Three Ways To Understand GSK's China Scandal

Last week provided yet another wrinkle in the unfolding scandal for GlaxoSmithKline (GSK) in China. Peter Humphrey appeared in shackles on Chinese television, offering up a solemn apology for having obtained information “by illegal means.” Accused of violating China’s personal privacy laws as part of their corporate risk consultancy practice, Humphrey and his wife had provided services to GSK in the past, although Chinese authorities have yet to explicitly connect Humphrey’s charges to GSK. The slow drip of information from the Chinese government has created confusion over what to make of these arrests, and more specifically their impact on healthcare and life science companies in China.

Based on what we know today, there are three ways to best understand the GSK scandal in China. First, that the crackdown on GSK is part of the growing anti-corruption program Chinese President Xi Jinping has set in motion.  In August, two senior executives of state owned enterprises (SOEs) were placed under “formal investigation,” the most recent being Wang Yangchuan, the vice president of China National Petroleum. This explanation can point to numerous and growing anti-corruption initiatives Xi has rolled out since taking office, with the GSK scandal and its associated allegations against other pharmaceutical companies as only more recent and high profile examples.

The second way to understand the GSK scandal is specific to healthcare reform. China is in the midst of a once-in-a-generation expansion of its healthcare system. The country is making massive investments in every facet: new hospital and primary care infrastructure is being built at a torrid pace, a national insurance plan has been rolled out that covers almost everyone in the country, providing increasing coverage for basic pharmaceuticals, devices and diagnostic procedures. Yet most, if not all, of these additional investments are being built on top of a weak foundation. Doctors are chronically over-worked and under-paid. Hospital administrators struggle to meet shortfalls between government reimbursement and the increasing costs associated with the levels of service and medical products they are expected to provide.

It should be no surprise that both hospital administrators and doctors have found alternative means to make up for the revenue not provided by the government. For administrators, their response has been to incentivize doctors to prescribe unnecessary pharmaceuticals, surgical procedures, and diagnostic evaluations. Doctors have supplemented their paltry incomes through the sort of bribes the GSK scandal has laid bare, as well as the back-channel “red envelope” payments that families make directly to doctors to ensure proper and timely care. The combination of these practices has created problematic inefficiencies within China’s healthcare system that must be dealt with if the massive additional investment the country’s central government is making is going to be used wisely and actually benefit the Chinese people.

Multinationals such as GSK did not create this environment; rather, they have had to determine how to navigate the complex field where international compliance standards overlap with how healthcare is consumed and paid for in developing healthcare economies such as China. The realization that companies such as GSK did not create this situation, but are bearing unequal blame for it leads to the third, and most troubling way to understand the GSK scandal: China is broadly becoming a less hospitable place for multinational companies to operate.

Over the last several years, surveys of American and European companies with significant investments in China have noted growing concern over what these firms perceive as a less hospitable environment to make investments and grow domestic market share. Many businesses believe they are being held to higher regulatory standards by China’s various ministries than are their Chinese competitors, a frustration that is certainly not new but seems more explicit and intense than in previous years. China’s efforts to create a consumption and service based economy, rather than simply a manufacturing one, reflect a fear on the part of the country’s leadership that absent a domestic consumer economy, the country’s growth could stall, with social and political fallout to follow. While perfectly reasonable fears, the government’s practices that have followed this recognition have meant that domestic firms are being provided increasingly privileged positions over international companies.

When measured against these concerns, the GSK scandal takes on a different and more troubling light.  Whatever corrupt practices GSK is ultimately found guilty of, the reality is that GSK’s domestic competitors are guilty of much more egregious behavior. For this crackdown to be taken seriously, and for it to have the right impact on the many inefficiencies that persist in China’s healthcare system, two things need to happen. First, China’s regulators need to turn their attention equally towards domestic players, and make sure multinationals see their competitors also be held accountable. Second, the reimbursement practices that lead to chronic revenue shortfalls in hospitals, and the ongoing poor pay for public hospital doctors need to be addressed. Absent either change, the only effect of the GSK scandal will be to push corrupt practices further away from companies towards distributors and independent sales representatives where businesses can claim they have no directly knowledge of, or influence on, corrupt activities.

Pharmaceutical companies in particular have convinced themselves over the last decade that they simply have to be in China. The combination of maturing patents and price constraints in their home economies mean some of the strongest prospects for revenue and profit are in China. Yet China’s pharmaceutical sector is undergoing a number of massive changes, the most important of which has nothing to do with the GSK scandal and its various explanations, but rather China’s aspiration to accomplish within the life science space what it has done in clean-tech. China’s 12^th Five Year Plan is explicit in its desire to develop the life science sector. As part of this, China is going to encourage international companies to partner with domestic Chinese academic institutions, research parks, and industry. Much of this encouragement will take shape around expectations for technology transfer, a necessary step if China is to close the gap between what its life science sector is capable of today, and where it hopes to see it evolve.

The idea that multinational life science companies have to be in China is not set in stone. What could change it? If the GSK scandal applies disproportionately to international companies, this sends a very clear signal that multinationals cannot compete at the same level or in the same ways, as can their domestic competitors. This forces multinationals into increasingly high end and specialty market segments that, while profitable, do not represent the sort of high volume opportunities that originally excited them. In addition, the concerted effort by the Chinese government to encourage technology transfer within this sector will lead to the competitive landscape shifting not only within China, but also in many of the other emerging economies around the world, where Chinese competitors could begin to challenge international players for market share.

China is not wrong to crack down on corruption. The country’s leadership is not wrong to leverage multinationals for more cost effective inputs to its healthcare system. But China needs to be careful that it not overplay its hand, lest it dis-incentivize the very industry players who have a much to offer the Chinese people in terms of disease management and quality of life.