Foreign Direct Investment in China - Case Study Example

The last decade has seen China becoming the key emerging nation in the Asia-Pacific region and the most attractive market and location for European multinationals”: A Discussion 2008 Introduction Since 1978, when China transformed itself from a strictly command economy to a more liberalized one, while maintaining its conservative political policies, the country has grown at an average rate of about 9 percent per annum (Hill, 2005). In 2007, real Gross Domestic Product (GDP) grew at 11 percent over the previous year, demonstrating the fastest growth among all economies in the world (CIA). Much of the growth has actually happened over the last decade. The fast economic growth rate in this world’s most populous country has not only resulted in increased demand for inputs of all sorts – ranging from iron and steel to oil and gas machinery – in order to create the infrastructure, it has also boosted demand for consumer goods. As a result of rising national income, the Chinese people can now spend more on consumer goods as well as on health and education. In terms of purchasing power parity, China was the second country, after the United States, in 2007 although in terms of per capita, it continues to be categorized as a middle-income country (CIA). Not surprisingly, China is now considered the most crucial and growing pharmaceutical in the world and is under the radar of all multinational pharma companies. Over the years, China, with the fastest growth of Gross Domestic Product (GDP) in the world, has not only become the most important country in the Asia Pacific region for international trade but also in the world. Primarily because of the low cost labor pool in China, almost all multinational companies in all industries have offshore facilities here. As a result, China has emerged as the largest trading partner of the United States as well as of many European countries. Besides, much of the international trade in the Asia Pacific is routed through China. This means that China is a major net importer from other south east Asian countries and a net exporter to the western world. At the same time, much of the movement of foreign direct investments in the world is directed towards China to cater to the huge market. China’s trade with ASEAN countries grew by 30 percent over the period and two-way trade between China and South Korea in 2004 became $79 billion and that with Japan $214 (Hill, 2005). In 2007, 21 percent of China’s exports were destined for the US while 7.5 percent of its imports were from Japan, making it a net exporter to the US. In contrast, with European countries, China has a more balanced trade (CIA). Hence, it would not be unjustified to claim that China, over the last quarter of a century, and particularly over the last decade, has emerged as the most important destination for global capital, both as an attractive market as well as a low-cost production base for the global market. In this paper, I will develop this argument in the context of the pharmaceutical industry and European multinational companies, with particular reference to Glaxo Smithkline Beecham. China as an emerging market The fast pace of growth in China has resulted in a burgeoning of the middle class in China. Hence, the vast pool of middle class consumers in a country of an estimated population of 1.3 billion in 2007 (CIA), which is larger than the total population of many western countries, is a target of all western multinational companies (MNCs). In terms of acquisition of technology and capital, China is in the process of “catching-up” with the west, like Japan and South Korea did in the 1970s and 1980s through export-oriented policies (Deloitte, 2005). While much of the investment in the infrastructure sectors of China has been in the state-owned enterprises, which are not too efficient, FDI that has been efficiently used are in the production of consumer products. Evidently, the interest of MNCs has been more to cater to the fast-growing consumer markets with rising disposable income in the hands of the Chinese people, particularly in urban areas, and growing aspirations. China’s consumer spending in 2003 was $1.1 trillion, 41 percent of this being on food spending (in contrast to 48 percent in 1997, reflecting the industrializing nature of the economy). Over the period 1997 to 2003, per capital disposable income of urban Chinese grew by 64.2 percent while per capita spending grew by 55.5 percent (Deloitte, 2005). The Chinese have always been a frugal population and despite the growing consumer spending, savings rate in the country is still quite high. This is a positive aspect for an emerging economy since it allows the possibility of productive investment. Along with industrialization that China was witnessing, the country has also been urbanizing, with housing stock in urban areas growing by 33 percent over the period. Although most of the growth is centered in urban areas, living conditions in rural areas has also improved, with more access to advanced household gadgets like television sets. Access to education has also increased for the Chinese so that the pool of skilled workforce is growing, making the growth sustainable in the future. Most Chinese households now own gadgets like television sets, refrigerators, air conditioners, personal computers, washing machines, telephone etc. that are available in the western world and were out of reach for a vast majority of Chinese two decades ago. Spending on automobiles, apparel, electronic gadgets and tourism by the Chinese are increasing phenomenally. Like the western world, the Chinese consumer market is also becoming a credit-driven one, with the financial sector