Part 1 Socio-Political Situation in China

Fractionalization of the political spectrum The Chinese Communist Party (CCP or Party) has been in power in China for 63 years a record that can put to shame almost any communist structure in world including the soviets. The politics of the People's Republic of China take place in a framework of the singleparty socialist republic. The leadership of the Communist Party is stated in the Constitution of the People's Republic of China. All power within the government of the People's Republic of China is divided among several bodies:

the legislative branch, the National People's Congress. the executive branch, the State Council the judicial branch, the Supreme People's Court and the Supreme People's Procuratorate the military branch, People's Liberation Army (PLA) via the Central Military Commission

Most positions of significant power in the state structure and in the military are occupied by members of the Communist Party of China which is controlled by the Politburo Standing Committee of the Communist Party of China, a group of 4 to 9 people, the paramount leader being Xi Jinping. The executive body i.e. the State Council is tasked with running day-to-day affairs of the country. The State Council is the chief authority of the People's Republic of China. It is appointed by the National People's Congress and is chaired by the Premier (Li Keqiang) and includes the heads of each governmental department and agency. Exploring the possibilities of a rift Often sever competition exists among the members of the Communist Partys Politburo & its Standing Committee - Chinas highest decision-making bodies. As part of a trend of very modest political pluralization, moreover, other political actors are increasingly able to influence policy debates. One test of a political system is its ability to manage political transitions. In the run-up to a once in a decade change in the Communist Partys leadership in November 2012, Communist Party Politburo member and Chongqing Municipality Party Secretary Bo Xilai fell from grace, exposing at least one serious rift in the leadership, raising questions about the tenacity of the one-party command structure opening room for factionalism. Many analysts, both in China and abroad, have questioned the long-term viability of Chinas current political system, in which the politburo remains above the constitution, leadership politics is a black box, & right to free speech and association are severely restrained Maintaining domestic stability is one the prime mandates of the 2.5m strong PLA and 800,000 strong police forces. However, the current domestic issues are getting more complex to control: a) Among the Chinese political systems governance difficulties is the phenomenon known as stove-piping, in which individual ministries and other hierarchies share information up and down the chain of command, but not horizontally with each other. b) A related governance issue is unproductive competition among official entities. It is not uncommon in China for multiple entities to attempt to assert jurisdiction over the same issue, competing with each other for scarce budget resources, power, and recognition from higher government officials. c) Although China is effectively a one party state, multiple coalitions, factions, and constituencies exist within the political system. Political mentorship, place of birth, the affiliations of ones parents, and common educational or work history may lead individuals to form political alliances. We believe that in the next ten years the Chinese political system may be quite different. There is a chance that the basic game shall change significantly by 2017, and even a chance that there wont be the same kind of Party Congress by 2022. Instead, we could witness transparent political process, more accountable and representative government, and increasingly democratic elections both within the Party and in the country. And its possible that very abrupt (yet largely non-violent) change could happen. Some intellectuals in China argue that cultural change takes 60 years, economic change takes 6 years, but political change takes 6 days, or even a weekend.

Fractionalization by language, race, religion Today China's population is over 1344 million, the largest of any country in the world. As per last consensus in 2010, PRC officially recognizes 56 distinct ethnic groups, the largest of which are Han, who constitute 91.51% of the total population with 8.49% being minorities. The Han Chinese the world's largest single ethnic group outnumber other ethnic groups in every provincial-level division except Tibet and Xinjiang The official spoken standard in the People's Republic of China is Putonghua. Its pronunciation is based on the Beijing dialect of Mandarin, which was traditionally the formal version of the Mandarin or Chinese language. Mandarin and its various dialects are spoken by more than 70% of the population. The Chinese government has implemented state atheism since 1949, making it difficult to ascertain the data on the religious diversity. Different surveys undertaken over smaller samples over the years have thrown up divergent results to establish any specific trend. Today, according to different surveys, Taoism is being practiced by over 30% of the Chinese population while Buddhism is practiced by between 11 - 18% of the Chinese. Christianity is practiced by 3 - 5% & Islam by 2% of the population. Thus religion, race, nor language has any major role to play in igniting any factionalist tensions. However in light of the recent and rising disparity due to the widening income gap across the social strata and also the glaring disparity in the economic growth of various parts of the country may lead to some fractionalization along the regional lines. As per BMIs recent forecast, separatist movements will remain weak, but unrest will occasionally erupt in the ethnic-minority regions of Tibet and Xinjiang, and related incidents of terrorist violence elsewhere are possible. There is a small risk that separatism in Xinjiang will escalate into a full-blown insurgency; a series of security incidents there so far in 2013 have resulted in numerous deaths. The Tibetan separatist movement could grow more violent when the exiled Tibetan spiritual leader, the Dalai Lama, dies. As yet, Chinas government shows no signs of moderating its harsh approach to dealing with separatist and ethnic unrest. However, there are some signs of new policy strategies being discussed in official think-tanks that may eventually lead to a change. Restrictive measures to retain power The Chinese government is famed for using all forms of restrictive practices ranging from legitimate constitutional provisions to use of force in order to suppress any anti-party commentary. The PLA is often touted to be the military arm of the CCP. The primary mandate of the 2.5m-strong PLA along with 800,000 strong police force is to ensure domestic stability i.e to prevent any social uprising. In the words of Tanner during his testimony before the U.S.-China Economic and Security Review Commission, that aptly summarizes the popular practices adopted by Chinese Authorities:

Despite the historic success of Beijings 30-year economic growth strategy, the available data from Chinese law enforcement sources indicates that unrest in China has continued rising for nearly two decades with little or no break. The list of government and managerial abuses that spark the great majority of these protests has changed little over the past decade, notwithstanding innumerable directives and laws from Beijing to stanch them. Beijing continues to struggle to find institutional responses that will check these abuses and predations by local officials. But over the past decade it has been far more ambivalent in promoting some of the legal and political institutional reforms first inaugurated in the late 1980s and 1990s that once promised to strengthen citizen access, oversight, and influence. Western analysts would be justified in asking themselves to what extent the promotion of political or legal structural reform can still be described as major priority of the Chinese Communist Party. Shortly after the onset of the 2008 economic crisis, Chinas public security forces issued new regulations aimed at forging a more sophisticated response to unrest. As with previous efforts to develop more effective police containment and management of unrest, the question remains whether Chinas law enforcement forces can develop the discipline and professionalism to carry out the new strategyand whether or not local Party authorities will let them. Besides physical force on the street the Chinese govt. has banned the use of twitter, google, Youtube, FB or any such mass medium of information sharing as part of the internet censorship drive. The govt. employees an army of tech sleuths to constantly monitor and track the web traffic flowing in and out of the country to check for any inflammatory/anti-institution rhetoric. Such heavy restraining measures cast a severe doubt the ability of any multi-national firm to seek grievance redressal through public campaigns. As the new firms contemplate investing in China, the informational barriers would have to come down sooner rather than later to ensure a healthy, conducive environment to carry out their businesses. Xenophobia, nationalism, corruption Corruption in China is widespread. The roots of the corruption lie in the extremely bureaucratic and rigid framework of the Chinese government. Given that everything falls under the aegis of just one party with minimal counter-vigilance to check existing structures. Given that most regimes have chosen to bring about only evolutionary changes in the govt. machinery mal practices and bribery have now been entrenched into the system. Among its forms are lavish gifts and expensive meals bestowed on officials by those seeking favors; bribes explicitly provided in exchange for permits, approvals, and jobs; privileged opportunities offered to officials or their extended families to acquire corporate shares, stock, and real estate; embezzlement of state funds; and exemption of friends, relatives, and business associates from enforcement of laws and regulations. As Chinas economy has expanded over the last 30 years, the scale of corruption has grown dramatically. 2011 report released by Chinas central bank estimated that from the mid-1990s to 2008, corrupt officials who fled overseas took with them $120 billion in stolen funds.46 Estimates of illicit financial flows out of China are many times higher. In a 2012 report, Global Financial Integrity, a Washington, DC-based research and advocacy organization, estimated that total illicit financial flows out of China in the decade from 2001 through 2010 amounted to $2.74 trillion, with $420 billion leaving China illicitly in 2010 alone.47 The international non-governmental organization Transparency International ranks

China 80th on its Corruption Perceptions Index, with the top ranking countries being the least corrupt. China ranks just below Sri Lanka and above Serbia. However, given the increased vigilante activism by a more vibrant civil society armed with social media and other internet based resources, the government has gone into a counter-offensive crackdown on bribery. The recent Bo-Xilai indiction openly demonstrated the entrenchement of the endemic. Thus, immediately following his appointment as Communist Party General Secretary in November 2012, Xi Jinping identified corruption and graft within the Party as pressing problems. He pledged to work with all comrades in the party, to make sure the party supervises its own conduct and enforces strict discipline. Many observers be lieve, however, that the Partys insistence on supervising its own conduct, rather than accepting supervision from outside, has been part of the reason that corruption has flourished. Critics charge, moreover, that when the Partys corruption-fighting agency, the Central Discipline Inspection Commission, conducts investigations; they are frequently politically motivated, even if they uncover real wrongdoing. Officials who keep on the right side of their superiors and colleagues may engage in large-scale corruption, while other officials may be investigated for lesser infractions because they have fallen afoul of powerful officials. Media commentators and academics have suggested a variety of measures to tackle corruption, including allowing the media to play more of a watchdog role and requiring officials to make their family assets public. So far, neither proposal has advanced significantly. Journalists who expose wrongdoing do so at their peril. In recent years, however, microbloggers have successfully exposed a string of corrupt officials. In one high-profile case, microbloggers drew attention to photographs of a local official showing him wearing at least 11 different luxury wristwatches on various occasions. Just one of the timepieces was worth more than twice the mans annual salary. Going forward, the virtual monitoring done by informed netizens shall play a decisive role in further governmental reforms. Managing corruption is a difficult but a mandatory art to be mastered for MNC seeking successful operations in D&E markets. However, the increasingly complex landscape due the recent crack-down both by the govt. and also the citizens have alerted the entire country that a mild revolution is on the anvil. Social conditions (population density and wealth distribution) The population density also shows significant diversity with most sparse in the mountainous, desert, and grassland regions of the northwest and southwest. The Inner Mongolia, Xinjiang, and Tibet autonomous regions and Qinghai and Gansu provinces comprise 55% of the country's land area but in 1985 contained only 5.7% of its population. Accordingly the economic disparity is distributed along the regional lines with wealth being disproportionately held up in wealthy centres such as Beijing, Guanzhou etc. Over the last twenty years, China has growth at phenomenal rates raising the per caputa standard of living but has also widened the gap between the rich and the poor. Results of a wide-ranging survey of Chinese family wealth and living habits released this week by Peking University show a

