A range of major policy changes is creating winners and losers among Chinese drug companies, as well as promising new ancillary business models.
Research and innovation in health care, including new drug treatments, have historically centered on developed markets due to high barriers to entry (including lengthy, capital-intensive development cycles). Pharmaceutical innovation and biotech activities in emerging markets, in contrast, have been primarily concentrated on the manufacture of generic drugs. This has certainly been the case for China, where the publicly listed health care sector was relatively small,1 and where drug manufacture until recently focused mostly on generic pharmaceuticals.
But this is set to change. Personal income in China is rising fast. With that increase, demand for better health care is rising, as people seek to close the gap of unmet needs. For active equity investors seeking high-quality, sustainable growth, it’s easy to make the case that the health care sector in China is likely to grow rapidly. In this piece, we’ll focus on the pharmaceutical and biotech industry in China, where several major policy changes in recent years, designed to boost competition and innovation (with more likely to come), are creating the conditions for quality companies to grow.
Abolishing Markups on the Sale of Drugs
Reducing overall drug costs has been a top priority for China’s government. A major step toward reforming drug costs was the end of markups on drug sales by hospitals – the Zero Markup Policy for Essential Drugs, also known as ZPED, in 2012. Until a few years ago, hospitals and doctors in China were primarily compensated through large markups on the sale of drugs. This compensation system created some unfortunate incentives for doctors and also disconnected pharmaceutical innovation from health care needs. Many pharmaceutical companies were realizing huge margins from the sale of low-quality generic drugs. When the markup on drug sales was abolished through ZPED, conditions were then set for a more efficient health care market.
Introduction of Centralized Procurement for Pharmaceuticals
To complement ZEPD, the Chinese government implemented a centralized drug procurement exercise in late 2018, with an eye toward fairly and effectively reducing drug prices. Through that centralized system, hospitals would jointly submit their procurement orders, which were then tendered to the lowest-price bidders, allowing winners to gain a larger procurement volume. This has allowed select pharmaceutical manufacturers to achieve economies of scale and save on marketing costs – while inefficient, unqualified players have tended to go out of business quickly. So far, we have only been through the third round of the centralized procurement exercise for chemical drugs, with more to come. Later rounds may also involve the bulk tender of injectables, biologics, and medical equipment.
Embracing International Standards for Drug Development and Approval
China signed on to the International Council for Harmonization of Technical Requirements for Pharmaceuticals for Human Use (ICH) as a full regulatory member in June 2017. This was an important milestone for the country’s health care sector. In connection with this move, China modernized its drug-approval processes and clinical-trial guidelines, bringing them in line with stringent international standards. Also, all existing and future generics are required to go through bioequivalence testing to certify that they are of the same efficacy and safety as the originals. In addition, China has introduced a number of reforms to accelerate the innovative drug approval process. All these changes have paved the way for Chinese drugs to be accepted in overseas markets in the future, and at the same time encourage innovation in drug development.
New Sources of Research and Development Funding
Pharmaceutical R&D is very capital-intensive and takes place over relatively long periods of time. This means that the government alone cannot provide all the R&D funding. In addition to seeking private equity and venture capital funds, pharma start-up companies in China are increasingly turning to public markets for funding as capital markets in China develop.
Two major dimensions of those plans – Shanghai’s Star Board, introduced in July 2019 as a listing venue for early-stage technology firms, and 2018 changes to IPO requirements for the Hong Kong Exchange (HKEx) that allow pre-revenue, pre-profit biotech start-ups to list – have greatly boosted market access for promising new pharma enterprises.
Innovent Biologics and Junshi are two companies that benefited from HKEx’s listing requirement change. These two firms saw share price growth of 280% and 150%,2 respectively, since listing in late-2018, with successful follow-on offerings (a key element of a functioning biotech market). Both are considered early-stage biotech start-ups, in their pipeline commercialization process, which otherwise would not have been able to raise public capital for further R&D.
Improved access to public funding is also promoting the development of ancillary and new business models, including contract research and development, telemedicine, health care e-commerce, and gene therapy. Wuxi Biologics, which is a drug contract development and manufacturing organization (CDMO), is fast gaining market share internationally and is a key service provider to early-stage biotech companies. It is winning due to its ability to provide top-quality service, with proprietary leading-edge technology platforms.
There is ample reason to anticipate growth and innovation in China’s health care sector. Policy changes aimed at fostering competition and boosting innovation are creating both winners and losers – this, in turn, yields opportunities for active equity managers. Meanwhile, stock-market liberalization efforts are working to attract listings and provide further opportunities for China’s pharma startups (and many new ancillary businesses) to access public markets – again, expanding the opportunity set for active equity managers. As managers of State Street Global Advisors’ EM Equity Select strategy, we plan to be there to capture these opportunities.
This information should not be considered a recommendation to invest in a particular security or to buy or sell any security shown. It is not known whether the securities shown will be profitable in the future.
1 In China, health care spending accounts for only 7% of GDP, compared with 18% in the United States and 12% in Japan. The health care sector comprises only 5.5% of the MSCI China Index, compared with 14.5% for the MSCI US Index.
2 As of 25 August 2020.
The views expressed in this material are the views of the Fundamental Growth and Core Equity team through August 31, 2020, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent. All information is from State Street Global Advisors unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
Investing involves risk including the risk of loss of principal.
State Street Global Advisors Worldwide Entities
©2020 State Street Corporation. All Rights Reserved.
Expiration Date: 9/30/2021