developing and providing more opportunities for the Chinese urban population to adopt a “buy now pay later” spending behavior. Although the Chinese people have traditionally been price-sensitive when consumer spending is concerned, brand consciousness is increasing with the increasing availability of MNC products. This has important implications for the pharmaceutical market since with urbanization and education, the demand of western-style drugs also increases. As a result of the one-child policy of the government, population growth in China is slow in comparison to other emerging economies (Deloitte, 2005). It is estimated that over the next 20 years, the population will grow by only 11 percent to touch 1.45 billion. However, even this implies an increase of 147 million people, more than the total population of Japan. Hence, China will continue to remain a large consumer market from the perspective of a western company. However, because of the decline in fertility and mortality rates as well as late marriages, the demographic pattern is shifting towards an ageing population. The proportion of children and young people in the total population is expected to decline while that of older people will grow (Deloitte, 2005). Therefore, demand for drugs and medical equipment in China can be predicted to grow in the future as the incidence of geriatric diseases increase. Besides, with industrialization and adverse environmental effects, other lifestyle diseases like diabetes, hypertension, etc. also increase. Foreign Direct Investment in China China receives foreign direct investment (FDI) of about $75 billion annually, the largest in the Asia Pacific region (CIA). At the end of 2007, there were 5,000 multinational companies, from 172 countries in all parts of the world, operating in China. The same year, the country had a stock of FDI of an estimated $758.9 billion from almost nil in the late 1970s (CIA, IMF). By the 1990s, China became the largest recipient of FDI in the world, contributing 25-30 percent of the FDI directed towards all emerging economies. It must be acknowledged, though, that a part of the FDI in China represents return of disguised capital inflows from the Chinese that originate from China through Hing Kong and other south eastern countries because of tax, tariff and other issues (IMF, 2002). Some of the FDI is also really borrowings on account of infrastructure development. Even discounting these issues, though, there is a significant amount of FDI inflows into China as a result of entry of MNCs into the country since the 1990s. As much as 60 percent of total FDI inflows into China are directed towards the manufacturing sector, followed by real estate (24 percent) and distribution including transport, wholesale and trading (6 percent). Within manufacturing, half is in labor-intensive sectors like textiles and apparel, food processing and furniture. The rest of the FDI inflows are shared equally by technology-intensive sectors like pharmaceuticals, electrical machinery and equipment and electronics and capital-intensive like petroleum refining and chemicals (IMF, 2002). Most of the FDI inflows have been through subsidiaries of MNCs or through joint ventures between MNCs and Chinese companies. In the early years of liberalization, MNCs were allowed into China only through joint ventures but since 1986, MNCs are allowed to have wholly owned subsidiaries in China (IMF, 2002). FDI inflows in China has been boosted by reduced tariff rates, which fell by over 50 percent in the 1980s, and was around an average 15 percent in the early 2000s, encouraging imports of intermediate products and raw materials for domestic production and for the export market. Such export-oriented trade policies transformed China and made it the most crucial economy in the Asia Pacific region, replacing the erstwhile “Asian Tigers” – South Korea, Thailand, Indonesia and Hong Kong – in terms of importance to the western world. China has attracted such huge FDI inflows because of the potential of the huge growing market as well as export-oriented production enabled by the large pool of low-cost skilled and semi-skilled workforce. Low wage costs in China have given it a distinct advantage over other countries in Asia Pacific. Besides, the improvements in infrastructure, particularly on the eastern coast, have made it an attractive destination for MNC production facilities. The development of Export Processing Zones (EPZs), which were provided with infrastructure at par with the western world and also fiscal incentives, has become the major recipient of FDI inflows. China’s accession to the World Trade Organization in 2001 was accompanied with a number of commitments with regard to market access to global capital, reduced tariff and non-tariff barriers, reducing geographical restrictions (for automobiles), increasing foreign ownership limits in telecommunication, life insurance, distribution and retailing and securities, and full entry to foreign banks (IMF, 2002). Much of the FDI inflows into China are intra-regional, that is from Japan and south east Asian countries. Such trade has grown faster that global trade, from 35 percent in the 1980s to 55 percent in 2006 (Kawai, 2007). The share of east Asia in world trade increased from 25,2 percent in 1990 to 26 percent in 2006 and in FDI as percentage of global FDI flows, it increased from 18.9 percent to 33.7 percent. This shift is both a result of rapid economic growth in China and production chains and supply networks by MNCs for which production facilities in this region has assumed crucial importance. Most western MNCs have located sub-processes in the production chain in Asia to take advantage of cost differences and have