wide gap in income between the nations top earners and those at the bottom, and a vast difference between earners in top-tier coastal cities and those in interior provinces. The top 5% account for 23% of Chinas total HHI. The lowest 5 % accounted for just 0.1 % of total income. Average annual income for a family in 2012 was $2,100. When broken down by geography, the survey results showed that the average amount in Shanghai, a huge coastal city, was just over $4,700, while the average in Gansu Province, far from the coast in northwest China, was just under $2,000. Average family income in urban areas was about $2,600, while it was $1,600 in rural areas. Ordinary Chinese are increasingly resentful of wealth being accumulated by a select few and in particular by people connected to party officials and government censors often try to limit discussion in public venues of the personal wealth of the richest Chinese and of the families of Chinas leaders. The unemployment rate in China estimated to be in the range of 4.4 percent to 9.2 percent. It is also estimated Chinas Gini coefficient to be 0.49 in 2012, less than the 0.51 in 2010. The Chinese government avoided releasing an official number for several years. Then in January 2013, the head of the National Bureau of Statistics, Ma Jiantang, said the Gini coefficient was 0.474 in 2012, down from a peak of 0.491 in 2008. Strength of radical left Though communism has governed China for the last 60 years, the recent & extra-ordinary growth for the last 2 decades has introduced the Chinese to quasi free-market policies. While the western media may laud China for its extraordinary economic success, some intellectuals, as well as former military officials, workers, and farmers have raised serious concerns about the downside of thirty years of unfettered economic growth. Crony capitalism, the failure to ensure an adequate social welfare net, and growing environmental challenges are all seen as failures of the current Chinese political economy. These loopholes have now led to the emergence of "the New Left". These scholars are suspicious of further market reforms and want a stronger state-hand in the market to ensure social justice. Some of China's recent reform initiatives, such as the drive to develop a "harmonious society", derive from an element of the political spectrum that is concerned overwhelmingly with social justice. The nature of such a state in the political realm, however, is not as well defined. Scholars associated with the New Left, such as Professor Wang Shaoguang at the Chinese University of Hong Kong, express dissatisfaction with Western democracy as it is practiced. Yet they do not have a clear alternative to propose. They seek a system that is accountable, responsive, and responsible, but do not know precisely what political institutions will best bring such a system about.4 In their concern over representative democracy, they pose a challenge to those who seek more revolutionary reform. Thus the chances of radicalism being re-introduced remain weak and only a theoretical possibility. From the stand point of any Pharmaceutical firm planning to engage with China, the left radicals should not be a major concern area.

Dependence on and/or importance to a hostile major power The Chinese shares a historic bias against Japan and anti-Japanese sentiment, in particular, has been a recurring theme among online Chinese nationalists. Periodically, Chinese nationalists use Internet and the street to contest historical inaccuracies in Japanese textbooks calling for retribution. Nationalists had also begun with anti-Japanese protests after recent territorial disputes in the South China Sea, thereby providing the government an impetus to adopt a tougher stance in its negotiations with Japan. Chinas traditional ties with erstwhile neighbor India has been rocky. While the two nations have seen phenomenal increase in their mutual trade, the border conflicts have escalated over the recent period. Repeated violation of border treaties has been observed with both parties engaging in exchanging gun-fire keeping the foreign embassies busy for both countries. After much and frantics visits by premiers from both does a peace accord seem to be have reached. At a global level, China has fancied a head-on tussle with U.S of A. Chinas hard-liner stance with the U.S. on all key strategic issues such as exchange rates to environmental guidelines to Chinas domestic patent rights to the famed conflict over banning Google/FB have meant the power politics of the world heavy weights is out in the open for everyone to see. Thus, an American company entering into the Chinese markets may have to be wary of the potential barriers it may face while it establishes its identity. Negative influences of regional political forces China may not have much regional diversity in political opinion given its one-party one command structure it is some to some of worlds most engaging separatist movements. The on-going tiffs over the Mongolia, HK and Taiwan are fairly well documented but it is the far flung & neglected regions of Tibet and Xinjiang that have seen heavy blood-shed and unrest over the last few years. Both these regions are home to minority populace and are also equally distant from main-stream Chinese economic hot-spots. Also, both regions are fairly rich in term of its natural wealth in minerals and other extractive materials and thus view the PRC with abundant suspicion of exploitation. The Chinese govt. on the other hand has not restrained itself in exercising force to exert its control over the regions. His Holiness Dalai Lama, the keeper for Tibet has been forced into poli tical exile in Himachal Pradesh, India and his well-being decided the future of peace in the region. Xinjiang on the other hand is another offshoot of the fallen Qing empire inhabitated primarily by the Uighur muslims. Beijing has used all its military might to stamp down any violence by perpetrators of secessionist movements. Societal conflict (demonstrations, strikes or street violence) Growing disparity between the rich and the poor, opaque political transformations, rampant corruption at levels of government has created significant resentment among the citizens thus leading to often violent protests. According to Chinese law enforcement estimates on so-called mass incidentstheir official term for a wide variety of group social protest has increased every year from 1993 to the late 2000s. Numerous police analysts report that official mass incident figures

rose from 74,000 in 2004, to 87,000 in 2005, and to more than 90,000 in 2006. Official figures for the year 2007, and at least one analyst asserts that incidents declined slightly that year, though the number of persons participating increased dramatically. Despite Chinese government efforts to keep protests down in the run-up to the 2008 Olympics, the spring and summer witnessed several high profile or violent incidents. While the west focused on the March 14 riot in Lhasa, Tibet, Chinese police were also fixated on major incidents such as those in Wengan, Guizhou, and Menglian, Yunnan. Protest numbers apparently spiked with the onset of the financial crisis soon after the Summer Games, and by the end of 2008, total mass incidents had reportedly risen to 120,000 despite the pre- and post-Olympic security. Nationwide figures for 2009 and 2010 are not yet available, although local data and reports by some prominent Chinese academics indicate protests climbed greatly in 2009 in the wake of economic difficulties. Thus, the police and PLA are finding their hands full trying to suppress a national uprising in the making. In addition to the mass incidents, the increasing role of the Internet in Chinese political life poses a significant challenge to the Partys efforts to constrain political reform. While the Internet is a important asset critical to the progress of the nation I also possesses significant threats too. The Internet is, in fact, evolving into a virtual political system in China. The Chinese people are increasingly using for information, organizing work, and co-ordinating online protests online. As the blogger Qiu Xuebin writes, "When the interests of the people go unanswered long term, the people light up in fury like sparks on brushwood. The internet is an exhaust pipe, already spewing much public indignation. But if the peoples realistic means of making claims are hindered, in the end we slip out of the make-believe world that is the internet and hit the streets Instability (non-constitutional changes, assassination, civil war) CCP maintains water tight control over all aspects of state, judicial or military matters make it to be the supreme authority in the country. The rule of law is in its weak form in the country. Scholars who have been privy to various models of government in the west now call upon institutional reforms that transform the political structure in the country. For e.g. Political activist and Nobel Peace Prize winner Liu Xiaobo represents the boldest of those who call for such revolutionary reform with his online human rights manifesto, Charter 08, and his calls for universal values, direct elections, constitutional democracy, separation of powers, and protection of private property, among other elements of institutional reform. Ex premier Wen, a vocal proponent of fundamental reforms, did conduct a small experiment on political modernization in Shenzhen. The stated goal is strictly in line with the Partys constrained vision of political reform: to build a socialist democracy and a rule-of-law system, to develop a clean, efficient and service-oriented government, and to construct a complete market system, a socialist advanced culture, and a harmonious society. At the same time, the approach has some potentially revolutionary reform elements: gradually expanding direct elections, introducing more candidates than there are positions for heads of districts, and considering allowing candidates to compete for positions of standing members of district or municipal Party committees by organizing campaigns within certain boundaries.

Thus success of this reforms remains to seen. But in these trysts with democracy shall lay the future course of Chinese civilizations that sits on the cusp of a new era.

References (for Part I) Web Sources Economic Intelligence Unit Reports Business Monitor International periodical reports CFR: Council on Foreign Relations Online Links New York Times - 2013/07/20 Survey in China Shows a Wide Gap in Income Forbes.com - 2013/01/20 The China Miracle: A Rising Wealth Gap bbc.co.uk Xinjiang: China jails 20 for terrorism and separatism Wikipedia Tibetan independence movement East Turkestan independence movement List of active separatist movements in Asia Political Structure in China Demographics of China Literature Elizabeth C. Economy. Nobel Peace Laureate Liu Xiaobo and the Future of Political Reform in China Murray Scot Tanner. Unrest In China And The Chinese States Institutional Responses Susan V. Lawrence & Michael F. Martin. Understanding Chinas Political System Tyler Durden. The Far More Important 'Election' Part 1: China's Political Process

Part 2 The Economic Risk Rating

The overall aim of the Economic Risk Rating is to provide a means of assessing a countrys current economic strengths and weaknesses. In general terms where its strengths outweigh its weaknesses it will present a low economic risk and where its weaknesses outweigh its strengths it will present a high economic risk. These strengths and weaknesses are assessed by assigning risk points to a pre-set group of factors, termed economic risk components. The minimum number of points that can be assigned to each component is zero, while the maximum number of points depends on the fixed weight that component is given in the overall economic risk assessment. In every case the lower the risk point total, the higher the risk, and the higher the risk point total, the lower the risk. The Economic Risk Components GDP per Head It is the estimated GDP per head for a given year, converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the average of the estimated total GDP of all the countries covered by ICRG. In world perspective China's performance has been exceptional. In 1300, it was the world's leading economy in terms of per capita income. It outperformed Europe in levels of technology, the intensity with which it used its natural resources, and capacity for administering a huge territorial empire. By 1500, Western Europe had overtaken China in per capita real income, technological and scientific capacity. From the 1840s to the middle of the twentieth century, China's performance actually declined in a world where economic progress elsewhere was very substantial. In the past quarter-century, China has had a rapid growth trajectory-a process of catch-up which seems likely to continue well into the present century. By 2030 Chinese per capita income will probably be above the world average, and it will again be the world's biggest economy as it was from 1300 to 1890.1 Potential Risk: China's GDP per capita doubled to $6,100 from 2009 to 2012. However it does not mean that this rapid growth has transformed the lives of the Chinese people. According to Zhuang Jian The fast-rising yuan value in recent years helped China achieve a higher GDP per capita in this short span". This means the domestic growth is still not developed in China For China, GDP for 2012 is $ 83582 Average of the estimated total GDP of all the countries covered by ICRG is GDP Per (Billion)
1 2

Head Country

China in the World Economy 1300 2030 by Angus Maddison www.data.eiu.com

$1839 $1129 $878 $5959 $8358 3632.6

3

India South Korea Indonesia Japan China Average

Therefore GDP per head = 8358/3632.6 = 230% Using the risk point table given by ICRG, the risk point assigned for this is 4.5. GDP 8358 Country CHINA Percentage 230 Risk Point 4.5

