Like any country, China catches the occasional cold. But the explosion of a chemical warehouse in Tianjin on Aug. 12, occurring in the middle of a year when the news about the country has been mostly bad, reinforced a narrative that China has turned ill. Other symptoms of this illness are a deflating stock market, the devaluation this month of the Chinese currency, and the worst economic slowdown in decades.
With a death toll of at least 135, the Tianjin tragedy brought into focus other challenges that China is contending with. In the days after the accident, authorities said official corruption likely enabled the dangerous goods warehouse to operate without appropriate safety procedures just over a mile from a cluster of apartment towers. The aloofness of the local government was highlighted when it took the mayor of Tianjin a full week after the explosion to appear at a press briefing.
Since it began liberalizing its economy in 1978, China has for the most part been a growing and profitable market for the world’s chemical companies, with annual gross domestic product (GDP) expansion exceeding that of almost every other country. Now, after a string of bad news, the enthusiasm is no longer unanimous, and the difficulties of doing business in China—which have always been there—are coming to the fore.
Opinions among chemical industry executives vary, but the general view is that although China has several symptoms of economic illness, the country remains a promising market. And in several business sectors, opportunities still abound, even in the short term.
BASF, the largest foreign investor in China’s chemical industry, remains clearly of the opinion that the country merits the highest level of attention. “China is absolutely still the key market in Asia, both for BASF and for the industry overall,” says Albert Heuser, president of BASF in China and Taiwan. “It’s true that the growth rates have been slowing down, but you have to remember that last year, China’s GDP growth was more than double the entire GDP of the Philippines.”
Still, what the immediate future will bring in China is hard to predict. While talking with stock analysts last month, Andrew N. Liveris, chief executive officer of Dow Chemical, noted that the company had achieved strong financial results in the country in the second quarter. But he added: “China remains a very mixed bag; a very solid second quarter for us is not necessarily a harbinger of the third quarter.”
Similarly, despite his bullishness, Heuser acknowledges that BASF’s sales in China and Taiwan in 2014 were about the same as in 2013. The company’s profit margins for major commodities such as caprolactam, acrylics, and isocyanates are “under pressure” in China, he notes.
China’s economy is no doubt under stress, and the high-single-digit or even double-digit GDP growth it enjoyed for years seems to be over. According to World Bank data, one has to go as far back as 1990—a year after the crackdown in Tiananmen Square—to find an economic growth rate lower than the 7% that China is generally expected to tally this year. This month, China’s manufacturing activity was at its lowest in six-and-a-half years, according to the latest Caixin purchasing managers’ index.
It’s hard to tell what chemical company managers think about China’s direction. A survey conducted in February and March by the European Union Chamber of Commerce in China says 68% of the chamber’s members who work in the oil and chemical sector expect the slowdown to have a “significant” impact on their business in China. Yet a different survey conducted this year by the American Chamber of Commerce in Shanghai indicates that 78% of the chamber’s members in the chemical industry are either slightly optimistic or optimistic about their growth prospects in China.
For David S. Jiang, president of the Beijing-based chemical market research firm Sinodata Consulting, the outlook for China is decidedly gloomy. “It’s going to be tough for the chemical industry for the next two to three years,” he says. “There is overcapacity for most products.” Overcapacity is a particular problem for local producers of commodity chemicals that can’t compete internationally owing to China’s lack of indigenous oil and gas feedstock, he adds.
But foreign firms will also be affected because of the broad erosion in profit margins that overcapacity causes, Jiang points out. Moreover, even though foreign firms tend to be more innovative, their Chinese competitors are quick to imitate most new chemicals or materials that they launch in the country. “Foreign companies face the commoditization of their products in China,” he says.
The Chinese economic slowdown is unfolding as foreign firms find it increasingly difficult to comply with the country’s laws. Last year, a Chinese court fined GlaxoSmithKline nearly $500 million and sentenced some of its executives to jail terms when the company was found guilty of paying bribes to doctors to increase sales. GSK is the most dramatic example, but for years chemical and drug producers in China have complained about environmental regulations that they say have become stricter than those in Europe or the U.S.
