anyi's space

Doing business in China

The change and progress in China are astronomical even to a Chinese native as myself. Every time I go back to visit, I have to ask myself if I am still in the cities that I was familiar with. With the goal of eventually going back to China to develop my career, I believe it is worthwhile to revisit some common business practices and underlining cultural norms in China from an outsider’s point of view.

Guanxi and Mianzi - Important cultural concepts

The behavior of Chinese people and organizations is still largely governed by Confucianism. For a foreign business to succeed in China, it is important to understand two very important social concepts that are derived from Confucianism – Guanxi (connections) and Mianzi (face).

Guanxi is a central concept in Chinese society. Literally, ‘Guan’ means gate, barrier, ‘xi’ means link or tie; so the word means connections, relationship, or networking. This word is becoming more widely used instead of  "connections" and "relationships" — as neither of those terms sufficiently reflect the wide cultural implications that guanxi describes. In essence, ‘guanxi’ describes the connection or relationship between any two people who are linked together because one has done a favor for the other, and the other is expected to return the favor sometime in the future.  It is natural that guanxi exist between relatives, old classmates, co-workers, business partners, or any old acquaintaces . In chracteristics, Guanxi is personal and cultivated through time, and ususally it is built upon trust, though not sentimentality. Chinese tend to conciously build a guanxi network around them (Wang, 2005).

Guanxi is a critical means of entering into business in China. It is so pervasive in the Chinese business world that any business, local or foreign, inevitably faces guanxi dynamics. While Western businesspeople are pressured to keep their personal and professional lives separate, the lines between family, friends, and work are far blurier in China. Guanxi is not inherently unetheical though many corruptions do arise from such social phenomenon. When applied properly, guanxi helps business partners develop deeper and closer relationships than is standard in the West (Fernandez and Underwood, 2005, p22)

Mianzi literally means face, and symbolizes a person’s esteem and honor. Confucianism defines Chinese social behavior protocol. It stresses the social order through one’s proper behavior based upon his/her social status and relationship with others. Whenever a person does not conform with such social codes,  or, does not acknowlege the other’s social status or reputation, it said one causes the other to lose face. “Giving” face is an act of honoring such social codes. Losing or giving face is external and perceived according to social codes by others. It is important for Chinese to give face, especially in a public setting. When an act is perceived by the other and bystanders as losing face, it is very difficult to compensate or reconciliate. Losing face one time can mean losing business with that client or contact forever.

Choice of Location

China does not have a homogenous market; rather it is collection of many local markets. Each region in China is greatly different in local culture, economic development level, business practice and  local government regulations (McGregor, 2005). Often a favorite product in one city is not necessarily  a choice in another city  . For example, Qingdao beer is a Chinese brand that sells all over the world and a favorite in Shandong province; but, in Beijing, the favorite beer is Yanjing beer, a local brand.

Among more than 300 cities, a majority of the foreign enterprises operate mainly in first tier cities – Beijing, Shanghai, Guangzhou and Shenzhen. These cities have well developed infrastructures for business; better developed rules and regulations; more efficient city government;  a bigger talent pool and higher standard of living. The down side is the cost of doing business is also high and markets are satuating.  

More foreign enterprises are looking to move into the second tire cities – Chengdu, Dalian, Tianjin, Qingdo, Shangyang and Chongqing (Marshall & Heffes, 2006). These cities are striving to develop their economic magnitude and eager to attract foreign investment. The downside is that they still lag quite far behind the first tier cities in business development and market sophistication. For foreign businesses, it takes more effort and patience to go through hurdles in government buracracy and deal with the lack of skilled managerial talent for hire. The remaining Chinses cities are largely untouched by foreign businesses with the exception of a few multinational enterprises such as Macdonald’s, KFC, Wal-Mart and French retail giant Carrefore.

Because of such vast differences, it is crucial to find a local partner originating from the city of choice. For instance, it is usually not a successful formula to have a Shanghainese as a partner to work out a business deal in Beijing, and vice versa.

Negotiation of business

The concepts of guanxi and mianzi indicate that a majority of human interactions are personal based. Chinese generally don’t like to do business with strangers, but they will, if there is a guanxi person acting as a go-between. To have a business deal, most Chinsese would like to take time to find out the human side of foreign business people. What sort of person you are is more important than what you do. A good deal of time is spent exploring your character. They want to know your background, your family situation, your likes and dislikes. This is a relationship and trust building process. To have help from a guanxi person (local partner) will move the process foreward more smoothly.