Real GDP Growth It is the annual change in the estimated GDP, at constant 1990 prices, of a given country is expressed as a percentage increase or decrease. China is the fastest-growing major economy in the world, which has lifted hundreds of millions of people out of poverty over the past generation. Investors should not be unduly concerned about GDP growth in China. The countrys dependency on exports to boost growth has made it vulnerable to the global recession. Private consumption is weak at less than 40% of GDP. Though the GDP growth in China is slowing however China can promote domestic consumption in order to stabilize GDP growth which had previously driven by exports and investments. Chinese consumption is currently much lower than other major economies at 35%~40% per capita compared to US on 71% which itself shows the domestic growth opportunity in China. Chinas economic growth is slowly becoming more broad-based, with domestic consumption likely to rise in importance in relation to exports thanks to a middle class of 200-300mn people. Chinas ongoing urbanisation will be a major driver of growth an d new cities will emerge in less developed inland provinces. The UN forecasts Chinas urban population rising from 40% in 2005 to 73% in 2050: a gain of 500mn people. However it needs to be seen that export oriented country like China which had policies to save and investment more in the economy can drive up the domestic consumption. If the transition is done then the GDP growth will stabilize. According to Nueberger Berman product specialist Ria Nova, the other way was to introduce more institutional investors into the Chinese mainland equity (A share) market through the
3

http://data.worldbank.org/indicator/NY.GDP.MKTP.CD

Qualified foreign institutional investors. According to her, returns in this market have dropped 30% or more in the last four years, partly because it is majority-owned by retail investors with a vigorous trading mentality. The government wants to stabilise returns by giving access to longerterm participants like insurance companies. Thus we see that GDP growth in China will not be an issue in the long run if handled with care. Also the growth rate for real GDP for last 5 years was at an average of 8.86%. Potential Risk: In Nomuras baseline scenario, Chinas GDP growth slows to 6.7% in the first half of 2014 and recovers slightly in the second half, bringing next years GDP forecast to 6.9 %, Chinas slowest since 2008. Both cyclical and structural factors contribute to this slowdown. Structurally, Chinas potential growth is on a downtrend due to a dwindling and aging labour force and a lack of reform. The government still runs the national and local economies, making China slow and not very dynamic.4 In a higher risk scenario, GDP growth slows to 5.9% for fullyear 2014 and to 5% in the first half of next year and this could lead to China defaulting on its loan payments. For China, the real GDP growth for 2013 is estimated at 7.7%. Therefore using the real GDP change risk table, the point assigned to China for this indicator is 10. Annual Inflation Rate It is the estimated annual inflation rate (the un-weighted average of the Consumer Price Index) is calculated as a percentage change. Not only worries over China's slowing growth trajectory may be greater concern but also inflation could be a concern. Fears of stoking inflationary pressures will inhibit the new administration from resorting to significant monetary easing. Slowing growth in agriculture bodes ill both for price stability and Beijing's self-sufficiency goals. Rebalancing is inherently a long-run process; progress in bringing it about will be slow. However for now inflation is not a pressing concern. First-quarter results show a rise in CPI of 2.4%, or 1.4pp below that of the same period in 2012 (and 0.2% below the annual figure for 2012). The only categories which experienced price rises above the average were food and housing (up by 3.8% and 2.9%). Producer prices for industrial products fell by 1.7% year-on-year. Potential Risk: The inflation rate was higher than a median forecast of 2.9% in a Reuters poll and August's 2.6%, but was still below the official target of 3.5% for 2013. If the inflation rate increases in the coming months, then there will further policy tightening which might affect the overall growth of the economy. For China, the annual inflation rate is estimated at 2.6%. Therefore using the annual inflation risk table, the point assigned to China for this indicator is 9.5. Budget Balance as a Percentage of GDP It is the estimated central government budget balance (including grants) for a given year in the national currency is expressed as a percentage of the estimated GDP for that year in the national currency.
4

http://www.forbes.com/sites/kenrapoza/2013/07/24/when-china-sneezes-everyone-gets-sick/

China's solid fiscal position is enough to make debt-ridden European and U.S. governments green with envy. But turning strong public finances into a pro-growth fiscal policy won't be straightforward. Economists focus on the budget balance the difference between government revenue and expenditure as the main measure of the impact of fiscal policy on growth. In 2012, many expect China's Ministry of Finance to spend more than its income, run a budget deficit and buoy domestic demand. However in China, the budget balance doesn't tell the entire story on the government's impact on growth. An enormous volume of gray revenue raised by local governments isn't included in the Ministry of Finance's numbers. The most important omission is revenue from land sales effectively a tax on real-estate developers and home buyers. Land revenue of 2.9 trillion yuan ($457.3 billion) in 2010 was equal to 7.3% of gross domestic product. What matters for the overall fiscal position isn't just how much gray revenue is raised but how much is spent. Whatever be the case, the ministry of finance has to increase the budget deficit to increase domestic consumption as the export demand is fading due to crisis in Europe and US. Potential Risk: If the budget balance increases and if the GDP growth decreases, then there is high chance of default on the loans. If there is a default, then the credit rating will be affected and thus raising money will be difficult. Companies investing China must look at the growth rate of Chinese economy before deciding whether to invest or not. For China, the budget balance as a percentage of GDP is estimated at -2.0%. Therefore using the budget balance risk table, the point assigned to China for this indicator is 6.5. Current Account as a Percentage of GDP It is the estimated balance on the current account of the balance of payments for a given year, converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the estimated GDP of the country concerned, converted into US dollars at the average rate of exchange for the period covered. In the fourth quarter of 2012, there was a surplus of $65.8 billion in the current account. According to the calculation of statistics requirements of international balance of payments, there was a surplus of $107.4 billion in goods trade account in the fourth quarter, a deficit of $19.6 billion in service trade account, a $21.8 billion deficit in income account and a $100 million deficit in current transfer account. In 2012, China had a surplus of $213.8 billion in its current account regarding its international balance of payments, a deficit of $117.3 billion in the capital and financial account and an increase of $96.5 in its international reserve assets. Last year, China's current account surplus increased by 6% year-on-year, the ratio of which to GDP in the same period was 2.6%, decreasing by 0.2% than that in 2011. However it was the first time China's balance of payments transferred from "double surpluses" to surplus in current account and deficit in capital and financial account since the Asian financial crisis. Thus it also reveals that China has enhanced its ability in balancing its balance of payment

on its own. Also Chinas massive trade surplus and huge foreign exchange reserve serves as a major cushion against external shocks. Potential Risk: Though China has able to manage the Asian financial crisis as it had double surplus current account. However now it has reduced its current account and as the export demand is lessening, the current account surplus may soon be over if domestic demand is not increased. If the current account surplus goes down, then external shock will start affecting Chinas economy. For China, the current account as a percentage of GDP is estimated at 1.9%. Therefore using the current account risk table, the point assigned to China for this indicator is 12.5. Summary: Economic Risk Indicator Economic Indicator GDP per Head Real GDP Growth Annual Inflation Rate Budget Balance as a percentage of GDP Current Account as a percentage of GDP Point 4.5 10 9.5 6.5 12.5

The Financial Risk Rating The overall aim of the Financial Risk Rating is to provide a means of assessing a countrys ability to pay its way. In essence, this requires a system of measuring a countrys ability to finance its official, commercial, and trade debt obligations. This is done by assigning risk points to a pre-set group of factors, termed financial risk components. The minimum number of points that can be assigned to each component is zero, while the maximum number of points depends on the fixed weight that component is given in the overall financial risk assessment. In every case the lower the risk point total, the higher the risk, and the higher the risk point total the lower the risk. Foreign Debt as a Percentage of GDP It is the estimated gross foreign debt in a given year, converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the gross domestic product converted into US dollars at the average exchange rate for that year. As on 30th September 2013, the amount of debt China owes foreign lenders stood at 771.95 billion U.S. dollars. Of which, 403.31 billion U.S. dollars were international commercial loans and 59.14 billion U.S. dollars were loans extended by foreign governments and international financial organizations, according to data released by the State Administration of Foreign Exchange. Meanwhile, 309.5 billion U.S. dollars were debts stemming from trade loans between companies, the data showed. Potential Risk: China has a high component of foreign debt. China economy policy is to borrow heavily and invest in capacity building projects which return more than the cost of borrowing. Due to recent crisis in US and Europe where US being one of the major export destinations for China, export demand has fallen and China is lying with over capacity. If the Chinese are not able to generate demand for their over-capacity, then growth rate will fall and probability of default on loans will increase. Though China has state owned assets, land reserves in dealing with

local government debt but they wont solve the fundamental problem. As long as the debt financed investments are not economically viable, there will be an unsustainable increase in debt and if this continues forever, a debt crisis will take place The majority or 80.79% of the nation's foreign debt was denominated in the U.S. dollar Foreign Debt % of GDP = 1 Public Debt % of GDP = 1 16.3% = 83.7% Therefore using the foreign debt risk table, the point assigned to China for this indicator is 3.5. Foreign Debt Service as a Percentage of Exports of Goods and Services The estimated foreign debt service, for a given year, converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the sum of the estimated total exports of goods and services for that year, converted into US dollars at the average exchange rate for that year. Potential Risk: The amount of debt China owes foreign lenders is approaching the $1 trillion market. Outstanding short-term foreign debt, due within one year, rose to $565.68 billion from $540.93 billion at the end of last year however the country has over $3 trillion in cash reserves. More than enough to service its borrowing or wipe it out entirely and still have a few trillion left over for a rainy day. Investors have been mildly concerned over Chinas debt levels, from federal to municipal to corporate debt. For the first time ever, a Chinese solar company Suntech Power defaulted on a $531 million debt. Suntech Power is now in bankruptcy protection. For China, Total Exports for the year 2013 is $2224 billion Total Foreign Debt = 83.7% * 9379 = $7850 billion Short Term Debt = $565.68 billion (This amount is going to be serviced) Foreign Debt as a percentage of Export = 565.68/2224 = 25.43% Therefore using the foreign debt percentage of export risk table, the point assigned to China for this indicator is 7. Current Account as a Percentage of Exports of Goods and Services The balance of the current account of the balance of payments for a given year, converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the sum of the estimated total exports of goods and services for that year, converted into US dollars at the average exchange rate for that year. For China, Potential Risk: As discussed that export demand is falling and this is hampering the Chinese economy, the current account surplus will come down. If the indicator falls, it shows that export is not able to generate enough current account surpluses and China being an export oriented economy, the GDP of the economy will go down. To counteract the effect of this indicator, the Chinese government is looking to spur the domestic growth. So this indicator together with domestic demand can tell us whether the economy will do well in the future or not. If the