The Tianjin disaster could well pile additional regulatory pressure on chemical producers, reasons Beth Epstein, director of global risk and investigations at the Shanghai office of FTI Consulting, a business advisory firm. “The Tianjin tragedy was so public, it could trigger a lot of action” in enforcement, she says.
Chinese regulations have been getting stricter for a long time, but it’s just the process of the country catching up with the West, observes Norbert Meyring, a partner at the Shanghai office of the consulting firm KPMG. For example, China will soon launch an industrial emissions scheme, something that has existed in Europe for a decade, he notes. Ultimately, the majority of China’s 27,000 chemical producers, both local and foreign, will be able to comply with the country’s increasingly strict environmental regulations, he expects.
Meyring, who has advised clients on the Chinese chemical industry for 14 years, is not overly concerned about the slowdown. On the whole, “growth rates in the chemical industry have come down quite a bit from the overall 10% growth in 2014,” he says.
“Of course, foreign chemical producers are worried because setting up a chemical plant requires a big up-front investment,” he says. But China represents more than 50% of the Asian chemical market and remains a major importer of many chemicals. “If you invest in China for the Chinese market, that’s attractive,” he says.
Although he is generally downbeat about the Chinese chemical sector, Sinodata’s Jiang notes that foreign chemical producers can compete in China by fine-tuning their products to the needs of their local customers. “Chinese companies are weak in applications development,” he says.
Given that China overproduces many chemicals, one strategy for a foreign chemical firm could be to buy commodity chemicals locally and formulate them to meet users’ needs. A good market for that, Jiang suggests, is epoxy resins, which often must be customized before use by customers in the adhesives and coatings industries.
BASF’s Heuser agrees that applications development “is absolutely an important area, one where we can differentiate ourselves from the competition.” China is a maturing market, he says, in which BASF works closely with its customers in the electronic, construction, crop protection, and other industries. The German company operates a large and still-expanding R&D center in Shanghai. The first phase, already built, can accommodate 450 scientists. A second phase, slated for completion later this year, will allow BASF to employ more than 1,000 people at the site.
Some scientists at the site will be conducting basic research on new materials for global use, Heuser notes, while others will be adapting BASF materials for local customers. Besides BASF, numerous foreign chemical firms operate R&D centers in China.
“Our strategy is to bring our R&D closer to where the customers are because we want to ensure that we are collaborating and developing innovations that really suit the local markets,” Heuser says.
For instance, using its Elastolit-brand polyurethane, BASF has developed a system for producing lightweight and wind-resistant utility poles for China. Because the poles are so strong, they can be set 120 meters apart, instead of the 50-meter spacing required for traditional poles.
This feature is useful in mountainous regions and other hard-to-reach areas. Moreover, workers can carry the lightweight poles uphill manually without having to hire a helicopter. The poles have survived Chinese typhoons that have taken down other types of poles, Heuser notes.
Entrepreneurs also still see much promise in the Chinese chemical industry. In Hangzhou, an hour’s drive south of Shanghai, Hongyu Huang is bullish about his newly formed company, ByCatalysis Technology. “We’re basically a solution provider,” he says. Whereas many companies in China simply push a catalog of products, he claims his firm focuses on the needs of its customers. Huang, who was previously a salesman at the catalyst manufacturer Johnson Matthey, says catalysts are often the solution they are looking for.
In the dyestuffs industry, for instance, Chinese companies are struggling to meet increasingly stringent environmental controls. It’s a problem that often can be solved by applying the right catalyst to the production process, Huang says.
Similarly, certain pharmaceutical intermediates are in low supply in China because firms ceased production when their plants couldn’t meet environmental standards. Working with such firms, ByCatalysis develops cleaner production processes with the help of the right catalysts, which Huang’s company either sources from Chinese toll manufacturers or buys from foreign suppliers.
Despite the growing regulatory burden, China is a competitive exporter of custom-made chemicals used as intermediates in the agrochemical and pharmaceutical industries. Stephen Wang, founder and CEO of Kingchem, concedes that labor expenses in China have been steadily going up and that he has been investing to reduce the environmental impact of his facilities in Fuxin, in northeast China. The company is in the process of building an incinerator for liquids that cannot otherwise be properly treated.