Most of the getting to know each other process involves banquet and entertainment (Karaoke) and small talk. Unitl the local business decides that you are trustworthy and fit to work with, no formal, serious negotiation will happen. Therfore, patience is really a virtue in dealing with Chinses partners. One of the biggest mistakes Western companies make is to consider only China's low costs of doing business, while underestimating the high transaction costs that comes with a business climate based on relationships and reputation (Loyalka, 2006)

As for formal meetings, being on time and dressing properly is important. It shows respect and seriousness to your business partner. During the meeting, Chinese tend to avoid saying no because they do not want to make you lose face. This can cause confusion and misunderstanding at times, so when you phrase questions, try not to ask questions that have to be answered yes or no; instead ask how or when they do certain things. Try to have a clear organizational hierarchy of the Chinese business; for lower level staff will always defer to their superior and an agreement with a subordinate can be easily denied by the superior. Present your plan in a clear and abbreviated form and get it translated into Chinese. If your Chinese partner is committed to a deal, many technical and practical details can be worked out at a later time.

The commitment to a business deal is far more inportant than a contract. Signing a contract is just an intention of the commitment. Many contractual details have to be reviewd and negotiated afterwards. Because law and regulations are in development and subject to change in China, a contract  can sometimes be difficult to reinforce when economic situations change or government interference arise(Child, 2006).  Therefore, to have good government “guanxi” to solve contractual disputes or government interference can be very benefitial.

IV. Trade deficit and Exchange rate issues

This part attempts to understand the reasons that result in huge trade deficits between the US and China; the arguments over the issue of reminbi (RMB) revaluation and its potential effects on reducing the trade deficit. The study is mainly based upon the book “US-China Trade Dispute: Rising Tide, Rising Stakes” ⁸ by the Institute for International Economics and other sources specified in the writing.

Why the US has a huge trade deficit

The US has been running trade deficits with rest of the world for more than 20 years. Its global deficit especially increased from $375 billion in 2000 to $725 billion in 2005. The main causes of the US trade deficit are low national savings and a strong dollar. The widening US trade deficit between 2000 and 2005 reflects lower household savings and a higher federal budget deficit. US household savings were a modest 2.3% of disposable personal income in 2000 and decreased to -0.4% in 2005.  The federal budget had a surplus of $230 billion in 2000, by 2005, it ran a deficit of $318 billion (Figure 5). In macroeconomic terms, when a country spends beyond its income, as the US has done on a large scale for years, imports must exceed exports to absorb the difference between national spending and national income. The rest of the world willingly provides the dollars to finance US spending because the US is an attractive place to invest. By the end of 2005, foreign investment reaches $2.2 trillion in Treasury securities, or 55% of the public debt not held in Federal Reserve and US government accounts, according to a Department of Treasury report.

The high US trade deficit is concentrated in manufactured goods because this sector accounts for 80% of US exports and imports. In 2005 the trade deficit in manufactured goods is $541 billion. The US is increasingly becoming a services economy, and the trend has a much longer history than the trade deficit. The proportion of manufacturing jobs has dropped from 31% in 1950 to 12% in 2005, but the drop is especially apparent since 2000. China is specifically blamed for the job losses and trade deficit because most US imports from China are manufactured goods.

Impact of trade with China on the bilateral deficit

In 2005, China became the US’s 3rd-largest trading partner and the 6^th-lagest export market. Though US exports to China increased from $18 billion to $47 billion between 2000 and 2005, its imports from China increased from $103 billion to $250 billion, resulting in a deficit increase of $81 billion to $201 billion (Figure 6).

One of the direct reasons for the deficit increase is the steady reduction of Chinese trade barriers that facilitated the growth of Chinese exports as well as imports. Previous sections of this study report have detailed explanations on China’s economic growth.

Though the magnitude of the bilateral trade deficit is large, it has to be viewed in the context of global economy. The US trade deficit is global and the deficit with China is only part of the US external imbalance with the rest of the world. According to US data, although China has a running trade surplus with the US, it also runs trade deficits with other countries, especially East Asian countries or areas – Japan, Korea, southeastern Asian countries and Taiwan (Figure 7). What happened in these years is that these areas have moved their operations to China. China is more often becoming a final point of the global assembly line. Goods assembled from imported parts and components account for 65% of Chinese exports to the US. 