current account goes negative, then the government wont be able to service their foreign debts through current account which will result in default and credit downgrade. Total Exports for the year 2013 is $ 2224 billion. Current Account for the year 2013 is $ 178.20 billion. Therefore Current account as a percentage of Export = 178.20/2224 = 8.01% Therefore using the current account as a percentage to export risk table, the point assigned to China for this indicator is 13. Net International Liquidity as Months of Import Cover The total estimated official reserves for a given year, converted into US dollars at the average exchange rate for that year, including official holdings of gold, converted into US dollars at the free market price for the period, but excluding the use of IMF credits and the foreign liabilities of the monetary authorities, is divided by the average monthly merchandise import cost, converted into US dollars at the average exchange rate for the period. Potential Risk: The official reserves are used for various purposes like meeting loan obligation. Also the reserves are increasing because of stable exchange rate maintained by the Central Bank else appreciation of currency would have happened. If that happens in an export oriented economy where export demand is low then the growth will be adversely affected and the reserves will quickly dry up. Total Import for the 2013 = $1772 billion Average monthly import = $1772/12 = 148 billion Official reserves = $3.66 trillion Therefore Net International Liquidity as Months of Import Cover = 3660/148 = 24 Therefore using the Net International Liquidity as Months of Import Cover, the point assigned to China for this indicator is 5. Exchange Rate Stability The appreciation or depreciation of a currency against the US dollar (against the euro in the case of the USA) over a calendar year or the most recent 12-month period is calculated as a percentage change. China had been fixing its exchange rate at 2-US$1 until 1984, when the government changed its policy and started Yuan depreciation, resulting in a drastic shift from 2 per US dollar in January 1984 to 8.7 per US dollar in January 1994. During the period from January 1994 to June 2005, China pegged its currency to the US dollar at around 8.4 per US dollar. Around 2005, it started to appreciate for a while before being re-pegged at around 7.0 in July 2008. World leaders expect China to take actions by next year to adopt more flexible exchange rates. Facing such a strong and consistent pressure from the USA along with other developed countries, China promised to gradually move toward a market-oriented exchange rate, but still infuriates its major trading

partners recently for the pegged regime. Despite a recent halt to the appreciation of the yuan, the recession is leading to job losses in Chinas export sector and thus increasing social instability. Potential Risk: If appreciation of currency happens then China will lose its competitiveness in the export market and this will lead to lower growth rate. Till China is not able to spur domestic demand, China should peg its currency. However this could lead to strain relationship with its trading partner. For China, the exchange rate stability is estimated at 6.2%. Therefore using the exchange rate risk table, the point assigned to China for this indicator is 10. Summary: Financial Risk Indicator Economic Indicator Point Foreign Debt as a Percentage of GDP 3.5 Foreign Debt Service as a Percentage of 7 Exports of Goods and Services Current Account as a Percentage of 13 Exports of Goods and Services Net International Liquidity as Months of 5 Import Cover Exchange Rate Stability 10

Part 3 Legal system in China: Basic structure

The legal system of the People's Republic of China (PRC) is based on the PRC Constitution, which stipulates that political power is exercised by the people through peoples representation. This is achieved bottom up, from the local level up to the provincial and national levels. In practice, policymaking and administration are at times highly centralised and uniform in nature, and
at other times highly decentralised and diverse.5 Legislative function: The National People's Congress (NPC) and its Standing Committee have the power to pass laws (enact and amend) on behalf of the state. The Chinese Communist Party: It is technically separate from the government. The Party parallels, overlaps with and controls the government at all levels. While this achieves a certain high degree of national uniformity and cohesion, this arrangement tends to set the Party above the government. Executive function: the State Council of the PRC (State Council) is the highest level of state executive administration and has the power to enact administrative rules and regulations consistent with law. The Ministry of Commerce (MOFCOM) is the administrative body that is responsible for approving foreign investment. The State Administration of Industry and Commerce (SAIC) and Local AIC are responsible for business registration and other legal/regulatory oversight functions. Judicial function: the judicial power to apply the law in civil and criminal matters is vested in the people's courts at various levels central, provincial and municipal/local. Court cases do not act as binding precedents. The Party-controlled central legislative/executive/judicial structure is repeated at lower levels. Laws and regulations made at lower levels generally only serve to implement central-level enactments must not conflict with those made at higher levels. It is also important to note that despite the uniformity attributable to centralisation, there is may be high variation in local practice and interpretation wherever central policy is silent or unclear. Direct foreign investment is not permitted across the board in China. It is important to first assess under what conditions the contemplated activity is open to foreign investment. Investment activities are classified into 4 broad groups Permitted, Encouraged, Restricted and Prohibited. Investment decisions are also largely taken considering the special investment zones available national level high-tech industrial development zones; regular economic and technology development zones; free trade zones; and export processing zones.

Legal & Regulatory system for doing business in China6

http://www.out-law.com/en/topics/projects--construction/community-infrastructure1/doing-business-inchina-part-1---overview/ 6 http://www.sixsmart.com/SSPapers/pmw10.htm

Before entering the Chinese market , the stability of the Chinese government, Chinese laws, property rights, price controls, and business restrictions need to be analysed. The Chinese government has in the past strongly controlled prices, markets, products, foreign assets, and personal assets. However the Chinese government has progressively chosen to open markets to foreign investors and to create laws and regulations more in line with the WTO guidelines. This has encouraged more foreign investment in China in recent years. Building Laws and Regulations for Investment There is a general understanding that excessive approval delays, personal rivalries, dishonesty, and graft exist in the mechanism. Other perceived problems are related to leadership succession, nepotism, favoritism and increased corruption. The Chinese government has been taking steps to create and enforce a stricter legal system, support freer commerce, and embrace the global marketplace. The Sino-Foreign Equity Joint Venture Law was passed in 1979 to build a legal structure governing foreign investment. Since then, China has continued to build a legal system that will protect both their rights as well as the rights of their foreign partners Protection of Private Property Rights Private firms have been one of the driving forces behind China's rapid economic growth in recent years. Some systemic problems persist and need to be tackled in order to encourage additional development; an important one being the need for additional legal protections for private property rights. Under the Communist regime, private firms were associated with capitalism. They were typically forbidden or subjected to various restrictions. However China adopted an open-door strategy in the 1970s and the situation has since improved. This significant shift in government policy, however, has yet to be fully reflected in the provisions of Chinese laws. Insufficient protection of private property rights can otherwise lead to a widespread hesitation to reinvest in the country and expand businesses. Protection of Foreign Assets Since 1979, China has built a legal system that attempts to protect the rights of Chinese citizens as well as the rights of their foreign partners. New Chinese legislation is regularly introduced in an attempt to modernize their economic legal structure. China is also expected to increase the creation and enforcement of laws protecting the property rights of foreign corporations. However, there is a risk that this may not completely protect foreign assets. Government Price Controls The Chinese government retains the capability to impose strict wage-and-price controls, but this practice in not currently enforced. The majority of prices in China are now dictated by market rates. China lifted price controls on many items as part of entering the World Trade Organization. The current policy of relaxed price controls is likely to continue as long as it benefits the Chinese people.

Corporate Restrictions in China There are several restrictions for firms operating in China. Certain firms may be blocked from entering a particular field that is available only to state-owned companies. Certain firms face difficult rules regarding technology, personnel, and financing. Also, certain firms may be forced to shoulder an unreasonably large tax burden. Furthermore, financing may hinder access to funds. Recently, however, more and more foreign companies are doing business in China. The government has realized that in addition to reinforcing the protection of property rights, facilitating competitive and fair market conditions is necessary to allow further development of the Chinese economy. As a major step in this direction, discriminative measures against foreign firms are being gradually removed following China's WTO accession Chinas Accession to WTO China joined the WTO in the process of transition from a planned economy to a socialistic market economy. Access to the WTO promotes Chinas policy to reform its economy and open up to world competition. This meant that China was committed to reforming its laws, regulations, decisions, etc in order to ensure the implementation of the WTO agreements. WTO focuses on fair trade between members. The fields WTO encompasses have been extended to investment, services, intellectual property rights and other issues beyond pure trade. Changes in the Legal Climate for Foreign Investment after Chinas WTO Accession7 i. Fields open to foreign investors have been further extended. For example, there are 351 industries specified as encouraged activities, an increase of 94 items over those stipulated in the Guidance Catalogue of 2004. Encouraged industries account for 73 per cent of the list, up from 69 per cent in 2004. ii. Transparency of foreign investment polices is enhanced. The catalogue therefore contributes to transparency by clearly indicating the group into which each industry will fall, thereby clarifying which policies and regulations are relevant to them. This makes the relevant instruments easy to ascertain and access, so facilitating foreign investment. iii. Domestic innovation and upgrading of industrial structure are encouraged. In order to promote domestic innovation and to upgrade the national industrial base, foreign investment is encouraged in modern agriculture, hightech industries, modern service industries, cuttingedge manufacturing and infrastructure iv. Energysaving and environmentallyfriendly industries are encouraged. In order to promote the more effective use of resources, environmental management and sustainable development, the Guidance Catalogue of 2007 encourages industries in the area of clean production technology, recycling resources, ecological environment protection and the comprehensive utilization of resources. v. Coherent development across regions is encouraged. The eastern and coastal regions of China were the first areas opened to the world, whereas the western, central and northeastern regions are relatively underdeveloped. China particularly encourages investment in underdeveloped regions. The government is determined to improve
7

Bond Law Review, Vol. 20, Issue 1 - January 2008: The Legal Climate for Foreign Investment in China after its WTO Accession

infrastructure significantly, improve the investment climate, allow more market access for foreign investment and attract expert personnel to western regions. Establishing a business in China8 Foreign invested enterprises (FIEs) wishing to establish a presence to do business China must establish one of the several different statutory forms of FIE. In general, only companies with 25% foreign equity or more can be considered as FIEs. Forms of FIE include: 1) Wholly foreign-owned enterprise (WFOE): a limited liability company 100% owned by one or more individual or corporate foreign investors. The liability of the investors is limited to their subscribed registered capital. WFOEs are the most popular form of FIE. 2) Equity joint venture (EJV): a legal person company invested in together by both foreign and domestic corporate investors. The equity interests of the investors, and the division of profits, is strictly proportional to their shares of contributed registered capital. 3) Cooperative joint venture (CJV): normally established as legal person limited companies, but may also be established as a non-incorporated contractual cooperation. The liability of the partners in an unincorporated CJV is unlimited, and investors tend to have greater flexibility. Non-incorporated CJVs are typically only established for specific limited purposes and activities such as collaboration in natural resources exploration and venture capital investments. 4) Foreign invested company limited by shares (FICLS): a joint Chinese and foreign -invested company, hence a form of joint venture (JV), limited by shares. An investor's liability is limited to its individual subscription. Companies seeking listing on the Chinese stock market must be in the form of a FICLS. A WFOE, EJV or CJV may convert to an FICLS in accordance with PRC law. 5) Holding company and regional headquarters: investors with major operations already in the country may wish to consider establishing a holding company or a regional headquarters to help consolidate certain group treasury, support services and trading functions. There are significant minimum investment thresholds, and operations are limited to holding company functions. Key challenges in the business & regulatory environment9 Some recent developments born out of friction between foreign companies and the Chinese business environment are: Coca-Cola's failed effort to take over Huiyuan Juice, 2009; Google's exit from the market amid allegations of government hacking, 2010; The arrest of Wal-mart employees over mislabeling of pork products, 2011; Caterpillar's loss of $580 million after acquiring a Chinese construction equipment company that had fraudulently inflated its revenues; The bribery case involving GlaxoSmithKline. According to the annual survey conducted by the American Chamber of Commerce in Shanghai, the key business challenges in China faced by companies are as shown in the graph below.

http://www.out-law.com/en/topics/projects--construction/community-infrastructure1/doing-business-inchina-part-2---establishing-a-business-in-china/ 9 The American Chamber of Commerce in Shanghai China Business Report 2012-2013

Rising costs, HR constraints and preference for local firms and resultant competition were stated by participant companies.