re-integrated them with the primary chain. Hence, much of the east-west trade is on account of that between Asian affiliates of global MNCs to the host and other markets in parts, components, semi-finished and finished products. Chinese Pharmaceutical Market It is predicted that China’s pharmaceutical market will become the fifth largest by 2010 and the largest by 2050 (Price Waterhouse Coopers, 2006). In 2005, the size of the market was estimated at $19.2 billion, excluding the market for traditional Chinese medicines (TCM), which was substantial. It is estimated that consumer spending on western-style pharmaceutical products make up only 25 percent but this is expected to grow with growing urbanization and education. Locally produced generics, that is, those that are copied from off-patent drugs, make up much of the organized pharmaceutical market in China, which is a major problem with the MNCs. As much as 97 percent of the drugs sold in China (other than TCMs) are either generics or counterfeits. The regulatory body, State Food and Drug Administration approved 10,000 generic drugs in 2005. The high share of generics stems from the fact that China still has a low per capita income and the per-capita expenditure on pharmaceutical expenditure is only $15, which is one of the lowest in the world. Hence, the bulk of the Chinese population can afford only TCMs and generics. Besides, as a result of liberalization and a move towards a market-based economy, the government’s social spending has also gone down hence the population has to depend on individual income for health products. The health insurance program is being promoted and about 10 percent of the population is now covered under it. However, despite the low per capita spending on western-style drugs, the large population of the country makes it an attractive market for the pharma MNC. Therefore, there are 600 active joint ventures in the highly fragmented Chinese pharmaceutical industry in which the top 10 companies control 15 percent of the market (Price Waterhouse Coopers, 2006). Almost all global leaders, like Glaxo Smithkline Beecham, Roche, Johnson & Johnson, Novartis and Pfizer, are present in China. As a result of China’s accession to the WTO in 2001, the import tariff rates on pharmaceutical products have been reduced to 4.2 percent (Price Waterhouse Coopers, 2006). Since 2004, MNCs are allowed to distribute their products across the entire geographical area. However, non-tariff and regulatory barriers exist as do corruption and problems with the distribution mechanism that is inevitably linked to the hospital network, which is largely state-controlled. Most MNCs distribute drug products through a dealer network comprised of an estimated 6,000-8,000 wholesalers. About 80 percent of the drugs are sold through hospitals and clinics while the rest is sold through pharmacies. Although some global pharmacy chains and medical equipment manufacturers are exploring ways to enter the market, this is still in a nascent stage. Hospitals and clinics, which purchase drugs through a bidding process, generally prefer locally produced drugs. Because of pervading corruption, MNCs have to cough up significant amounts of money bribing middlemen in the pharma distribution chain. The government is attempting to develop the retail pharmacy network in order to control over-prescription by hospitals and clinics as well as over-invoicing on drugs. This has been successful in some areas. For example, in Shenzhen, 40 percent of the western-style drugs are sold through retail pharmacies. In 2005, it was estimated that China had about 180,000 retail pharmacies. Some local pharmaceutical chains are building extensive retail networks in both urban and rural areas. The Over-the-counter (OTC) drug market is growing in China, as a continuation of the process of TCM consumption although this market still contributes only 20 percent of the market. The main component of the OTC market is predictably the TCM products, followed by cough and cold preparations, vitamins, minerals and indigestion preparations (Price Waterhouse Coopers, 2006). TCMs are also now packaged and sold like MNC products, providing stiff competition to western MNCs. Hence, the local retailers are the decisive factors in pushing the OTC products of MNCs. Although the government gives MNCs the same status as the local companies, the intricate distribution network makes it difficult for the MNCs to operate in this market. The cost of production is low and the government has a policy to keep drug prices low but the high distribution costs inevitably increases the retail prices. Yet, this is too large a market, and a fast-growing one, for any MNC to ignore. Besides, the government is attempting to rope in MNCs in order to increase research and development in the pharmaceutical industry. Partnership between local universities, research institutes, local companies and MNCs has resulted in a rise in patent applications as well as. In another recent report, Price Waterhouse Coopers (2007) finds that the Asia, led by China, India, Singapore and the rest of Asia Pacific, is set to replace the United States and Europe as the driving market for the pharmaceutical industry. Based on interviews with executives of 92 Asian pharma companies and 93 MNCs, it is found that despite the high growth of this market, there are concerns regarding operational difficulties and intellectual property rights in these markets. However, there has been a considerable improvement in intellectual property protection in Asia, particularly after China’s accession to the WTO, over the last five years. Most MNCs, in their bid to increase global market shares, are focusing on China. However, many of the domestic