Anti-corruption crackdown rocks China's healthcare: implications & market impact

China's healthcare sector: is it a buying opportunity or a sinking asset?

On Friday, July 28, the China Central Commission for Discipline Inspection (CCDI) convened a meeting in Beijing to unveil a year-long initiative aimed at enforcing strict anti-corruption measures within the nationwide pharmaceutical industry. The announcement was met with palpable unease in the financial markets, which was soon reflected in the numbers: the MSCI All China Health Care index (KURE) has plunged more than 7% since the date of the CCDI meeting, while the onshore Pharmaceutical ETF (512020.SH) experienced a similar plummet. Jiangsu Hengrui Medicine (600276.SH), one of the most severely impacted stocks, saw a staggering drop of 20% in its price from July 31st to August 11th.

Under the rigorous enforcement of anti-corruption, several drug makers halted their planned IPOs:

On the evening of August 7th, Shanghai Rongsheng Biopharmaceutical Co.'s IPO on the STAR Market[*] was terminated due to a voluntary withdrawal.

On July 31st, the IPO application of Fujian Mindong Lijie Xun Pharmaceutical Co. on the GEM [*] was halted as both the issuer and the sponsoring institution withdrew their listing application.

So far this year, 12 pharmaceutical companies have canceled their listing plans on the Shanghai and Shenzhen stock exchanges. This includes 2 on the main board of the Shanghai exchange, 4 on the STAR Market, and 6 on the GEM. Apart from Rongsheng Biopharma, companies like Hanwang Pharma, Lijie Xun, and Zhishan Biotech have also withdrawn their IPO applications. During regulatory inquiries, these firms drew attention due to their sales expenses.

*STAR market: officially known as the Shanghai Stock Exchange Science and Technology Innovation Board

*GEM: officially known as the Growth Enterprise Market

The intensity of the campaign is unprecedented: Based on partial news reports, from the beginning of this year until the end of July, at least 155 hospital heads and party secretaries nationwide have been investigated. This number is roughly equivalent to the total number of similarly ranked individuals investigated for bribery from 2018 until the end of 2022. [source]

Considering that the overall profit of the pharmaceutical sector is still growing, the valuation has reached a historic low. With the China healthcare sector at its lowest point year-to-date, questions arise about the viability of China's healthcare sector: is it a buying opportunity or a sinking asset?

In today's article, we delve into the context of the nationwide anti-corruption campaign, aiming to shed light on the driving forces behind it. We'll also offer our perspective on the anticipated trajectory of China's healthcare equities at the end.

Why anti-corruption is imperative, from the perspectives of pharmaceutical corporations, healthcare workers, and patients:

The pharmaceutical corporations: weak innovation capabilities lead to prioritization of sales over R&D

A recent report by Jiemian, a Chinese finance-focused news outlet, summarized the core issues within the pharmaceutical sector:

According to data collated from East Money Choice, a major financial information services provider in China, in the first quarter of this year, the A-shares market had 488 listed pharmaceutical and biotech companies. Excluding 7 unprofitable listed pharmaceutical companies, 29 of them had a sales expense rate — that is, the proportion of sales expenses to operating income — exceeding 50%.

In 2022, the number of A-share pharmaceutical companies with sales expenses above 1 billion yuan far exceeded 60. Among them, Fosun Pharma, Buchang Pharma, BeiGene, Baiyunshan, and CR Sanjiu had sales expenses exceeding 50 billion yuan, with Fosun Pharma's sales expenses surpassing 90 billion yuan.

In contrast, the R&D expenses of pharmaceutical companies have dropped significantly. Taking the A-share listed pharmaceutical companies as an example, there are numerous companies with R&D expenses of less than 100 million yuan. The phenomenon of "prioritizing sales over R&D" is common among the majority of mature domestic pharmaceutical companies.

China's pharmaceutical industry has historically focused on imitation due to weak R&D capabilities, forcing companies to leverage their sales capability to compete with foreign pharmaceutical companies. Even in the pursuit of innovation, there is a tendency for drug makers to be "fast followers" and produce imitation drugs. The prevalence of identical or similar drugs due to the historical emphasis on imitation drugs creates fierce competition, forcing pharmaceutical companies to prioritize sales rather than R&D.

