A critical juncture for China's pharmaceutical industry

2 March 2020

Green pill

Significant industry change

The Chinese pharmaceutical sector is at a critical juncture. The external industry environment, where both multinational corporations (MNCs) and domestic players operate is undergoing transformational changes impacted by a series of regulatory reforms. The most significant of these is the implementation of a new type of mechanism for drug procurement and pricing through:

1) the volume-based Centralized Procurement system (CP)

2) and the National Drug Reimbursement List (NDRL) negotiations.

At this critical juncture in the industry, we believe it is the companies that can evolve the fastest which will survive and thrive.

1) The centralized procurement system (CP)

Endorsed by China's leadership, the newly formed and super-powerful medical insurance fund agency, the State Medical Insurance Administration (SMIA) was behind the significant policy innovation of Centralized Procurement (CP). Under this, SMIA organises public tenders for drugs on the medical insurance reimbursements lists by offering guaranteed volumes to winners, thereby encouraging participants to bid much lower prices.

The guaranteed volumes represent between 50%–80% of the total annual usage of the chosen drug categories in all public hospitals across the entire country. The rules of CP were refined and adjusted over the past year from initially allowing only a single winner for a limited number of drug categories during the first-round trial implementation in 11 cities, to allowing multiple winners in the latest second-round tender involving 33 drug categories over a national basis.

During the two rounds of CP conducted in December 2018 and January 2020, the final tender prices both fell by an average of 50% versus original market price, with some down as much as 90%. The steep price cuts mean the primary policy goal of achieving large savings on medical insurance spending was accomplished; ironically, it also highlights the long-standing structural issue within China’s pharma industry - specifically, the excessively high drug price1.

Man holding trays of tablets

Understanding the reasons for high prices

High drug cost is a complicated matter with several important factors at play, but at the core is the issue of ‘prescription power’.

  • The predominant current drug tender system in China is conducted on a provincial basis under the purview of local health administration bodies. However, unlike a complete tender process, the local health administrations only oversee the pricing negotiation part, without actually fulfilling the purchasing and payment of drugs. Hospitals, the purchasers, are required to purchase drugs at the set price and the Ministry of Human Resources and Social Security (MoHRSS), the payer, will pick up the bill. The segregation had led to a fundamental misalignment of incentives, which combined with a poor accountability mechanism, had impaired the system’s ability to carry out powerful and effective drug price negotiation. This led to only a limited price cut during the provincial tenders.
  • A tiered pricing system is another key reason behind historically high drug prices. Under this mechanism, pricing is differentiated according to MNCs’ branded drugs, first-to-market domestic generic drugs and other domestic generic drugs; this has led to different price discount levels during tender price negotiations. Originally, tiered pricing was adopted to reflect drug quality differences, which was necessary due to the lack of a robust generic drug approval process in China, such as mandatory bioequivalence testing (BE)2. As a result of tiered pricing, branded drugs sold in China can command a much higher premium over other generics, even after patent expiry, which gives rise to the anomaly of not having the ‘patent cliff’ in China.
  • China’s public hospital market – the actual purchaser of medicines – has very high entry barriers, which is another culprit for high drug costs. Current prescription administrative regulation stipulates that for any given drug with the same generic name, public hospitals cannot procure from more than two manufacturers. This is called the ‘1 category 2 products’ rule, which is put in place to prevent sales bribery. The consequences are that for any given drug category, hospitals normally procure one MNC’s branded drug for its superior quality and efficacy and one domestic generic drug for its cheaper price. This has ended up further reinforcing the pricing power of branded drugs even after their patent expiry. On the other hand, dozens or potentially even hundreds of domestic generic drug makers fight each other over the only other spot left to sell into the public hospital market, which accounts for the vast majority of the total drug market in China. What domestic generic makers compete on first and foremost is the sales capability, since there is little point competing on quality. Sales activities are unfortunately prone to corruption in the form of rebates to individuals with purchase decision-making powers (prescription power) at public hospitals. Admittedly, compensation levels of doctors in China are significantly lower than their counterparties in developed countries in both absolute and relative terms, which leads to the reliance on kickbacks on drug prescriptions as an important additional source of income.

The steep price cuts mean the primary policy goal of achieving large savings on medical insurance spending was accomplished; ironically, it also highlights the long-standing structural issue within China’s pharma industry - specifically, the excessively high drug price1.

The industry impact of CP

The incumbent procurement and pricing system has reduced the competition between brand drugs and generic drugs by allowing the former to command a price premium. For instance, the top-two largest suppliers to public hospitals in China have for a long time been two MNCs: Pfizer and AstraZeneca. At the same time, the selling expenses that domestic generic makers are paying to gain access to the public hospital market and to protect their market share thereafter are ultimately reflected in their drug prices.

Volume-based centralized procurement is designed to address these issues from the root by: 1) establishing a new national agency, the SMIA which is fully empowered and held accountable to ensure efficient policy making and execution3; 2) requiring mandatory BE testing as a prerequisite to be deemed eligible for CP, thereby eliminating drug quality differences and pricing differences between branded and generic drugs; 3) taking prescription power away from hospitals and doctors by centralising drug procurement, which in turn breaks down hospital entry barriers.

Asian female pharmacist inspecting shelves

Enforcing the policy

The upheaval of drug procurement and pricing policy has unsurprisingly received much resistance from the industry. The regulators have implemented a raft of supplementary polices to ensure implementation.

