Even after a plunge last month that wiped $46bn off Chinese health-care stocks, domestic drugmakers may be far from their floor as a Beijing-led policy shift gathers pace.

China’s plan to drive down generic drug prices through a centralized bulk procurement program is set to redraw the industry by forcing its thousands of small generic drugmakers to streamline and consolidate after decades of enjoying outsized profit margins.

“There won’t be a second act for traditional generic drug makers in China,” said Dai Ming, Shanghai-based fund manager at Hengsheng Asset Management Co. “In the past, there was hope that these companies would benefit from more government investment in health care due to the aging population, but now these health-care stocks will be further hurt by policy and undergo a greater correction.”

Health-care stocks faced more pressure at the start of 2019. The MSCI China Health Care Index fell 4.2 percent on Wednesday, to the lowest level since March 2017.

In order to survive the shifting landscape and rely less on generics — drugs whose patents have expired — many companies are scrambling to pump money into research and development. Discovering a new medicine allows companies to earn high profits for as long as the new drug is covered by a patent, balancing out the loss of revenue from the fall in generic drug prices.

Chinese companies had been in a sweet spot. Among the top 100 generic drug makers, Chinese firms had a 74 percent gross margin and an 18 percent profit margin in the third quarter, compared with a global average of 55 percent and 9.5 percent, respectively, according to data compiled by Bloomberg.

Regulatory Quirk

The privileged position was due to the quirks of China’s regulatory system. While multinational giants had to wait years for approval to import their new drugs, the domestic generic makers could do a thriving business in copying, testing and getting local permission for the medicines.

At the same time, the industry benefited because of the lack of a centralized system for quality control. Multinationals like Pfizer Inc. and AstraZeneca Plc could win more hospital tenders for their off-patent drugs, as they could more easily offer quality assurances for their higher-cost medicines. That kept prices elevated throughout the pharma sector.

Now, China has embarked on a pilot program in which major cities bulk-buy certain drugs together, forcing companies to bid for contracts and driving prices by an average of 52 percent, one by as much as 90 percent. Last week, Chinese Vice Premier Sun Chunlan said China would be expanding the program to cover more cities and drugs, as medicine prices must fall for health care to be affordable for the people.

R&D Race

Chinese companies that are already heavily invested in R&D stand the best chance of surviving the new landscape. Among mainland shares, Jiangsu Hengrui Medicine Co. has invested the most in research by far — amounting to 16 percent of revenue in the latest quarter. Guangzhou-based Yipinhong Pharmaceutical Co. is in second place with 8.4 percent. Zhejiang Jingxin Pharmaceutical Co., Chengdu Kanghong Pharmaceutical Group Co. and Tianjin Lisheng Pharmaceutical Co. have invested about 8 percent of sales into research.

Among Hong Kong-traded shares, CSPC Pharmaceutical Group Ltd. has 8.14 percent of sales invested in research and Sino Biopharmaceutical Ltd. has 6.23 percent.

At present, Jiangsu Hengrui gets 20 percent of its revenue from novel drugs and 80 percent from generics, a ratio it wants to flip, Lianshan Zhang, president of global R&D, said in an interview last month.

But a successful novel drug can take decades to develop, and the Chinese pharmaceuticals are up against the deep pockets and research talent of the multinationals, who are now enjoying rapid approval from Chinese regulators for their new medicine.

And since their investment funds come from revenue generated by generics, the plunge in prices may set off a vicious circle, said analysts.

“With generic drug revenue being compressed, there’s a chance that it can’t cover the necessary investment to transition to novel drugs,” said Huarong Securities Co. analyst Zhang Keran. “The market does worry whether or not there will be sustainable cash flow going forward.”