To be included in the medical insurance list and gain entry into local hospitals, many drugs, despite their simplicity and lack of innovation, require significant public relations efforts. Consequently, Chinese pharmaceutical companies exhibit high sales expenses, many of which are not genuine sales costs. This includes normal academic conferences and medical instructions, but a large portion involves relations management, where money is channeled through intermediaries or distributors, eventually manifesting as kickbacks to doctors. Doctors receive these kickbacks through a unique intermediary, the "medical representative". While in countries such as the US, this profession promotes innovative drugs, treatments, and equipment, in China, they more often act as a middleman, ensuring doctors prescribe their company's drugs in return for kickbacks.

Common medical products such as hypertension and antibiotics exemplify this situation:

…after a large number of imitations and price reduction, hypertension and antibiotics medicine have become "poor and voluminous" [Baiguan: prevalent but low in profit margin]. The reason behind this is not difficult to understand. China is a populous country, and the user base for such drugs is very large. Their production threshold and cost are relatively low, and the business strategy of pharmaceutical companies to obtain a share of the large market is very clear.

From the perspective of patient medication and doctor prescription, the effect of treatment for common diseases may be similar at the patient level. It is not easy for patients to perceive the difference in efficacy between different variants of medicines. Therefore, the drug and pharmaceutical company that a patient actually uses in the end depends on the doctor's prescription. One of the responsibilities of medical representatives is to encourage doctors to prescribe their company's drugs.

Corruption and kickbacks: How high sales costs occur

High sales costs can lead to corruption, with direct payments and incentives to doctors for prescribing specific drugs.

Kickbacks refer to fees that sellers return to buyers. In the pharmaceutical industry, there are two types: 1) Kickbacks to hospital drug procurement staff, similar to department store commissions 2) Commissions to doctors for selling drugs, even though they do not directly procure them.

While kickbacks to procurement staff primarily impact hospital profits, doctors receiving them may overprescribe, harming both patients' wallets and health.

Pharmaceuticals are primarily sold in public hospitals. Public hospitals, especially the larger ones, occupy an administrative monopoly position, allowing them to obtain a higher markup for drug sales compared to competitive markets. However, the leadership of public hospitals doesn't prioritize their profits, as they cannot freely allocate their own earnings. Hence, there's little oversight on the issue of doctors receiving kickbacks. After local policies introduced a "zero markup" rule, forbidding hospitals from profiting from drug sales, hospitals became more lenient about doctors accepting kickbacks. After all, doctors are hospital employees, and treating kickbacks as a form of benefit isn't seen as detrimental by the hospital. As a result, the markup initially intended for the hospital has now become kickbacks for doctors.

According to disclosures from the Central Commission for Discipline Inspection and the National Supervisory Commission, some pharmaceutical merchants send representatives to hospitals at regular intervals. These individuals often blend in with patients, discreetly delivering envelopes filled with cash to doctors, department heads, and related supervisory leaders. The amount varies based on the recipient's position, ranging from tens of thousands to over a hundred thousand yuan.

The money spent by pharmaceutical companies inevitably needs to be accounted for in various decorated ways. This has led to numerous cases of "fake invoicing." In response to the phenomenon of using fake invoices and bills to siphon off funds for external use, the Central Commission for Discipline Inspection and the National Supervisory Commission have "named and shamed" several times in their publicized historical cases. For instance, Beijing Chengnuo Medi-Tech Co., Ltd. was found to use unrelated personnel's plane tickets and invoices for reimbursement, diverting funds amounting to 915,100 yuan. Tonghua Yusheng Pharmaceutical Co., Ltd. listed promotional expenses with fake invoices, involving an amount of 1.7 million yuan.

Sanofi (Beijing) Pharmaceutical Co., Ltd. was investigated for fabricating business items to embezzle funds. In 2018, the company listed 149 million yuan in expenses for academic seminars or experience exchange meetings in the medical field. However, doctors associated with these conferences, which involved an expense of 938,200 yuan, stated that either they were fake or that they did not attend. The fabricated business items were mainly concentrated in areas such as academic research, experience exchange, market research, and consulting.

Underpaid and overwhelmed: The complexity of corruption in China's healthcare

The prevalence of kickbacks and corruption within China's healthcare system is a multifaceted issue. On one side, a noticeable lack of innovation can drive pharmaceutical companies to focus heavily on sales, sidelining research and development. This, coupled with a culture of greed and centralized power structures within many healthcare institutions, exacerbates the problem. However, a significant, yet often overlooked aspect is the economic pressure faced by healthcare professionals themselves. The wages doctors earn often do not mirror their true labor value, given the grueling hours and demanding conditions. Consequently, many are lured to accept kickbacks as a supplementary income source, further complicating the ethical landscape.