Much has been written and said that China’s unfair trade practices, including the artificially low value of its currency, Yuan, are the causes of the trade deficit. Since January 2005, Congress has introduced more than 15 new bills against Chinese practices, ranging from the undervalued RMB, China’s slow progress in meeting WTO commitments, and standards for assessing countervailing duties to concerns about national security. Within specific sectors, dispute over textiles and clothing is the most prominent. China has especially faced strong opposition and lobbying from US textile industry out of the fear that cheap Chinese textiles and clothing would flood the American market after the Multi-Fiber Arrangement (MFA)* expired on January 1, 2005, and all quotas were lifted. A new bilateral textile trade agreement went into effect in 2006 to set quotas on Chinese exports till 2008. However, an estimate by the Department of Commerce in 2004 indicates that the limit in textiles and clothing import would only cut the US deficit by $5 billion (Figure 8).

The largest and most important dispute is over the RMB exchange rate. It affects all imports and exports for both countries and other related countries. According to the above DOC estimate, a 20% appreciation in RMB value against the US dollar would cut the bilateral deficit by $36 billion. Advocates state that RMB reevaluation has the potential to reduce the bilateral trade deficit by $60 ~80 billions, a figure greatly larger than all other trade disputes combined.

Chinese currency regime and current situation

Between 1995 and 2005, China had a fixed exchange rate of its currency, RMB yuan, at about 8.28 to a dollar, and regulated with a tight capital control. In July 2005, under considerable foreign pressure, China ended the decade long peg, and moved RMB regime toward a managed flexible exchange rate based on a currency basket (the exact composition of the currency basket is unknown), allowing yuan to move up or down with a narrow band of 2.1%. Since then, the RMB appreciated against the dollar, closing at 8.011 Yuan per dollar as of May 1, 2006.

The reasons that proponents believe that Chinese currency is undervalued are: First, China has greatly increased its global trade surplus with $102 billion at the end of 2005 (5% of its GDP), the figure is three times of the $32 billion surplus in 2004. The widening of the surplus reflects a slower import growth. Second, China has huge foreign exchange reserves, by the end of 2005, it reached $819 billion. The capital control maintained by Chinese government also contributes to the build-up. Third, large volume of foreign direct investment (FDI) has poured into China, totaling about $40 billion in 2004, which was far greater than investments in other developing countries, such as $4 billion in India and $1 billion in Russia.  Fourth, Chinese economy showed signs of overheating from 2004 to the first half of 2006, with growth rate reaching over 9%, and high real estate prices.  According to the arguments, significant reevaluation of Chinese currency could help slow down exports, encourage imports and slow down its domestic economy.

Although RMB appreciation is a majority consensus, experts disagree considerably to what extent RMB should be revalued - whether it is undervalue by 10, 25 or 40%. For example, former Federal Reserve Chairman Alan Greenspan and former US treasury secretary John Snow think the RMB should be revalued, but not with a set target. Experts in International Monetary Funds caution against a large appreciation; and US National Manufacturing Association and other interest groups campaigned to force an up-to-40 percent appreciation on grounds that the trade deficit is hurting the US manufacturing sector. Some experts believe the RMB is undervalued by 15-25%. It is worth pointing out that there are some experts against revaluation of the RMB for the reasons that revaluation could destabilize Chinese and global economy; and the bilateral trade deficit is not caused by the Chinese undervalued currency.   

According a report of by the US Department of Treasury, the US is intensifying its effort to encourage China to move more rapidly to a market-based, flexible exchange rate⁹. The report also points out that Chinese leaders should state a clear commitment to a flexible exchange rate, but they also expressed a strong preference for a gradual adjustment. China recognizes that the country’s growth cannot be maintained through continued reliance on net exports. It needs to stimulate domestic demand. China has placed strong emphasis on consumption and rural development in its most recent Five-Year Plan. The caution of the Chinese government in adopting fundamental policy changes also reflects the complexity of its domestic economic difficulties such as a weak financial system and many social problems that come with economic reforms.  

I. Statement of purpose

Overview of evolution of pharmaceutical industry in the past decade and demonstrate increasing important role played by biotech companies; Compare and analyze Genentech and Pfizer to illustrate how the two companies managing its R&D in the changing environment. 