Challenges in business environment The important regulatory challenges according to the survey are: Bureaucracy (74%) Unclear regulatory environment (72%) Tax administration (66%) Customs clearance delays (62%) Customs and trade regulations (61%) Difficulty enforcing contract terms (61%) Obtaining required licenses (58%) Difficulty in litigation (50%) Domestic protectionism (between provinces) (49%) Legal restrictions on market access (49%)

Regulatory Challenges The environment for foreign companies in China has been getting tougher since 2006, when the nation came to the end of a five-year schedule of market-opening measures it pledged as the price of admission to the World Trade Organization. Soon after the WTO-mandated reforms concluded, foreign firms began to complain of an increase in discriminatory practices, more difficulty in getting licences and approvals, and a generally less friendly attitude from officialdom. The wordings of the Chinese laws are often ambiguous and hence can be interpreted in many ways. Laws on trade, intellectual property rights, labor and taxation are often refined which leads to complexity in interpretation of the laws. Antitrust laws China's Anti-Monopoly law was adopted in 2007. Its provisions are partly consistent with Western economies competition policy frameworks, in that they provide for a substantive test of the impact on competition and consumers of the merger or anti-competitive conduct. In contrast to the European law, however, the Chinese law leaves significant room for the use of competition policy to further industrial policy objectives. The Chinese law explicitly allows the inclusion of economic development and national interest in the assessment. The Chinese antitrust law can therefore technically be used to pursue industrial policy objectives and protect domestic industries. Ministry of Commerces commitment decisions often aim to protect domestic competitors from the potential increase in the competitiveness of merged companies. Companies are sometimes

prevented from pursuing a certain line of business (like Wal-Mart/NiuHai), or from reducing their input costs.10 Finding a local partner Finding a local partner to do business in China is crucial because has China has "gained a reputation as a place where deals and contracts are often treated more like suggestions than concrete agreements"11. Having a Chinese partner does pose some risk. The partner company could infringe the foreign company's intellectual property, so it's critical to vet potential partners thoroughly before making any decisions. Ideally, a good partner is an incorporated company that is about the same size as the entering firm, at least partly Chinese-owned, has a strong network and is well-connected in the Chinese market. Partnering with massive state-owned enterprises is best avoided, according to leading law consultants. It is advisable to retain a Chinese lawyer before attempting to enter the Chinese market, as the paperwork and regulations, while not as opaque as in the past, are still difficult for a foreigner to navigate. Due diligence is required to reduce the risk of poor partnering to the entrant's business 12. Below are situations that careful due diligence can help avoid. Fake companies - A company approaches and offers a big deal with very favourable margins. This would involve paying a certain amount of relationship building fees to clear the relationship with important local stakeholders. The company disappears soon after you transmit the money to its account. Paper tigers - A company promotes itself a leading company in its industry but fails to present any strong and persuasive evidence to substantiate its claims. Shell companies - A company with registration information but with no significant assets or active business records. Parasite companies A company relying heavily on its relationship with local government officials. Intellectual Property Infringement & Enforcement13 The legal framework for protecting intellectual property in China is built on three national laws passed by the National People's Congress (NPC): the Patent Law, the Trademark Law and the Copyright Law. The framework of regulations, rules, measures and policies have been made by the NPC Standing Committee, the State Council and various ministries, bureaux and commissions. To enforce IPR protection, an administrative system has been established within the government. To handle cases of infringement of IPRs more efficiently, special intellectual property courts have been established in some cities and provinces.
10 11

http://www.voxeu.org/article/chinese-competition-policy http://www.ibtimes.com/how-do-business-china-guide-entrepreneurs-investors-1378695 12 http://www.tradecommissioner.gc.ca/eng/document.jsp?did=132268 13 Understanding Chinas Business Risk Environment, Marsh Risk Alert, Volume V Issue 3

The enforcement of protection of intellectual property rights is difficult in China. Without adequate education with regard to IPRs, there is little awareness that infringement is a crime. Strict laws and patents in economies of the West protect domestic and foreign businesses, whereas in China, the legal system is designed in such a way that gives rise to ambiguity. Shanzhai 14is an integral part of the Chinese tradition promotes individuals sharing what they create with the society to promote greater harmony. Shanzhai in business today takes the form of imitation of goods. Hence anything from shoes to cell phones are copied and sold openly in markets across the country. China today is the worlds largest producer of counterfeit products. Governments around the world continue to pressure Chinese authorities to do a better job of enforcing IP laws, and there are signs of progress. In May 2006, President Hu made a speech in the Political Bureau of the Chinese Communist Party calling for strengthening the country s IP system. Some progress has also been seen in enforcement. In February 2006, the U.S. Department of Justice obtained a conviction against a U.S. citizen for counterfeiting a popular pharmaceutical. With the cooperation of Chinese law enforcement, the operation resulted in the seizure in China of 600,000 labels, 440,000 tablets, and more than 500 pounds of raw pharmaceutical manufacturing materials. Chinas State Administration of Industry and Commerce (SAIC) is the primary enforcer of IP regulations. It has the authority to seize counterfeits from markets, warehouses, and factories. Many companies find it helps to be proactive with the SAIC by using an independent investigative firm to track counterfeiters, locate the warehouse or the factory where the counterfeiters are producing the product, and then pass the information on to the SAIC along with a formal letter of complaint. In theory, the SAIC should then raid the offending site. Brand owners are well-advised to keep up the pressure on pirates through investigations and raid actions. They should also practice thorough due diligence on employees and potential business partners to see if they have a track record of IP theft or are currently involved in counterfeit activities.

International Disputes Resolution15 China has several institutions for arbitration such as China International Economic and Trade Arbitration Commission (CIETAC). Only litigations containing an "external element" can be arbitrated outside China. Dispute resolution in the commercial area is characterized by: (i) demonstrable overall progress; (ii) considerable efforts to improve the regulatory framework and respond to investor needs,
14

Jayaraman, Karthik:"Doing business in China: A risk analysis", Journal of Emerging Knowledge on Emerging Markets, Fudan University & The Norwegian School of Management, November 2009 15 "Dispute Resolution in China: Patterns, Causes, and Prognosis": Randall Peerenboom and He Xin - The Foundation for Law, Justice and Society in collaboration with The Centre for Socio-Legal Studies,University of Oxford

thus reducing vertical disputes and tensions between businesses and the state; (iii) a rapid rise in litigation to resolve horizontal commercial disputes among business operators through the late 1990s followed by relative stability; (iv) improvements in enforcement, particularly in more developed urban areas; (v) notwithstanding considerable progress, ongoing problems with litigation, including significant regional differences in the nature of the economy, the nature of disputes and institutional capacity, and (vi) a renewed emphasis on judicial mediation in response to ongoing problems

SWOT Analysis of General Business Environment Strengths Opening up various sectors of its economy to foreign investment. China is the top destination for FDI with its vast supply of cheap labour. Weaknesses Foreign companies complain about the poor protection of intellectual property in China. Chinese corporate governance is weak and non-transparent by Western standards. Choice of right local partner is accompanied by considerable risk for foreign companies. Opportunities Urbanisation and infrastructure drive will provide major opportunities for foreign investment in landlocked provinces as well as the transfer of skills and knowhow. The Chinese government is giving more protection and encouragement to the private sector, which is now the most dynamic in the economy and accounts for most of the country's job growth. Threats China's government might block attempts by foreign firms to take over assets of national importance. China is experiencing rising labour costs, prompting some investors to turn to cheaper destinations such as Vietnam. Pharmaceutical Industry in China legal & regulatory dimension The domestic pharmaceutical market in China is highly fragmented. Traditional systems of medicine have long had a major presence in China. The industry is still small-scale with a scattered geographical layout, duplicated production processes, and outdated manufacturing technology and management structures. The Chinese pharmaceutical industry also has a low market concentration and weak international trading competitiveness, coupled with a lack of patented domestically-developed pharmaceuticals. Earlier, the industry had been riddled with problems such as: Poor IP rights protection, nontransparency for drug approval procedures, ineffective governmental incentives, and poor corporate support for drug research. Accession to the WTO has brought a stronger patent system, medical insurance is now more widespread, and pharmaceutical-related regulations have been tightened. Changes to the

patenting laws in full compliance with the requirement of the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS Agreement) and the poorly developed infrastructure of Chinese pharmaceutical R&D have created gaps in the market, which offer a scope for foreign investments. SWOT Analysis of the pharmaceuticals industry16 Strengths Progressive healthcare Reform by Central government Among the top five drug markets in the world in terms of overall size. Large pool of highly skilled, low-cost scientists and general labour. Rising per capita drug expenditure on the back of strong economic growth. Weaknesses Highly fragmented market. Complex and protectionist (biased) drug pricing and reimbursement policy by the government, Lack of tight enforcement of domestic patent laws. General focus on lower-cost pharmaceuticals and production overcapacity. Government bureaucracy, non-transparency and corruption. Opportunities Rapid growth in generic drug sector. Patented drug sector growth boosted by rising demand for hi-tech treatments. The fastest growing over-the-counter drugs sector in Asia. Modernisation of local manufacturing sector Rising foreign direct investment (FDI) following increased intellectual property rights Increased tax revenues, allowing the government to expand health insurance coverage. New and improved drug registration process to place less emphasis on personal connections. Increasing research and development capacity.