Some examples include a ‘two-invoice policy’ and a ‘National Drug Monitoring List’. The former aims to reduce distribution layers – a natural place to hide and launder the ‘off-the-book expenses’, while the latter is a list of drugs that are among the highest-selling categories at hospitals, but which lack convincing clinical data to back efficacy. The majority are classified as adjuvant drugs or TCM (Traditional Chinese Medicine) injectables. Both are characterised by having ambiguous clinical benefit as well as broad and vague off-label indications. As such, they have long been a hotbed of corruption and over-prescription. Drugs on this list will be removed from medical insurance coverage and prescriptions strictly monitored.

Lastly, enhanced prescription monitoring and assessment mechanisms at public hospitals which are linked to compensation and promotion for doctors and executives, have been developed to ensure effective implementation of all policies with the focus on ensuring winners of CP are procured and prescribed at hospitals.

As important as reducing the cost of generic drug prices, improving drug quality and development of high efficacy innovative drugs are also the primary focus of China’s healthcare reform.

The absence of a BE standard has led to an oversupply of sub-standard generic products. As domestic pharma companies have long been focused on establishing a competitive advantage based on powerful sales and promotion capability. This has resulted in low R&D investment levels to the detriment of the overall competitiveness of this strategically important sector. The reform therefore serves to not only promote the proper use of medical insurance funds, but also encourage R&D investments to improve drug quality and the overall industry competitiveness.

2) The National Drug Reimbursement List (NDRL)

NDRL negotiations led by the SMIA is another price-regulating mechanism. However, unlike CP which is designed to bring down prices of ‘off-patent’ branded drugs and their generics, NDRL negotiations specifically target patented drugs. It is a drug-selection and price-negotiation process carried out between a panel of pharmacoeconomic experts and an individual pharmaceutical company to make decisions on drug inclusion into the national medical insurance fund4.

Evidence of price reductions

NDRL negotiations, like CP, usually lead to a material price cut. So far, three rounds of NDRL negotiations have taken place involving 36, 17, 119 drugs respectively with the latest round being conducted in November 2019. The accompanying price cuts were 44%, 57% and 61% respectively5. Despite the significant price cuts, pharmaceutical companies have strong incentives in participating in NDRL negotiations with the hope of gaining significant volume upside which would normally offset average selling price (ASP) erosion. The level of price cut resulting from NDRL negotiation is determined by the competitive landscape of the respective treatment area, while the key to standing out from the competition is drug efficacy (as demonstrated by better clinical data), and to a lesser extent the cost advantage; CP, on the other hand, is a competition solely on price.

R&D a differentiator

The direction of reform and policy have profound impacts on a company’s strategy, R&D direction and capacity plans. Those that could withstand severe price cuts and thrive in the future competitive landscape are leaders in innovation, R&D efficiency, manufacturing quality and cost. A number of Chinese pharma companies have emerged that exhibit strong product development and R&D strategies. The most prominent examples include large pharmaceutical firms such as Jiangsu Hengrui, Sino Biopharmaceutical and CSPC, as well as small biotech firms like BeiGene.

As important as reducing the cost of generic drug prices, improving drug quality and development of high efficacy innovative drugs are also the primary focus of China’s healthcare reform.

Alternative R&D strategies

Chinese pharmaceutical companies are likely to continue to adopt the ‘me-too’ & ‘fast follower’ strategy by rapidly following global R&D hot areas in terms of mechanisms/ targets and developing differentiated molecules as these potentailly offer a higher R&D return and lower risk. For example, leading Chinese pharma companies have already demonstrated great competitiveness in developing PD-1 monoclonal antibodies (one of the most advanced oncology therapy drugs) and are well placed to benefit from the push towards these types of drugs, for instance, via faster approvals, inclusions in the NDRL, very low current penetration, less price pressure and higher demand elasticity.

On the generic drug front, leading domestic generic makers have adopted the following strategies:

  • Use of high barrier generics to fend off competition; for example, innovation in drug formulation to improve active pharmaceutical ingredient (API) bioavailability;
  • Commanding a vertically integrated API capability to establish cost and capacity advantage; steady supply and quality consistency are the crucial criteria to win CP tenders;
  • The development of biosimilar drugs (monoclonal antibodies) with intrinsically high barriers due to significant investment requirements and deep learning curves which hinders new entrants;
  • The development of better efficacy generated by incremental innovation compared with brand drugs.

The push towards innovative drugs (globally, not just in China) will also present excellent opportunities for the best of China’s contract research organisations (CROs) or contract development and manufacturing organisations (CDMOs), including the likes of WuXi Biologics and Tigermed. There are also opportunities in the medical device sector and some medical consumables, as these markets continue to see strong demand.

Asian female scientist preparing a slide to be microscoped

Conclusion

Dramatic regulatory changes in the Chinese pharmaceutical sector, which triggered an indiscriminate sell-off when the policy was initially announced in 2018, have significantly disrupted the existing valuation system and the outlook on China’s pharma stocks. Such a radical regulatory overhaul is comprehensively redefining the Chinese pharma industry. 

Established business models, R&D plans and marketing mechanisms now no longer work as effectively in the new market environment. While some industry leaders have struggled to adapt, others have already started self-transformation into more innovation-driven enterprises, or sought to become vertically integrated to establish cost advantages. At this critical juncture in the industry, we believe it is the companies that can evolve the fastest which will survive and thrive, ultimately tapping into a multi-billion drug market with large numbers of therapeutic areas that remain underpenetrated.

While some industry leaders have struggled to adapt, others have already started self-transformation into more innovation-driven enterprises, or sought to become vertically integrated to establish cost advantages.


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