II. Pharmaceutical and Biotech Overview

The pharmaceutical and biotech industries are both committed to bring new prescription drugs to market. The stock exchange markets list pharmaceutical and biotechnology as separate industries.

Pharmaceutical Industry

The pharmaceutical industry is composed of 310 major manufacturers with $1066 billion market capitalization as of April, 2006, which is only second to oil and gas industry ($1310.9 billion). (Figure1) [1] The Pharmaceutical Research and Manufacturers of America, an industrial association of 37 members of major pharma companies, reports that the industry has experienced average growth rate of 11% during the past 25 years, and an especially higher growth rate (14.5%) from 1995 to 2001 (Figure2) [2].

The industry is very competitive with several large players. The top ten companies dominate the market and make up 97% of the total market capitalization (Figure1). The big pharma (capital over $50 billion and sales over $500 million) enjoyed the highest profit rate among all industries until recent years be over taken by oil and gas industry. In 2001, the ten drug companies in the Fortune 500 list ranked far above all other American industries in average net return, at 18.5 percent return on sales. The median net return for all other industries in the Fortune 500 was only 3.3 percent of sales. Commercial banks were a distant second, at 13.5 percent of sales.[3]  The US has five of the ten largest drug companies - Pfizer, Bristol-Myers Squibb, Johnson & Johnson, Merck &Co. and Abbott Laboratories. Europe has the other five world top drug makers - AstraZeneca, Sanofi-Aventis, Norvatis, Roche Group, and GlaxoSmithKline.

Biotech Industry

Biotechnology is composed of 574 companies in stock markets with $336 billion market capitalization. The top ten leaders have 81% of the capital, and the top two companies, Amgen and Genentech, cover almost half (48.6%) of the capital of whole industry (Figure3). Biopharma industry started from early 1980s when Amgen launched its first biotech drug, EPO, to the market. As a young industry, it has been through some up and down periods with capital influx and drain, following investor confidence in profit promise and scientific breakthroughs in biotechnology.  The industry capital increased tremendously in the past 10 years, from less than $500 million in 1994 to over $300 billion now. Though majority of the biopharm companies (60%) are small to medium size in the term of sales revenue, $0-50 million, the industry now also have its top 10 leading companies with revenue over $500 million, [4]   among them Amgen and Genentech are out performing their big pharma rivals such as Pfizer and Eli Lilly. Pharmaceutical Executive magazine reports in its “2005 industry audit” that Biogen, Genentech and Amgen are number 1,2 and 3 with growth rate of 226%, 39% and 35%, respectively, whereas growth rate for most big pharma had dropped. [5]

R&D

Both pharmaceutical and biotechnology are heavily invested in R&D, and the investment has been highest among all industries. The biopharmaceutical industry is the most research-intensive and the US is leading the investment in the world. The growth in R&D has a growing focus on biologics. The statistics released by PhRMA shows that biotechnology and pharmaceutical research member companies invested a record $38.8 billion in R&D on medicines in 2004. This follows a steady increase in R&D over more than two decades, from an estimated investment of $2 billion in 1980. But despite skyrocketing R&D spending, the industry’s output of new drugs has been decreasing since 1996. [6]

The R&D in the industries is strongly dominated by product life cycle of drugs (figure4). Because of long development time (10-15 years) and very high cost (~$800 million) to put a new drug on the market, and the drug patent expiration limiting sales, pharmas are driven to find ‘blockbuster’ drug – drugs that generate over a $1 billion a year. Drug protection period governs the timing of putting new drug on market because soon as a drug’s patent expire, price of the drug will fall about 90%.  According to PhRMA, the average patent effective term for a drug is 11.5 years, therefore, sooner a company is able to release a drug to market after patent, and more profit can be realized.

Also because of the characteristics of the drug life cycle, drug makers tend to focus on products for chronic rather than acute diseases with large patient populations (such as cancer, arthritis, cardiovascular conditions). Ulcer medications, cholesterol treatments and antidepressants are the top three drug categories; the world’s two best-selling drugs Merck’s Zocor and Pfizer’s Lipitor, both treat high cholesterol. The two drugs had combined sales of $13 billion in 2004.