Part 4 Chinese Pharmaceutical Market17

The Chinese Pharmaceutical market is currently the third greatest pharma market globally, after the US and Japan, and in 2011 was worth $40 billion. It is forecast to increase dramatically to $200 billion by 2020 and increase its dominance as a leading player in Asia. As the current third market leader it is predicted that the Chinese pharma market will be the main competitor of the US by 2020. The Chinese pharmaceutical market is the main driver of the countries healthcare industry and in 2011 dominated with almost 90% share. Within the pharmaceutical industry drugs and active pharmaceuticals (API) are the main revenue generators. Over the Counter
16 17

Business Monitor International: China Pharmaceuticals & Healthcare Report, Q4, 2012 Deloitte: Opportunities in China's pharmaceuticals market, 2011

(OTC) medicines had a Chinese market figure of $9 billion in 2008 (18% of total market share) and by 2013 will become the worlds second largest OTC market. In the same year pres cription medicines dominated the market place with 62% share, and traditional Chinese medicine (TCM) made up almost 20%. Diabetes is one of the most successful therapeutic areas in the Chinese market and will reach over $2 billion in annual sales in 2019, compared to $700 million in 2009. Vaccine production is a leading strength in China with the ability to produce almost 1 billion doses each year according to the State Food and Drug Administration (SFDA). The country has almost 40 (38 in 2011) companies with vaccine manufacturing capabilities and the vaccine market was worth an estimated RMB1 billion in 2011. Over 40 different vaccines covering more than 26 indications are currently being made in China. The main vaccines that are currently exported are against hepatitis A, influenza and Japanese encephalitis. The oncology market in China is forecast to grow steadily and reach $2.2 billion by 2017 from $830 million in 2009 with a CAGR of 12.9%. Growing and distinctive Chinese pharmaceutical market 1. Pharmaceutical sales grew at a CAGR of 25.9 percent from 2007 through 2010, and are expected to continue strong but more modest growth from 2010 through 2015, at a CAGR of 15.5 percent. 2. The aging population will generate higher demand for health care services. Currently, the elderly population makes up 23 to 40 percent of the prescription drug market and 40 to 50 percent of the over-the-counter (OTC) drug market. 3. Out-of-pocket and private insurance healthcare payments rose steadily from 2007 through 2010, at a CAGR of 13.5 percent and expected to grow at a lower rate of 8.5 percent through 2015. 4. The CAGR for government healthcare payments was 17.9 percent from 2007 through 2010, and they are forecast to grow at 12.1 percent from 2010 through 2015 5. Although healthcare infrastructure expansion and the hiring of physicians have lagged, the net income and private healthcare expenditure of rural households have grown sharply over the past two decades. 6. Generics expected to continue to dominate the market, but patented drugs expected to see significant growth. Competition and changing Government health care policies 18 National firms compete and cooperate with foreign companies that have a direct presence in the market. The three major firms - one Chinese and two big Western multinationals - share only 10% of the market. Yangtze River Pharmaceutical Group is the leading player (3.6% of the markets value), AstraZeneca PLC controls 3.4% and Pfizer Inc. 3.0%. Bayern is gaining importance, as well. Chinas top three distributors - Sinopharm Group, Shanghai Pharmaceutical, and Guangdong Jiuzhoutong Pharmaceutical - had in combination less than 20% of overall market share in 2009. The number of firms has more than doubled from 2000 to 2010 and their scale has been also increasing. State-owned enterprises, foreign enterprises and private enterprises compete in the market. Even if the number of private firms has more than doubled in only 6 years, their average size is much lower than SOEs and foreign firms. SOEs, on their side, have been experiencing a period of reorganization and rationalization: their number
18

The rising Chinese pharmaceutical industry: local champions vs global players - Francesca Spigarelli, Hao Wei

decreased from 1.500 to 500, but their average size grew significantly, as well as their gross domestic output. In 2010, firms from abroad produced 27.01% of gross industrial output value. Anyway, despite the importance of foreign companies, their share in the market is not overtaking national firms, that are keeping their role and competitive position. Competition and rivalry among foreign firms and Chinese companies is going to be strongly affected by the changing landscape in proprietary technology. At the moment, foreigners hold the monopoly in many proprietary technologies. In the insulin market only, Novo Nordisk, Eli Lilly and Sanofi controlled more than 90% of the sales in 2010. This situation is going to change rapidly. In fact, more than 10 of the worlds best-selling drugs, including Pfizers cholesterol-lowering Lipitor and Lillys antipsychotic Zyprexa, lost patent protection in 2011. This is expected to directly result in a nearly US$5 billion reduction in those global pharmaceutical companies revenue. Furthermore, it is estimated that more drugs valued at about 77 billion $ in total are going off patent within the next five years. In March 2009, China's government revealed plans for a sweeping healthcare overhaul, and committed RMB850 billion to develop the country's healthcare system between 2009 and 2011. Among its provisions were to increase the Basic Medical Insurance (BMI) coverage from approximately 65 percent of the population to 90 percent by 2011; to revise the national Essential Drugs List (the "EDL", medicines reimbursable under BMI); and to allow the National Development and Reform Commission (NDRC) to more strictly regulate pricing. Domestic companies are mainly government owned and fraught with overproduction and losses. 19 The Chinese government has begun consolidating and upgrading the industry in an effort to compete with foreign corporations. It is estimated that most hospitals derive 25-60% of their revenue from prescription sales, hospitals remain the main outlets for distributing pharmaceuticals in China. This will change with the separation of hospital pharmacies from healthcare services and with the growing numbers of retail pharmacy outlets. Retail pharmacy outlets are expected to grow in number once the government finally introduces its system to classify drugs as OTC. The government is now encouraging development of chain drug stores, but the full effect might not be seen for several years. The central government has been playing a significant role in pharmaceutical price readjustment. Future price reductions will originate from hospital pharmaceutical retail shops. The rural pharmaceutical market will shift significantly. 80% of counterfeit products are consumed in rural areas. This provides a huge opportunity for pharmaceutical companies to develop the market in rural areas. China Generic Drugs Situation The wave of patented drug expirations will significantly boost manufacturing and sales of the related generics. In fact, generic drugs are the mainstay of China's pharmaceutical industry, and are likely to remain so for a long time. While the government encourages and relies upon innovation to meet industry targets, China will probably continue to rely upon widespread prescription of generics in the public insurance plan to hold down the overall healthcare

19

http://en.wikipedia.org/wiki/Pharmaceutical_industry_in_China#Governmental_policies

expenditures, and the current R&D capability also limits the possibility of launching domestic patented drugs in the near term. Traditional Chinese Medicine20 Traditional Chinese Medicine (TCM) is a more than 3,000-year-old medicinal practice whose doctrines are rooted in ancient books such as the Yellow Emperor's Inner Canon and the Treatise on Cold Damage, as well as in cosmological notions like yin-yang and the five phases. Starting in the 1950s, these precepts were modernized in the People's Republic of China so as to integrate many anatomical and pathological notions from scientific medicine. About 95 percent of general hospitals in China have traditional medicine departments and formal TCM training is an integral part of the national health program. There are more than 253,233 registered TCM doctors and assistant doctors across the country. According to data published by the Shandong University, hospitals practicing TCM treat more than 200 million out-patients and almost three million in-patients annually. TCM has been growing at a pace faster than the average rate of the entire Chinese pharmaceutical industry. The size of the TCM market is estimated to be close to $30 billion. According to the Xinhua News Agency, the cumulative sales value of the TCM industry is increasing at an annual rate of 23 percent. OTC Market Chinas OTC market is growing quicklyaround 17 percent per annum in recent years according to the China OTC Association's statistics, and faster than anywhere else in the AsiaPacific region. At this rate, observers at Espicom expect China to become the world's largest OTC market by 2020. In 2009, the total OTC drug market was RMB121 billion, with a split of RMB49 billion and RMB72 billion being sold in hospitals and retailers, respectively. Although OTC drugs only account for a minority of the Chinese pharmaceuticals market, their sales are growing in increasing proportion to sales of prescription drugs. Regulatory regime and policy development National authority & legislation The China State Food and Drug Administration (SFDA) is the national supervising authority for the pharmaceutical sector in China. It became operational in 1998 as the State Drug Administration (SDA) and was renamed in 2004. The SFDA has a number of departments to executive its different responsibilities, and the most industrial-related are the following three the Department for Drug Registration, the Department of Drug Safety & Inspection, and the Department of Drug market Compliance. Pharmaceutical regulation in China is based around the Drug Administration Law (DAL), first implemented in 1984, with the last major amendments taking place in 2001, and coming into force in September 2002. Drug registration, approval, and manufacturing Drug registration in China is a complicated and time-consuming process, involving a number of regulatory bodies at various levels of government, and at various regional levels. Drug approval applications could be sent directly to the central SFDA prior to 2002, but the applications are now initially reviewed by provincial and municipal authorities, and then passed to the SFDA for approval. The
20

http://www.biospectrumasia.com/biospectrum/analysis/2724/traditional-chinese-medicine-eats-pharmamarket

entire approval procedure generally takes between 18 and 26 months. Domestic clinical trials are mandatory for all drugs which are new to the Chinese market required by the Good Clinical Practice (GCP) guidelines. If a drug has not been approved in China or anywhere else, permission for the trial must be granted by the SFDA and the MOH, and it normally takes 12 months for the trial process. Once the clinical trials have been completed, the product must undergo a quality test. The manufacturer should provide enough product samples to conduct three complete tests. Manufacturers should be prepared for unexpected questions and test results; a large number of Chinese test laboratories are not rigorously controlled. The quality test should take around three months. IP Protection China's heretofore poor IP protection has been a countervailing factor in pharmaceutical companies collective drive to carry out R&D in the country. In addition, China's patent law is soon due to be revised, which should foster greater innovation and deter copycat drug makers. In recent years, a growing number of companies have become increasingly attracted to the idea of having an R&D center in China, as in-country research offers a general low cost base, a large patient pool, increasing scientific capabilities, the local industry's knowledge in the field of generic drugs, and insight into the country's growing drug markets. Moreover, manufacturers can only receive regulatory authorisation for products based on clinical trials that have been carried out in China Pricing Overall control of drug prices is the responsibility of the NDRC, whose pricing policy is based on the control of profit levels and sales discounts within the industry. Prices of drugs on the EDL are set by the government, while most other drug prices are set after negotiations between the government and manufacturers. The NDRC's purpose is to diminish the reliance of hospitals on drug prescriptions as a source of income by implementing the EDL. Some 300 drugs have been identified as critical for common illnesses and diseases, and should be made available to all patients. For drugs on the list, prices are fixed and no commission is paid for their prescription. Prices for these drugs have come down by 30 percent to 50 percent, which has reduced the cost of inpatient and outpatient care. Entry Strategy Based on analysis we have come out with suggestions where foreign firms can partner/make their presence in China. Since China generic market has occupied a quite big share, entry to generic market could provide access to huge market. However with the emergence of strict IP protection norms it is possible for a firm to reap benefits by investing in R&D and manufacturing facilities and come out with patented products. Various Pathways to enter Partnering o R&D Collaboration o Contract Manufacturing Presence o Joint venture o M&A

Partnering: regulatory considerations Non-clinical studies/clinical studies: The Chinese SFDA is very actively reforming the regulatory framework for conducting clinical trials and will likely further adjust its policies in step with advances in the clinical environment. In recent years, the agency has been striving to provide: Internationally Accepted Standards Normalization Greater Transparency Stronger Communication with Sponsors Closer Supervision of Clinical Trials. Traditionally, the approval timeline for Clinical Trial Applications (CTAs) has limited China's participation in global trials. However, the time has been reduced to an average of 7 months for NCEs and 12 months for biologicsa notable feat considering that the number of approvals has also been increasing by 18-20 percent over the past two years.