“Our cost difference with Europe is less than it was 10 years ago,” he says, “but I don’t see that within the next five years we would be coming close to Western costs.” Wang, who divides his time between China and New Jersey, where his wife and children reside, claims that he offers Western standards of quality and service at Chinese costs.
At Kingchem, there is simply no economic slowdown. The company’s growth, about 35% annually since 2009, Wang says, has been limited mainly by production capacity. He is currently talking with Chinese investors who could help him finance new plants. Several are interested, he claims.
At this point in 2015, the picture of the Chinese chemical industry is one of robustly healthy businesses chugging along amid overcapacity and some economic concerns. In a country where demand for chemicals is still growing, opportunities abound in many areas.
“China is definitely in a slowdown, but overall still has solid growth potential” KPMG’s Meyring says. With negative headlines such as the recent drop in the Chinese stock market, however, chemical company managers will need a lot of nerve to hold the course steady in the coming months.
Foreign companies lower expectations in China
Just a few years ago, China seemed like the pharmaceutical industry’s promised land, offering sales growth rates of 20% or more every year. Today, large drug companies are adjusting—with difficulty in some cases—to sharply lower growth and stricter regulatory requirements.
Exhibit A for the current travails of the international drug industry in China is GlaxoSmithKline. Last year, China fined the company nearly $500 million and sentenced some of its managers in China to jail for bribing doctors who prescribed GSK drugs. This spring, it laid off more than 100 Chinese staffers for contravening what the company called its “values and code of conduct.” Then last month GSK said its sales in China in the first half of 2015 were down 8% from the same period last year.
GSK isn’t the only firm struggling in China. At the end of 2014, Bristol-Myers Squibb laid off as many as 1,000 people in the country. BMS didn’t explain the move, but the company hinted at its reasons in an earnings announcement last year when it revealed that it was auditing some of its Chinese sales practices.
Meanwhile, Novo Nordisk reported lower sales growth in China in the first half of this year—about 5%—than in other parts of the world. The company blamed increased local competition and government price controls, among other reasons.
“Patients’ better knowledge of diseases and new treatment options, growing incomes, and steadily increasing government investment continue to make China an attractive market,” says Shangjun Yan, principal of management consulting at IMS Heatlh. “But the pharmaceutical business has its ups and downs, and foreign drug companies are facing a difficult situation.”
Already the world’s second-largest pharmaceutical market after the U.S., China is posting sales growth of about 10% annually, Yan says, which is strong by international standards. But foreign drugmakers had become accustomed to Chinese sales growth of more than double that, Yan notes.
International drug companies face several challenges in China. One is the complex and frequently reassessed regulations involved in the launch of a new drug. As a result, it is normal for a drug to become available in China anywhere from two to eight years later than in Western countries.
Increasingly aggressive drug price controls at the provincial level are another headache for foreign firms, Yan says. Wholesale prices of most drugs sold in China are determined by provincial governments through tenders. This mechanism creates downward pressure on prices, Yan explains. Several months ago, tenders in a central province forced multinational pharmaceutical companies to lower prices by 30-80%. The price cut demanded was so extreme that some foreign firms walked away from the tender, Yan says.
The ongoing crackdown on corruption that caught up with GSK is another challenge for major drugmakers. The British firm’s misadventure has led the whole industry to be more conservative with its sales practices in China.
Beth Epstein, director of global risk and investigations at the Shanghai office of FTI Consulting, a business advisory firm, advises international companies to apply the same ethical standards in China as they observe in other countries. “You may forego some sales in the short term, but it will likely benefit longer term,” Epstein says. The Chinese public, she notes, expects high standards of behavior from foreign firms and feels let down when one of them is caught breaking laws.
In the years ahead, the business environment could well improve for major drug firms, Yan predicts. For example, as local companies move down the value chain from “me too” to innovative drugs, they will start to make common cause with their foreign competitors and lobby for shorter approval times, fewer price controls, and an end to corrupt business practices.
Change is already happening. At the end of August, the Chinese Food & Drug Administration announced that it will reform its system for approving drugs and medical instruments. By 2018, it said, China will accept clinical studies conducted in multiple countries including China. By then, the agency promised, “every application will be approved or rejected within a certain time limit.”