number of local hires on technical as well as managerial skills. New demand for Chinese CRO services is beginning to come from Chinese domestic pharmaceutical companies, government/NGOs, and academia as a result of the government's mandate for innovation and the need to access high-quality research and expertise.

The Blossoming Talent Pool

The Chinese CRO industry is a fertile ground for cultivating talent in new drug discovery and innovation as the industry continues its close relationship and shared learning with its pharma clients and partners. For example, Lee Babiss left his post as president of research at Roche in February to join global CRO company PPD as its executive vice president of global laboratory services. PPD recently acquired China-based discovery research CRO BioDuro and clinical trial CRO Excel Pharmastudies.

One major reason Babiss cited for his departure from Big Pharma was a shift in focus away from drug R&D to managing budgets and cost cutting. "When I was at Roche, my reason to go to China was always for the talent, not cost," remarked Babiss. "China is very strong in synthetic organic chemistry. In medicinal chemistry, it may take three to five years for China to catch up to the US or Europe, [but] it is pretty close already. In biology and pharmacology, there are some disease models that are pretty good, [but] still a work in progress." It is just a matter of time before a wave of research talent exits the CRO industry to take the logical next step: starting fully integrated R&D-based biotech companies in China.

Another source of innovation comes from senior research scientists at Western pharma/biotech companies and research institutions. Because it takes a long time to develop truly novel drug-like compounds from the discovery stage, several new well-funded Chinese biotech startups decided to initially in-license compounds with positive clinical data from other companies, including from the US. Beijing's BeiGene is such an example, a startup cofounded by BioDuro cofounder John Olyer, former Howard Hughes Institute investigator Xiaodong Wang, and two Big Pharma scientists with drug approval track records. Hua Medicine, a Shanghai-based startup headed by CEO Li Chen (former CSO of Roche China) is another example. Simcere Pharmaceuticals, a Nanjing-based, New York Stock Exchange-listed company is also aggressively pursuing licensing to grow its top and bottom line.

Nevertheless, licensing activity remains in the infancy stages and has not yet approached its potential. Negotiating expertise on the Chinese side is sketchy, while Big Pharma companies remain wary of a partner's ability to manage and contain IP exposures—and challenges still exist to the government's ability to enforce basic patent standards.

Roadblocks on the Horizon

What are the major challenges ahead for China's dream of building an innovation-driven country? First, China's traditional research funding allocation process is influenced by seniority and personal connections rather than being merit based, resulting in unworthy projects being funded while truly innovative projects are ignored. Many Western-trained, China-born life science senior executives argue for a transparent, consistent, and merit-based government funding system where projects can be judged by international experts in the field with little political ties to the system, and where sufficient funding can be given to worthy projects in need of longer-term investment, provided that clear milestones at specific timelines are given for periodic evaluation. Second, in China's pursuit of record-breaking economic growth, the desire to be the first, or the fastest, to develop new drugs without proper quality safeguards often backfires and causes harm to the health and well-being of patients. Contaminated blood transfusion products (in particular the Heparin case) have served as a wakeup call to regulators as well as a painful reminder to the government to reform its lax regulation and quality control system for food and drug products.

For foreign drug makers, an additional strategic challenge is managing a restive local work force. Many of the returning sea turtles are distracted employees, paying their dues while preparing to start their own businesses. "Everyone wants to be his or her own boss some day, and get rich," said Changyou Chen, a returnee who cofounded Hefei Lifeon Biotech, an antibody discovery and development company, with his college classmate. "However, it takes many years and tremendous cooperative efforts to create a successful drug."

Human resources experts say that the get-rich-quick mentality creates anxiety and a high turnover rate for employees in many Chinese industries, including life science companies. This is especially true for sales representatives and CRO companies in big cities due to the fierce competition for top talent. High turnover adds to the cost of running a business and the hiring and training of new staff when part of the institutional knowledge is lost.

Education: Will it Set China Free?

Finally, China's long-term future in innovation is ultimately dependent upon the talent and creativity of its youth. The continuing influx of sea turtles will help build a solid foundation of science and technology expertise and know-how. China's educational system is still designed around the Confucian ethos of standardized tests and memorizing facts, with little emphasis on developing a student's ability to think critically and to develop an independent capacity to create. Many teachers complain that students educated in Chinese schools know how to score high in tests, but lack the ability to solve real-life problems, not to mention invent new things. The 12th Five-Year Plan attempts to address this problem by proposing a comprehensive new approach to Chinese education that incorporates more exchanges with Western institutions, introduction of Western-style elements like the scientific method, and more freedom in shaping curriculum. This could be one of China's most challenging tasks yet, as it might require confronting the country's authoritarian legacy—an outcome that could shape China's future.

Zhu Shen is the CEO of BioForesight, a consulting firm on cross-Pacific licensing and PR/media. She can be reached at bioforesight@gmail.com