Contract Manufacturing Benefits Cost Savings Mutual Benefit to Contract Advanced Skills Quality Focus Economies of Scale Risks Lack of Control Quality concerns Outsourcing Risks Intellectual Property Loss Loss of Flexibility and Responsiveness

Building own R&D facilities As most of the players are aware about the advantages of investing in R&D in China, foreign drugs manufacturers are setting up facilities in Chinese market. Government has also introduced dedicated parks which provide features ranging from proximity to suppliers and tax incentives. Incentives are available to pharmaceutical companies carrying out R&D in China and they are liable to get High/New Technology Enterprise incentive. HNTE incentive includes core ownership of IPR and having products/services fall under the scope of encouraged domains. However the pharmaceutical market is highly fragmented. Also, large parts of this layered market continue to be flooded with low priced, low quality products. The market, however, is undergoing major changes and becoming more mature. Two reasons are driving these changes first, a new regulatory system is forcing companies to focus on quality and safety; second, companies themselves are becoming more sophisticated and gearing up to meet the stringent regulatory requirements. Together this is driving the fundamental maturing of the life science industry, the report points out. Thus we can see that Chinese market has turned its focus towards strong IP laws and regulations however still the registration and approval process is complex and cumbersome. Partnering strategy should be in the field of generic or patents (considering strong protection to IPR).

Mergers and Acquisitions/JVs: 1. Access to existing market. 2. The partnership would provide access of strengths of both partners, the foreign firm expertise in developing innovative medicines and domestic players distribution network. 3. Quick access to fast-growing developer and producer of pharmaceutical products in China. 4. Access to existing sales and marketing network 5. However, the road is not that strong, There is a risk of multinationals running into the 2008 PRC Anti-Monopoly Law that regulates all M&As-domestic as well as cross borders 6. Another approach adopted by some pharmaceuticals is the research and sale of drugs that tackle entire lifestyle issues rather than simply marketing medications for specific diseases. This includes building a whole ecosystem to educate, train and benefit all the stakeholders involved. 7. Prices are fixed by the government which could lower down the profit margins for the firms 8. Complex deal structure is time consuming Large multinational groups from North America, Western Europe, and Asia are attracted to China, as a result of a more friendly and favourable business and institutional environment. Operating in the Chinese market is still considered high-risky, time-consuming and expensive compared to other emerging markets due to stringent regulations concerning safety and efficacy. China is also strategic for Western companies to reach other nearby Asian emerging markets: as operating in the country can offer a logistic and commercial platform to penetrate them. Second factor, China is a market for delocalizing the production of high quality and price competitive raw materials. In some specific market segment (antibiotics, cephalosporin), producing in China is a necessity. In the West, in fact, environmental and safety rules make it impossible to set up fermentation and chemical plants associated with pharmaceutical plants. Third aspect, China is the frontier to develop applied research program

Part 5 Scenario Analysis

The firm has 2 options for making an investment decision: 1) Selling generic drugs 2) Selling patented drugs Each of these options can have 3 scenarios for them: a) The situation remains the same b) The situation improves c) The situation detoriates

Patented Drugs China has altered its licensing laws to allow domestic pharmaceutical companies to make cheap generic copies of patented drugs under certain circumstances. The move is part of the countrys efforts to ensure it has the weapons to tackle health crises like AIDS, but there are concerns about the effect these policies could have on innovative drug development. The new measures allow the government to issue compulsory licenses to eligible companies to produce generic drugs. A clause has been added to existing patent laws stating: SIPO [Chinas State Intellectual Property Office] has the right to authorize compulsory licenses in emergencies, extraordinary conditions or in the public interest. Keeping all above point in mind, we proceed to with scenario analysis for patented drugs. Patented Drugs Situation remains same 1) Going by the current pharma policy framework and decision making process, to maintain the same level of FDI in pharma sector, China might not tamper or make its pharma policy more strict. 2) To provide access healthcare access to its population, China has set a maximum price for all -category of drugs. This situation will continue to exist. 3) A change in government wont cause drastic changes in current policy because most of the current government policies are pro-people and in benefit of the population. Patented drugs Situation remains same Key parameters 1) Amount of competition remains same 2) Government policy & regulations remains same 3) Government providing national treatment 4) Price Ceiling Key Issues that will 1) Same as existing scenarios. No drastic changes. arise Action to be taken 1) Firm should continue with its current level of investments in the either of its generic or patented drugs 2) Emphasis should be given on establishing distribution network 3) Consult with government while setting prices since the pricing mechanism is based upon three considerations when setting the maximum retail price - production cost, a wholesaler spread set by the government and the prices of comparable products in the market. Any products priced above this level will be cut.
Likelihood of situation to occur 1) In short term (1-2 years) situation would remain same

Patented Drugs Situation Improves 1) China entered the WTO in 2001 as a developing country. Due to this is gets various benefits that are offered to developing countries. On another note, China has trained its judges to understand WTO rules and regulations. It has also created a system to handle

the various patent issues that would arise after entering the WTO. Chinas entry into the WTO has been a win-win situation for China and the rest of the world. 2) Below is the list of Chinas trading partners 1st trading partner of following countries: Australia, Chile, Japan, South Korea, Hong Kong China, Malaysia, Russia, Brazil, South Africa, Saudi Arabia 2nd trading partner of following countries: Argentina, Canada, European Union, India, Indonesia, Mexico, New Zealand, Singapore, United States 3) All these factors lead us to believe that China in future will increase its adherence to WTO regulations and follow a stricter implementation when it comes to cracking down on fake duplicates 4) Due to economic recession of 2008 and 2011-12 there is mounting pressure from US, EU to further open up Chinese economy. This would create more private players in a particular sector thus bringing in efficiency in the system.21 5) China houses worlds largest population. The Chinese health ministry has laid an ambitious plan to provide healthcare access to every Chinese national by 2020. This provides a huge opportunity for various pharma companies. 6) China's Ministry of Commerce (MOFCOM) has outlined its plans for the development of the pharmaceutical sector from 2011 to 2015, focusing on the consolidation and distribution of drugs. Patented drugs Situation Improves Key parameters 1) Amount of competition decreases due to M&A activity 2) Consolidation seen among various local players to remain competitive (Rate of consolidation) 3) Crackdown on duplicate drugs 4) Stricter implementation of TRIPS of the WTO agreements 5) Pressure from US & EU for more open economy 6) Introduction of healthcare reforms undertaken by the government Key Issues that will 1) Acquisition of local players by MNC majors arise 2) Higher amount of FDI in pharma sector allowing foreign players to invest more in R&D 3) Increased healthcare expenditure 4) Price Ceiling by Government Action to be taken 1) Increase R&D spend for more patents since overall cost
21

http://online.wsj.com/news/articles/SB10001424127887324577304579056191917697998

2) 3) 4)

Likelihood of situation to occur

1)

2)

3) 4)

of R&D is lower in china Setup factories in china Collaborate with Chinese government to work on health and insurance schemes If the set prices are above the government ceiling prices then there is likelihood of the government cancelling the patent. This happened with the firm Vireads patent for HIV/AIDS being cancelled. The firm should work with the government in coming with a suitable pricing strategy for its patented drugs. Chinas reform policy is geared towards consolidation and swift developments are taking place in drug delivery and distribution system22. As per Chinese health ministry:- Chronic diseases like cancer and respiratory and heart diseases are Chinas biggest problems Due to all these factors consolidation is already observed in some firms23 So the likelihood of this situation remains high

Patented Drugs Situation Detoriates 1) Recent investigations of corruption in the pharmaceutical industry have focused solely on foreign enterprises, said Bruno Gensburger, the European Chamber's pharmaceutical chair. "To date, no single Chinese pharmaceutical company has been investigated," said Mr. Gensburger. 2) China has worlds largest population and the benefits of Chinas turnaround has not reached the poor natives. Also, 26% of Chinese population suffers from hypertension. This translates into 35.20 crore people having hypertension. A situation might arise where firms selling patented drugs against hypertension might face patent cancellation, under the pretext of national emergency. 3) Similar healthcare problems can be seen in other areas: a) 30 crore people in China smoke 4) An outbreak like H1N1, will force Chinese government to cancel patents of companies which come up with an antidote 5) As part of trade wars that is seen amongst countries, if US/EU bans some of the products of chinas pharma industry, as a retaliatory measure China can ban or revoke licenses of pharma companies. 6) Even today there is a wide state interference in the pharma sector. Majority of the firms are state owned. The various pharma companies and the hospitals are closely associated with each other, where the hospitals prescribe drugs of a certain pharma company. Due to this there might be a high entry barrier for foreign firms.
22

http://www.swissnexchina.org/foryou/kpmg-china-pharmaceutical-201106.pdf http://www.chinadaily.com.cn/business/2013-05/20/content_16510980.htm

23

7) Given the fact of Chinas ambitious health plan of 2020 in which it wants to cover every citizen under health cover, China may actually boast the production of generic drugs so that the health plan comes to their citizen at an affordable price. 8) China has relatively strict foreign exchange regulations. Moving currency in or out of the country often triggers a settlement, registration or approval requirement, depending on the type of transaction. 9) Depending on the structure of the transaction, a U.S. company may incur tax liability under Chinese law. For example, a U.S. company may be subject to Chinas enterprise income tax for certain China-sourced income such as interest, royalties, capital gains, etc. 10) An economic downturn will force Chinese government to aggressively pursue the option of generic version of similar drugs thus directly threating the patented drugs. A recession in US or Europe can cause such a downturn to occur. Patented drugs Situation Detoriates Key parameters 1) Government bans patents and revokes licenses 2) Promotes local generics 3) Introduces TBT or volume restrictions 4) Provides ceiling prices on various drugs 5) Problem of duplicate drugs (manufactured via reverse engineering processes) 6) Increases the price ceiling so that the patented drugs are available at much cheaper cost Key Issues that will 1) Most MNCs losing market share to domestic players arise 2) Government crackdown on MNC 3) Observation of TBT 4) Interference of the government in pricing strategy of the firm Action to be taken 1) China is a member of WTO. Approach WTO, since as per clauses of WTO government cant introduce TBT or provide national treatment 2) In case of patent revocation, there has to be an extremely solid case against the firm, the firm can again approach WTO or the Chinese judicial procedure 3) Price its drug appropriately to avoid clashes with the government and risk losing license 4) The firms may approach the government to crackdown on duplicates 5) Another option would be to acquire the firm that has duplicated the drug, since the acquiring firm has to cut down on the losses

Likelihood of situation to occur

1) Even though the likelihood of this scenario is less, there have been an instance where China, has revoked patent of Gilead Science Inc. for HIV/AIDS drug24

