Week Jan 14 - Jan 18, 2019

Unforeseen Chinese API problems opportunity for Indian companies

For the global pharmaceutical industry, China has been a major supplier of active pharma ingredients (APIs), raw material for pharmaceuticals, and intermediates (raw material for APIs) for decades. Manufacturing in China has some distinct legacy advantages due to the abundance of capital and other resources, low material costs and wage rates along with relatively lax environmental regulations. In conjunction with strong GDP growth, these favourable Chinese macros have created a conducive ecosystem via relentless supplies of raw materials and finished goods across sectors globally.

However, these Chinese supply lines have been facing some particular issues, most of which were never faced in the past. Cornered by growing pollution related issues, the Chinese government has initiated a strong anti-pollution drive. Thus, in the process, this has forced many APIs, intermediate and chemical units to close down. Similarly, on the macro front, issues such as a squeeze in easy availability of bank credits, increasing in-depth scrutiny, mainly from developed markets regulators, increasing labour cost due to higher standard of living and last, but not the least, the US-China trade war have impacted API exports to the US. Although Chinese goods have not been altogether out of the game, the void has provided other global players, especially Indian API manufacturers, an opportunity to fill the gap, to a greater extent.

China has been major volume source for global APIs...

The global API market is mainly driven by the US followed by China and India (see exhibit). The US has the larger share in the pie as most US based APIs are earmarked for patented products in the US. However, in volume terms, China and India are the largest manufacturers and suppliers of APIs across the world due to a favourable eco-system such as lower cost of production and presence of a large number of players due to legacy manufacturing capability. China has an added advantage of better logistics, fermentation capability and availability of intermediates and chemicals.

US dominates US$160 billion API industry

China dominates global API industry in volume term (%)

Source: Industry; ICICI Securities
...but Chinese APIs industry moves into unchartered territory

Over the last 12-18 months, many factories in China have been closed down of which ~25% are suppliers to pharmaceuticals. Some of the major issues are- 1) Environmental issues - Crackdown by Chinese authorities to address growing environmental concerns, 2) regulatory issues - emanating from failure to comply with upgraded manufacturing global standards, 3) Diminishing cost advantage - increasing operating costs, especially costs of labour and materials and 4) US-China trade war related impact on Chinese API exports to the US.

1) Environment issues - biggest concern for Chinese manufacturers
An environmental overhaul initiated by the Chinese government against polluting industries has led to the closure of many factories producing chemicals, intermediates and APIs. Many API companies are unable to comply with the stricter regulations because their plants are old and upgrading is unjustified for low margin products. The cost of making an established API plant compliant with new regulations has also gone up significantly over the years.

The crackdown initiated at a particular chemical plant can cause disturbance in the value chain that included intermediate and API players. The Chinese government has made it mandatory for chemical plants to operate from only those chemical parks that have complied with stricter environmental norms. As of now, only ~45% of the total parks are compliant, which implies major plant shutdowns or relocations, going ahead. Moreover, the Chinese government wants the plant relocations to happen in a time bound manner. Accordingly, it has set a deadline of CY20 for small plants and CY25 for large ones. The country's ministry of ecology and environment had also appointed 18,000 environmental supervisors who will examine areas across the country on a regular basis. Thus, going forward, adherence to the stricter environmental compliance is likely to be a major factor for units operating in China.

A recent report in the US journal of Chemical and Engineering had quoted an anecdotal account suggesting that 144 API manufacturers had shut down in the Beijing-Tianjin-Hebei region alone because of effluent violations. Some plants in China have invested in cleaner technologies and increased prices of their APIs while others have shut down, contributing to the market shortages. Additionally, restrictions like prohibition of chemical production within a kilometre of the Yangtze river (the world's third-longest river that flows through nine provinces of China), environmental tax (imposed in January 2018) and specific emission norms (implemented in July 2018) have added to the woes of API players in China.

2) Regulatory issues- Increased USFDA scrutiny taking toll on Chinese players
Total ~80% of APIs used in the US were sourced from China and India. The number of USFDA warnings to Chinese pharmaceutical manufacturers has jumped from five in 2014 to 22 In 2017. Some Chinese API companies have been found guilty of not following established manufacturing processes as well as data recording, as guided by the USFDA, from time to time. This has resulted in frequent recalls by customers using Chinese APIs. Recent worldwide recall of blood pressure drug Valsartan is a case in point as a single API sourcing from China led to US recalls by more than 10 formulation manufacturers. In another incident, number of children's vaccines were revealed to be faulty, putting an unknown number of infants at risk. These kind of lapses have led to frequent USFDA inspections and increased scrutiny. This has resulted in an increasing number of warning letters to Chinese plants with restriction on new approvals, rendering the plants unviable.