pharma companies, which had so long concentrated on operating as either joint ventures with MNCs or outsourcing agents, plan to grow their market share both in China as well as develop their footprint in the global market. MNCs continue to find competition from generics and TCMs as well as pricing pressures to be major deterrent for growth in the Chinese market. These companies want to shift from the outsourcing model to developing China as a center for clinical research. Glaxo SmithKline Beecham in China China is an important and growing market for Glaxo Smithkline Beecham (GSK), which has had a fully owned subsidiary since the mid 1990s. However, GSK has been selling drugs in China since the early 20th century. Wellcome opened its first distribution office in China in 1908 and Glaxo in Shanghai in 1910. The Sino-American joint venture, Tianjin Smith Kline & French Laboratories Ltd, was established in 1984 and Chongqing Glaxo Pharmaceuticals, another joint venture, was set up in 1988, although the latter was sold out in 2004. SmithKline Beecham (Tianjin) Co and SmithKline Beecham Biologicals (Shanghai) Co were established in 1995, Glaxo Wellcome (Suzhou) Pharmaceuticals in 1997 and SmithKline Beecham (China) Investment Co. in 1998. Glaxo Wellcome and SmithKline Beecham merged globally in 2000 and SmithKline Beecham (China) Investment was renamed GlaxoSmithKline (China) Investment in 2001 (GSK website). The company estimates the pharma market in China to be around $14 billion in 2006 and expects it to grow to $24 billion by 2010 (Chuan, 2004). GSK has five production facilities in China and shifting much of its global production here. It also partakes major research and development in China, investing $100,000 annually in antibiotics research in collaboration with Chinese scientists since the 1990s. Clinical research by pharma companies is also convenient in China because of the large patient pool and the diversity of diseases. Among the five production facilities of GSK in China, three are joint ventures with domestic partners. The facility in Shanghai produces prescription drugs and vaccines and the Tianjin one produces OTC drugs. The consumer healthcare business for the region is based in Hong Kong. The company has already invested $10 million in China for research and development. During the period 2000 to 2005, it ran clinical tests with 10,000 patients, 18 percent of which has been used for global studies (Yuan, 2007). Conclusion For European pharmaceutical companies, Asia offers vast opportunity of growth. Together, China and India has one-third of the world’s population but consumes only one-fifth of global production of drugs. Among all the emerging markets in Asia, Latin America and east Europe, China has been witnessing fastest economic growth and hence also the fastest growth in the pharmaceutical industry. It is predicted that it will become the largest pharmaceutical market by 2050. Hence, all global leaders in the pharma industry has already made their presence felt in China. However, the distribution channel in China still has many problems, with state control over hospitals and clinics, which are the major outlets and an intricate web of dealers, wholesalers and middlemen, all of which tend to discriminate against MNCs for domestic companies. However, the government is trying to promote the retail pharmacy, which would make the industry more transparent and hence easier for MNCs to operate. The competition from generics and TCMs is also severe and the market for OTC, though growing, is small. Most MNCs have production facilities in China through joint ventures with domestic companies. Besides, many Chinese pharma companies act as outsourcing vendors for global MNCs. The major opportunity for MNCs in China are in pre-clinical, clinical and chemical research since the country has a vast pool of patients and diverse diseases. Despite the problems with the pharmaceutical industry in China, the fast growing large economy has immense opportunities for European MNCs. Works Cited Hill, Christopher, R, Emergence of China in the Asia-Pacific: Economic and Security Consequences for the U.S., Testimony before the Senate Foreign Relations Committee, Subcommittee on East Asian and Pacific Affairs Washington, DC, June 7, 2005, http://www.state.gov/p/eap/rls/rm/2005/47334.htm CIA, China: The World Factbook, https://www.cia.gov/library/publications/the-world-factbook/geos/ch.html Tseng, Wanda and Harm Zebregs, Foreign Direct Investment in China: Some Lessons for Other Countries, IMF Discussion Paper, 2002, PDP/02/03, http://www.imf.org/external/pubs/ft/pdp/2002/pdp03.pdf Deloitte Research – China’s Consumer Market: Opportunities and Risks, July 2005, http://www.deloitte.com/dtt/cda/doc/content//DTT_DR_China_Consumer_Jul05(2).pdf Kawai, Masahiro, Overview of FDI: The US, Europe, Japan and Emerging Asia, Asian Development Bank Institute, 2007, http://www.tcf.or.jp/data/20071113-14_Masahiro_Kawai-PPT.pdf Price Waterhouse Coopers, Investing in China’s Pharmaceutical Industry, Price Waterhouse Coopers, 2006, http://www.pwchk.com/webmedia/doc/632785588008556096_ts_invest_pharm_mar2006.pdf Chuan, Qin, GlaxoSmithKline confident of Chinese market, China Daily, 19 June, 2004, http://www.chinadaily.com.cn/english/doc/2004-06/19/content_340781.htm Price Waterhouse Coopers, Have MNCs hollowed out their domestic economies to China?, August, 2007, http://www.pwc.com/extweb/ncpressrelease.nsf/docid/DE2160BA8F0134388525733000565DE3 Yuan, Robert, Pharmaceutical Operations Expand in China, Multinationals Set Up New Facilities in Asia, Genetic Engineering & Biotechnology News, Apr 15 2007, Vol. 27, No. 8, http://www.genengnews.com/articles/chitem.aspx?aid=2098&chid=4 Read More