Market

The US pharmaceutical market is the largest in the world and has the largest market share of drug sales; worth nearly $260 billion in 2004, with per capita expenditure at $880. It is estimated the per capita expenditure on drugs will be over $1500 in 2009. Europe takes second place in market size; Japan comes in third, and the rest of the world accounts for about 12% of the market. Market growth has been steady in recent years despite the dip in the country's economic performance. [7]

The private sector accounts for almost 80% of spending and pharmaceutical expenditure is equal to about 2.2% of GDP. In the public sector, at a federal level, pharmaceuticals are purchased by the Public Health Service, Medicaid and Medicare. Prescription drugs dominate the market, at over 90%, with doctors bang the primary access point to healthcare.

The market is expected to grow for following factors: With the implementation of Medicare drug plan, Medicare market is estimated to be account for almost 50% of the US market, making it the second largest drug market in the world. The aging population is another factor to demand more drugs. Economic development in developing countries will also increase the demand for more sophisticated drug.

Regulation

The main regulatory authority in the US is the Food and Drug Administration (FDA). The US FDA operates one of the world's most authoritative and respected systems of drug regulation. The last major revision of regulatory legislation took place in 1997 with the FDA Modernization Act. The US FDA keeps a record of all present US drug patents, known as the 'Orange Book'.  As a consequence of calling off Vioxx and Bextra from market, FDA has increased its scrutiny on new drug approval.

A new drug approval process consists of 3 clinical trial phases: phase I is mainly for safety test with 20-89 volunteers that lasts 1-2 years; phase II is a smaller scale of 100-300 volunteer patients to test for efficacy and side effects that lasts 2-4 years; and phase III uses 1000 -3000 volunteer patient to monitor adverse reaction to long-term use that needs another 2-4 years. And finally it is FDA review and approval phase, it needs about 3-5 years.

There are no pricing controls for pharmaceuticals in the private sector in the US, with the manufacturers free to set prices. However, as prices must be negotiated with various healthcare management bodies, indirect control does take place.

Changes in the industry

1. Big pharmaceutical companies have seen greatly decreased growth in the past 4 years (Figure). The Dow Jones index for the pharmaceutical sector dropped from above 400 to around 250 in the end of 2005. In the US market, sales growth rate has been hovering around 7%, and last year is the lowest in the decade, at 2.1%. Over the five-year period, 1999 to 2004, the pharmaceutical industry ranked 35 out of 44 industries, with a profit growth rate of 2.8 percent vs. the Fortune median of 20.3 percent during the same time period.

On the other hand, biotech sector is on the rise. The Dow Jones index increased from the low level of 200 in 2003 to almost 500 by the end of 2005 (Figure). Though the biotech industry generates much smaller sales in comparison to pharmaceuticals, the growth rates of some biotech companies are astonishing. The capital size of Genentech increased by $30 billion in just one year from 2003 to 2004 (~$54b to $84b, a 56% increase), after its successful launch of Averstin, a drug for treating breast cancer. In the same period, Pfizer’s capital size decreased by $55 billion from $261b to $206b, a 21% decease. “The industry audit” published by Pharmaceutical Executives tracks major companies’ performance each year. In past 4 years, both Amgen and Genentech are ranked top 2 for their excellent growth (Figure).

2. Another major change in the industry is mega mergers and acquisitions (M&A) in past 8 years. Start with 1989 mergers between Bristol Myers and Squibb, between SmithKline and Beecham, the 2001 merger of Pfizer and Warner Lambert, the 2003 acquisition of Pharmacia by Pfizer, and through the 2004 acquisition of Avantis by Sanofi. On average the industry had at least one major M&A transaction per year. In 2000, M&A reached a record of $238 billion. The consolidation aimed to reduce cost and increase drug development capability to fend off losses when best sellers go off patent.

The most notable trend in M&As in 2005 was the significant increase in big pharma acquisitions of biotech firms. Over the course of the year, there were 23 such deals – a huge jump from the average annual 5 to 7 biotech acquisitions by big pharmas. Licensing products by big pharmas are also on the rise. In the past 10 years, in-licensed products generated $45 billion and that amount is forecasted to grow to $73 billion in 2009. Almost 70% of these licensing deals are with biotech companies.

The decline of big pharmas in new drug development and sales and the overall increase of M&A of biotech companies signals the increasing maturity of the sector and its importance as a source of innovation for larger companies.