Number of warning letters to Chinese pharmaceutical companies

Source: Industry; ICICI Securities

3) Variable costs growing due to shortages of materials and labour besides socio-economic challenges
The regulatory enforcement and factory closures in China have led to an increase in raw material cost and inventory lead times. Regulatory enforcement had the biggest impact on smaller players causing a shutdown for most of these players. This has effectively shifted supplies to a few select large producers with higher minimum order requirements.

Similarly, on the wages front, China has hit a stage in its development at which demand for labour starts to grow faster than supply, creating labour shortages and pushing up the price of labour. Key reasons for the same are-

1) Social pressure - Wages in China are rising because of growing concerns among Chinese authorities about the consequences of income inequality of rapid growth. Millions of workers have migrated to Chinese cities where average wages are higher, creating a deeper imbalance in rural areas that already suffer from low incomes and low quality public services. Hence, the government's most recent five-year plan states that firms must increase wages by at least 13% every year. As a result, labour costs in China have doubled since 2010

2) Demographics impact - Under the "one child policy" the fertility rate dropped to between 1.5 and 1.8, well below the 2.1 figure required to keep the population stable. The old age dependency ratio will double in the next two decades while the size of China's labour force is projected to start shrinking.

China average wage cost doubles in past seven years

Source: tjj.zj.gov.cn; ICICI Securities

3) US bound API exports likely to feel the brunt of US-China trade war
The US accounts for ~40% of the global pharmaceutical market, in value terms. As per USFDA estimates, ~80% of APIs used in the US (in volume terms) originate from China or India. With regard to the current trade war between the US and China, the US Trade Representative's (USTR) office announced its intention to add a 25% tariff on ~US$50 billion worth of Chinese imports across 1300 categories of products, which includes APIs, insulin, epinephrine and vaccines. This could be particularly concerning for US generic drug makers, considering that the proposed tariff could cause increased manufacturing costs. Hence, if the trade war escalates, it may lead to reduced trade with China. This will likely encourage generics manufacturers to procure APIs outside of China.

Ripple effect of Chinese API shortages in India

The Chinese API shutdown has caused significant disturbances around the world including India. Prices of most commonly used APIs have shot up anywhere between 50% and 200% in past three to four months. This, in turn, has led to a spike in formulation prices of many therapies such as anti-infectives, vitamins, dermatology, anti-diabetes, etc. Indian pharma players are largely dependent on China for APIs. Chinese APIs account for ~80% of all imported APIs in volume terms.

Few instances of cost related escalation

Source: Agricultural economic survey 2015-16, ICICI Securities

 Some of China's loss can be India's gains...

The once unparalleled Chinese bulk manufacturing capability and capability in APIs is facing headwinds for the first time. Even though some lost ground is likely to be restored, the remaining vacuum still presents a good opportunity for players like Indian manufacturers to chip in. What can be termed as a new opportunity for Indian players is the strategic shift of global players from single sourcing to multiple sourcing of APIs and intermediates to counter the uncertainties in the future. India can be a perfect strategic fit as dual sourcing for global customers, mainly on legacy adherence to stringent compliance (1298 UAFDA approved API units), and zero-discharge compliance adopted by most players as the behest of state government besides technical capability, and local sourcing.

Another advantage for sourcing APIs from India can be its legacy proficiency in formulations (where China lags), thus providing end to end solution for the customers. The Indian formulations market is the third largest in terms of volume and thirteenth largest in terms of value globally. The Indian pharma industry supplies >50% of global demand for various vaccines, 40% of generic demand in the US and 25% per cent of all medicine in the UK.

Potential incremental opportunity for Indian players

Source: Industry; ICICI Securities;on assumption of ~20% shift in API business from China to other countries due to recent issues

 Annexure 1- Initiative taken by Government of India to promote APIs (bulk drugs), which have been highlighted in the Draft Pharma Policy-

  • Plans to create mega bulk drug (API) parks where benefits of scale can be availed of by using common facilities for pollution control, effluent treatment or any such common activity

  • Such mega parks would provide clearances for plants with minimum interface/single window clearance of various

Annexure 2- Number of USFDA approved units as per GADUFA facility payments list

Source: USFDA; ICICI Securities



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