Generic Drugs The generic market in China has high amount of competition. It is difficult for uncompetitive firms to survive. Government is in favor of policies, which drives out uncompetitive firms forcing them to be acquired by large multinational or domestic firms. Innovators have witnessed the growth in the generic industry and struggle to cope with pending patent expiries, many of them have turned to acquisitions and supply agreements to expand into generic drug markets as well. Generic Drugs Situation remains same Generic drugs Situation remains same Key parameters 1) Number of competitor remains same 2) Rate of consolidation 3) Number of new players in the market Key Issues that will 1) Level of competition would remain same arise 2) No significant change in government policy Action to be taken 1) None Likelihood of 1) The likelihood of this situation is MODERATE situation to occur Generic Drugs Situation Improves 1) Consolidation seen amongst drug distributors brining in higher efficiency in the entire value chain 2) OTC drugs will see higher consumption due to increased awareness and promotion of self-medication. 3) The government 12th 5 year plan clearly lays emphasis on generic version of drugs 4) As one component of a broader set of national goals of 12th 5-year plan, to push industry consolidation and industrial advancement, pharmaceutical companies are encouraged to consolidate domestically, eliminating outdated and excessive capacity, solidifying market share and technologies to build their businesses. This in turn would reduce the amount of competition in market 5) Increased acceptance of generics among providers and patientsfocusing first on ensured quality 6) Initiatives such as the EDL, price-capping, the recent anti-corruption investigations, and reform of the drug mark-up system will favor the use of generics Generic drugs Situation Improves Key parameters 1) Number of competitors decrease in the market
24

http://www.bioworld.com/content/china-revokes-viread-patent-pricing-was-issue

Key Issues that will arise

Action to be taken

Likelihood of situation to occur

2) Significant amount of consolidation activity seen in the market. Rate of consolidation will be high 3) Migration of population from rural to urban areas 4) Higher spend by government on health reforms 5) Lesser amount of beauracracy 6) Rising population of middle class 1) Spending on health per person will increase 2) Expected generic drug market size by 2015 is USD 82 billion4 3) Large number of patent cliffs will arise from year 2012 of many well-known drugs (631 drugs having patents to expire between 2012-2016) 1) Increase the number of generic drugs in market 2) To become immediately visible in market form joint venture with local pharma firms 3) Acquire attractive local firms manufacturing generic drugs 4) Work on establishing distribution network to reach even rural areas 5) Take strategic initiatives to plan ahead and capture the large pie of the generic market 1) The likelihood of this situation is HIGH

Generic Drugs Situation Detoriates 1) One of Chinas visionary aims is to become self-reliant in pharma sector in the next 20-30 years. For this to happen a lot of domestic industries will be motivated for R&D giving rise to huge competition to foreign players. 2) Medicine is a field where science maintains a sometimes uneasy coexistence with personal belief systems. Every doctor knows that interactions with patients are not simply about medical evidence, unambiguous diagnoses, and textbook prescription. The healing process is influenced by seemingly irrational factors, including mysteries such as the placebo effect. 3) As part of policy, China may introduce hindrance in drug approval process for foreign firms. Generic drugs Situation Detoriates Key parameters 1) Increase in number of competitors 2) Bribery cases against MNC officials bringing criminal charges against firms and individuals Key Issues that will 1) Slowdown in expansions processes of firms

arise Action to be taken

2) 3) 1) 2) 3)

Likelihood of situation to occur

Increased restriction of government on firms Crackdown on MNC officials25 Immediately settle bribery charges Work with government to reduce political risks Work in building infrastructure facilities like hospitals and create goodwill amongst Chinese population 1) The likelihood of this scenario remains MODERATE

Part 6 Analysis of the Entry Strategy

Based on the findings in part 4 of the report, the preferred entry strategy comes to be entering the Chinese market through M&A or JV and utilize the benefits present in R&D sector in China to come up with patented products. Though this seems to be the ideal and harmless way forward but the scenarios considered in part 5 of the report are equally plausible and hence require prior planning of actions. In this part we will be looking into various factors which may affect our decision to enter the Chinese market through investment in patented products and the possible plan of action which might be taken to negate the adverse situations. A recent development The Ministry of Health (MOH) of China has come up with the latest version of Good Manufacturing Practices (GMP) 2010 on 12th February 2011. This move signifies Chinese governments resolve towards upgrading the quality of Chinese drug companies and increasing their competitiveness in the international market. An implication of GMP 2010 will be the consolidation of fragmented Chinese drug markets because of increased manufacturing costs due to compliance requirements with the new guidelines. Some small-sized companies might get eliminated from the market. This presents an excellent opportunity for the MNCs to acquire these small-sized firms which is the preferred entry strategy as per our research. But at the same time multinational drug companies have to make sure that they comply with guidelines. In spite of the grace period of 5 years given to domestic drug firms to improve their manufacturing practices, MNCs need to make sure that the prospective acquisition target should be in a position to comply with the new guidelines. Besides elevated standards for manufacturing, there is additional requirement for training the employees, implementing a drug recall system and having quality checks at each level. The new norms could lead to shutting down of close to 500 small and medium firms. These norms have clauses which are very different from US and European norms and hence need a comprehensive review before investment. Action Plan for Patented Drugs entry strategy

25

http://www.pharmalive.com/china-arrested-how-many-glaxo-employees-at-least-30-so-far

Scenario: Normal Conditions The parameters which decide whether the conditions remain normal or not are the market environment with respect to competition, government policy and regulation, and the continued treatment of MNCs as foreign firms. Each of these factors working alone or in tandem can give rise to a variety of risks and hence a variety of actions which the company might have to take. Competition The current Chinese drug market is highly fragmented with about 5000 companies producing drugs and about 98% of them engaged in Generic drug manufacturing. This shows that though the patented drug segment is very small but there is ample scope of growth. In the generic drugs segment OTC medicine sector which is close to RMB 96.4 Billion in 2010 is set to grow at the rate of modest 7.7%. The Chinese believe very highly in preventive medicine and tend to selfmedicate for minor ailments. This has led to bypassing of doctors especially in urban areas given higher education and awareness levels about the health issues. MNCs occupy prominent position in OTC medicines with leading JVs which are operational in China being Xiang-Janssen, Wyeth OTC and Bayer-Beijing. Competition is expected to get fiercer as major global players seek to enter this sector. The government discourages self-medication and hence it seems wiser at this point in time to enter the patented drugs segment. If the government decides to take the OTC drugs out of the list of medicines for which reimbursements are given then the OTC manufacturers will be in huge disadvantage. The right way forward might be the prescription drug market as China is set to become the third largest market for prescription drugs. The continued efforts to increase the health sector spending by China would propel it to overtake western markets. Almost half of the top ten pharmaceuticals companies in China are foreign players but they control not more than 2.5% market share each. If the condition remains same then we might see further consolidation on expected lines and hence, if the normal competitive conditions continue we suggest holding on to the investment made as more opportunities might arise in near future. Government Policy and Regulation The government controls the prices of Essential Drug List medicines and for other medicines prices are set after negotiations between government and manufacturers. This suggests that government control almost all aspects of pricing of medicines. The National Development and Reform Commission (NDRC) plays an important role in deciding the prices of drugs included in the essential drug list (EDL). The main purpose of NDRL here is to reduce the role played by hospitals in prescription and make the essential medicines available to everybody. For drugs on the list no commissions are paid and prices remain fixed. The current system works as a deterrent for companies to invest in R&D and bring out new medicines. Given the clause about compulsory licencing during emergency situations which remains very subjective, it is risky for a company to venture into patented drugs segment. At the same time the governments intent to focus on improving the pharmaceutical industry through creating standards and increasing the spending from $ 52.2 Billion in 2010 to a forecasted figure of $ 85.1 Billion with CAGR of 15.5% presents an equally lucrative opportunity to enter in to patented drug segment. Given the entry strategy of JV which will have lesser capital expenditure as compared to acquisition, it seems like a moderate risk. For acquisition, more

reforms particularly in drug pricing and control regime should happen before one decides to enter the country. Treatment of MNCs as foreign firms Recently the special pricing agreement which stood ground for almost 20 years between government and pharmaceutical industry has been scraped off. This has resulted in elimination of differential pricing for about 100 MNC drugs which will be demotivating for these firms. As acquisitions lead to invigoration of nationalistic sentiments, it seems fair to assume that continued focus on acquisition as the strategy to grow in the sector can attract more ire in terms of policy. JVs can still be hopeful of support from the government. Scenario: Favourable Conditions The important factors which will determine whether the conditions are favourable in the pharmaceutical sector in China or not are the rate of market consolidation, stricter implementation of TRIPS, pressure by US and EU for greater market access, and health care reforms in China. Taking a holistic view of these factors would give us the right plan of action in due course. Rate of Market Consolidation With the GMP guidelines having an effect on the pharmaceutical sector, closure of close to 500 small sized firms is a definite possibility. If this rate of market consolidation further increases because of government focus on improving quality standards or other external factors it gives further opportunity to consolidate through acquisition of smaller companies. In this situation the firm should invest in the generic sector as well as majority of the companies which will go through consolidation will be in this sector given the presence of 5000 companies. Stricter implementation of TRIPS As pointed out in the earlier section national treatment of foreign firms is an issue in China. One of the most important actions which would determine the favourability of conditions is the crackdown on counterfeit drugs. Apart from effects on patients ranging from placebo effect and other injuries and fatalities to the patients, there is also loss of Drug Companys brand equity and profits which is in the range of 10-15%. Recent reduction of benefits given to foreign firms has led to apprehensions in the industry about the attitude of government towards these firms. Continued benefits from the governments side will further encourage the MNCs to come forward. In case there are efforts towards stricter implementation of TRIPS the firm should try to increase their investments further into R&D and bring out new drugs to cater to the market. Pressure from US and EU for greater market access Pressure from these developed countries will work towards further easing of restrictions and help in FDI as majority of the FDI comes from these countries and some of the biggest pharmaceutical companies come from these countries. Healthcare reforms in China The Chinese government has launched massive healthcare reforms in 2009 which is bound to have impact on the industry landscape. The major focus areas being accessibility and affordability of drugs. The government plans to build a network of network of health facilities, expand the public medical insurance system to cover more than 90% of population and reform

of the drug supply system. As far as the reform in drug supply system is concerned there is intent to consolidate the Reimbursement Drug List (RDL). These would further push down the price of the drugs for the population. If there is support from the governments side to encourage drug companies to bring out novel drugs and making these drugs available to population, it would lead more firms to invest in patented drugs sector which is currently only 2% of the total pharmaceuticals sector. So, further healthcare reforms should be a good sign for the firm to further increase investments in R&D. Scenario: Adverse Conditions In case of adverse conditions the government might take the actions ranging from banning of patents and revoking of licences, promote local generic drug companies, introduce TBT or volume restrictions, decreasing the ceiling prices of controlled drugs or putting up ceilings for currently decontrolled drugs and not cracking down on counterfeit drugs. In all these cases the actions taken by the firms would depend on the kind of business arrangement they are having in China. In case of JVs firms could shift focus from patented drugs to generic drug manufacturing. The greater risk which is present with the firms having R&D investments due to higher capital investments leaves them with the only option of selling of their assets and leaving the country.