Be Careful for What You Wish

Recently, the business press has been full of articles about manufacturing workers in China demanding higher wages and better working conditions. The highest profile developments have been at the electronics contract manufacturer Hon Hai Precision Industry (Tucheng, Taipei County, Taiwan), which makes a broad range of products, including Apple's (Cupertino, CA) iPhone and iPad. A spate of suicides in recent months has shown a spotlight on the company's employment and led the company to promise a doubling of wages for many of its 800,000 employees. Around the same time, Honda (Tokyo) faced strikes at its Chinese plants and those of some of its suppliers, which forced it to grant a 24% wage and benefit increase.

Jim Miller

Government policies are also driving up labor costs, according to press reports. Local governments have decreed increases of 5–25% in the minimum wage paid by companies operating in their jurisdictions, and they are getting tougher in their enforcement of labor, worker safety, and environmental laws. New government policies are also making it harder to fire or lay off workers.

The rapid rise in labor costs is a result of economic and demographic factors in China. The rapid growth of the Chinese economy, which grew almost 12% in the first quarter of 2010, has made it tougher for companies to attract new staff as competition for labor increases. According to the Wall Street Journal, job vacancy postings in China were up 35% in the first quarter.

The pressures have been particularly extreme in Beijing and the coastal cities where much of China's industrial base is located. Costs of living in cities such as Shanghai and Shenzhen are growing rapidly. Although companies and the government are looking to make more investments in inland cities, where wage rates are currently cheaper, it is expected that the wage increases will be felt even there, thanks to fewer people entering the labor force as a result of the government's one child policy.

Rising wages are likely to be accompanied by an appreciation of China's currency, the renminbi. The exchange rates between the renminbi and the US dollar and the euro have been managed by the government to protect the export sector. China has been under growing international pressure to let the currency rise, and the need to control domestic inflation is another driving factor for revaluation.

Good news for bio/pharma

While causing near-term dislocations, most observers believe that the improving wages and work conditions and appreciating renminbi will create a more sustainable Chinese economy, one driven more by domestic spending and less by volatile exports. That's good news for global bio/pharmaceutical companies because it validates one of the major legs of their corporate strategies: pursuing growth opportunities in emerging markets. As they have faced declining opportunities in North America and Europe, global bio/pharmaceutical companies have focused their strategic resources on emerging markets, especially the BRIC countries (Brazil, Russia, India, and China). The key underlying assumption for that strategy is that rising incomes and living standards in those countries will trigger greater spending on drugs. Industry-watcher IMS Health has projected that spending on drugs in China will grow 20% during the next five years.

To take advantage of that growth, global bio/pharmaceutical companies have been investing heavily in those countries through acquisitions, establishment of research and development (R&D) and sales organizations, and in-licensing of products to build their local pipelines. The wage increases in China are an indication that the assumptions and projections underlying those investments are sound.

Mixed news for service providers

European and North American service and materials providers will be inclined to welcome the rising costs in China because it will improve their cost position relative to their competitors in China. A 25% increase in labor costs, combined with a 10% appreciation in the renminbi, would have the effect of raising the cost of sourcing in China by 25–35%. European providers may get an even bigger gain in competitiveness in light of the rapid devaluation of the euro and British pound. After factoring in the additional costs of managing long-distance sourcing relationships, bio/pharmaceutical companies will see the costs advantages of sourcing from China narrow and may be more inclined to stick with local providers.

However, the second-order effects of the rising wage costs may cause service providers in mature markets even more pain than they are facing today. That's because Chinese service providers and manufacturers will respond to their eroding competitive cost position in starting materials and simple chemistry by moving to higher value-added products and services such as formulation, advanced chemical intermediates, and biologics. This move to higher value-added services is exactly the strategy that North American and European companies have used to stay in business in the face of low-cost competition from the BRIC countries. They will now be looking at lower-price competition in the more sophisticated services and technologies that have been their refuge in recent years.

Shifting economic balance

In a recent essay posted on the Project Syndicate website (www.project-syndicate.org), two distinguished economists, Mohamed El-Erian, CEO of the investment giant PIMCO, and Nobel Prize winner Michael Spence, stated that if global trends continue, "not much more than a decade is needed for the share of global GDP [gross domestic product] generated by developing economies to pass the 50% mark when measured in market prices." This change would be a fundamental transformation of the world economy and a dramatic shift in where the greatest opportunities for growth will be in coming years.

Surprisingly, pharmaceutical service providers, especially those offering nonclinical development and manufacturing services, have been slow to recognize this shift in the world balance of economic power and to respond to the new opportunities. Most continue to maintain an "us versus them" mentality and ignore the fact that their most important customer base, the global bio/pharmaceutical companies, are making major commitments to the emerging markets. The roster of Western active pharmaceutical ingredient and dose manufacturers that have embraced the emerging market opportunity is small, and includes Lonza (Basel, Switzerland), Evonik (Essen, Germany), AMRI (Albany, NY), and DSM (Heerlen, The Netherlands). Those companies got a head start on exploiting the new opportunities that the emerging markets offer.

The rising costs of doing business in China and other emerging markets may provide a momentary competitive reprieve to pharmaceutical service providers in North America and Europe. However, those companies may end up being sorry that they got what they wished for because the response to those rising costs may be more even challenging. Rather than fighting the tide, they need to learn how to rise with it.

Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903, fax 703.383.4905, info@pharmsource.comwww.pharmsource.com.