According to a recent interview by People’s Daily:

• Registration fees are so low that they are comparable to the cost of services like haircuts and massages:

Dr. Yin Jiayin, the director of the Adverse Reaction Department at Peking Union Medical College Hospital, charges 14 yuan for an ordinary outpatient visit, and each patient requires 15 minutes of consultation. The average cost per minute is less than 1 yuan. In Beijing, a man would spend at least 30 yuan for a 15-minute haircut, while a 60-minute at-home massage would cost about 150 yuan, and 15 minutes would also cost more than 30 yuan.

• Surgery costs are minimal despite the complexity and risk of surgeries:

Dr. Wang Renzhi, the director of the Neurosurgery Department at Peking Union Medical College Hospital, stated that brain surgery is technically more difficult than general surgery and carries a higher risk. However, the cost of performing brain surgery is less than 2000 yuan and is shared by four or five doctors and a few nurses, with a few hundred yuan per person. In contrast, the cost of a similar brain surgery performed by foreign doctors generally reaches tens of thousands of yuan.

Certainly, this does not justify corrupt practices, but it underscores the complexity of the issue at hand. There is a clear need to reallocate misused funds and enhance the pay structure for healthcare workers.

From an average citizen's perspective, anti-corruption enforcement is imperative

Patients face over-prescribed medications, unnecessary procedures, and exorbitant fees due to doctors seeking personal gains.

Grandpa Xu, a terminally ill lung cancer patient, underwent excessive treatments at a hospital despite his deteriorating condition. He was persistently given medications, injections, and IV fluids, even though he couldn't consume many of the prescribed medicines. After his passing, he left over 500,000 yuan in medical bills and three bags of unused medicines. [Story from People’s daily]

In May of this year, China's Central Commission for Discipline Inspection exposed a corruption case involving a hospital in Pu'er city, Yunnan Province. Despite opposition from the hospital leadership, its dean, Yang Wenjun, oversaw the purchase of a tumor treatment device for 35.2 million yuan, from which he personally received a kickback of 16 million yuan, making him a millionaire from this single deal. This instance is just the tip of the iceberg of corruption in the medical field, shedding light on why medical expenses for the public are so high. [source]

The unprecedented intensity of enforcement

The anti-corruption campaign in the healthcare field is not unprecedented. Since the initial nationwide crackdown, nearly every year over the past two decades has witnessed one if not multiple, anti-corruption initiatives targeting the healthcare sector.

However, the intensity of this round of anti-corruption enforcement is unprecedented in its scope and intensity:

"Academic conferences [Baiguan: hotspots where illicit kickbacks and bribery occur] have been postponed, which has never happened in history." Combined with recent media reports of delayed academic conferences in provinces such as Shaanxi and Zhejiang, an industry insider who has worked as a pharmaceutical representative for many years confirmed to Hu Xiu (a media outlet covering China’s business and tech) that this is indeed the "strongest anti-corruption campaign in the history of medicine."

…several medical-related associations such as the Chinese Medical Association, China Non-Public Medical Association, Shaanxi Medical Association, Zhejiang Medical Association, and Guangxi Medical Association announced the postponement of academic conferences. Among them, Guangdong, Guangxi, Zhejiang, and Shaanxi are considered to be the strictest provinces in this round of anti-corruption.

Furthermore, according to the industry platform "Yutu Broker," which provides part-time information services for medical device representatives, many pharmaceutical representatives in various cities including Guangzhou, Xi'an, Kunming, Qinghai, and Guiyang have already taken leave. Many young pharmaceutical representatives are concerned about losing their jobs due to this. Some even jokingly comment, "If you don't visit the hospital, you're afraid of being laid off; if you do visit, you're afraid of being arrested." [Hu Xiu]

More importantly, the focus on high-level figures is more pronounced in this anti-corruption drive compared to previous ones. Since the beginning of 2023, at least 155 hospital directors, executives, and secretaries have been investigated nationwide, which is more than double the total number investigated for bribery in the previous year. The regions involved in the investigation are distributed across many provinces, including Sichuan, Chongqing, Yunnan, Jiangxi, Hunan, Shandong, Guangdong, and Zhejiang. The government's determination is also evident in the establishment of whistleblowing or other reporting mechanisms.

Our view of the market: Is it a buying opportunity or are assets sinking?