Short Run Economic Analysis - Establishing Bio-Pharma in Poland

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Short Run Economic Analysis - Establishing Bio-Pharma in Poland

  1. 1. BioCo Overseas Pharmaceutical Manufacturing Plant Analysis Short-Run (India and Poland)Contents: I. Executive Summary- Competitive Advantages or Disadvantages II. Background III. Important Short-Run Economic Factors a) Fiscal Policy b) Monetary Policy c) Trade Policies d) Wages and Labor e) Political Environment Gold Cohort Rajeev Kalavar Jordan Lindsey
  2. 2. Jeff Lo Ian Ranahan Brian Soby Susan Song Sanjay SrivastavaI. Executive Summary- Competitive Advantages or DisadvantagesShort-RunFactors Poland India Comments Poland: Prudent policy should allow future adoption of the Euro providing a natural hedge against projected revenues. Sound policy points to continuedFiscal & growth and stability.Monetary India: Beneficial tax cuts would reduce construction costs but may be shortPolicy lived. The threat of high inflation and currency fluctuations create potential risk." Poland: Being part of EU allows trade with other EU member states with relative ease. The "Intra-Community" trade laws provides zero-rated VAT andTrade easy market access into the EU.Policies India: Trade with EU may become more favorable based on FTA discussions that began in 2007. Although, timeframe is still uncertain. Poland: Low wages for Europe with incoming supply of labor. IncreasingWages & wages for skilled labor.Labor India: Lower wages but growing at a very fast rate. Compeition for skilled labor. Poland: Least feeble in Eastern Europe. We expect liberalization policy will continue under the current and next administration, the chief driver beingPolitical integration into EU.Environment India: The results election are difficult to predict; Concessions made to the Communist and Regional parties could have substantial detrimental impacts by creating stricter labor regulations and a pro-union bias.OverallII. Background
  3. 3. BioCo, a biopharmaceutical drug developer, has just received FDA approval to sell a new Hepatitis B drug, HepCure, in the United States. Based on on-going positive efficacy studies versus major competitors and looming approval in the EU, BioCo expects production requirements to grow drastically over the next 10 years and is looking to build a manufacturing plant in the developing world to be the primary worldwide supplier in meeting this future need. BioCo decided to produce in a developing country as opposed to a developed country in order to take advantage of lower production costs relative to competitors. The management of BioCo believes this cost savings will be a significant source of competitive advantage in the future as new products are brought to market and the profit margins on future drugs declined due to increased competition from generic drug makers. BioCo has narrowed its decision down to two countries in which to build its new production plant: Poland and India.III. Important Short Run Economic Factors a. Fiscal Policy - Government spending and taxation: Poland Fiscal policy is expected to tighten in Poland in order to meet criterion for joining the EuroZone. In 2008, Poland ran a current-account deficit of 5.4% as a percentage of GDP. Analysts project the deficit spending to decrease to 3.7% of GDP by 2013. The trend towards decreased deficit spending may dampen overall economic growth as shown by a decrease in expected real GDP growth. Source: http://www.economist.com/countries/Poland/profile.cfm?folder=Profile-Economic%20Data In looking to build a manufacturing production facility, the decrease in government spending should be beneficial as it will help keep inflation down and should free up resources in the labor pool. As BioCo anticipates hedging the costs required to build the production facility, no, or little, adverse effects should be felt from the potential appreciation in the Zlotty over the next few years.
  4. 4. Poland seems to be moving towards a flat tax with an end goal of harmonizing personal income taxes(PIT) with the corporate tax rate of 18%. Reducing taxes should help to spur growth by providingconsumers with more disposable income. As the decrease in taxes is accompanied by a decrease indeficit spending, the shift in dollars from the government to its citizens should help employ capitalmore effectively. The decrease in taxes should also hopefully entice more workers to enter the laborpool, which should drive competition.Overall, as the on-going costs of operating a manufacturing plant are minimal compared to the initialbuild-out increases in the standard of living and the associated wage increases do not have a hugeimpact on the decision to build the plant in Poland. HepCure will initially be patent protected so willhave high margins. Accordingly, a 20-30% increase in real incomes would not have a significant impacton profitability. As the patents on HepCure expire in 10-15 years, BioCo will need to consider how toutilize the Polish plant and if it makes sense to outsource development of HepCure if costs in Polandare too high.IndiaIn response to the financial crisis, the Indian government has made major tax cuts and taken on a largeamount of debt in order to fund stimulus and other packages. This brought the deficit level from thecurrent 3.17% of GDP in 2007-2008 to its current rate of 12% of GDP. In February of 2009, Standard &Poor cited this large deficit when they warned of the possibility of future downgrades to India’s creditrating, an event that would drop them below their current BBB rating and into the junk ratings.(Srivastava 2009)Source: http://www.economist.com/countries/India/profile.cfm?folder=Profile-Economic%20DataAmong India’s tax cuts is a 4% cut to the central value added tax (CENVAT) that would benefit BioCoduring the construction of the plant by reducing the cost of steel and other materials costs.(Fabrication 2009)b. Monetary Policy – Inflation and Interest Rates:PolandInflation in Poland has risen recently from 1% in 2006 to 4% in 2008 to the mid-3% range thus far in2009. The rise is due to strong GDP growth and an increase in food and energy prices as the Zlotydepreciated against the Euro. An increase in the inflation rate has several short-term implications. Ifthe National Bank of Poland, NBP, is not able to bring inflation down to the 2.5% target, the pricestability required to join the EU may not be attained. An inability to join the EU means that Polandwould not adopt the Euro or may delay adopting the Euro.
  5. 5. Should Poland fail to adopt the Euro, BioCo will not have a natural hedge against expenses incurred inPoland following plant completion. Exposure to this currency risk may have significant implicationsshould the Zlotty appreciate significantly against the Euro (where revenues will be raised). Based onthe historical performance of the Zlotty, BioCo does not expect that the Zlotty would appreciatesignificantly against the Euro without adopting as it is the stated intent of the Polish government tojoin the EuroZone and have a stable currency.In order to keep inflation in check, the NBP will need to adjust interest rates to contract the moneysupply. The rise in interest rates will make the cost of borrowing higher; however, as themanufacturing plant is being funded through monies raised in the US, BioCo does not expect andincrease in the costs of the initial build-out from the tightening of monetary policy. Indeed, the hedgesthat will be in place to cover the initial costs of the plant build-out should protect BioCo from anyadverse interest rate costs. After plant completion, Poland should be on the Euro and BioCo will besubject to the Euro versus dollar variance in FX rates.India The banking sector in India is largely government owned and subject to a number of lending requirements that prevent it from operating efficiently and servicing the capital needs of the market. To assist with alternate funding, the government has taken a number of steps since 2000 to open the capital account and allow foreign investment. Asthe Indian economy grew at accelerated rates in the mid-late 2000’s, large capital inflows occurred asforeign investors channeled money into the Indian economy. Most of these inflows have come in theform of external commercial borrowing (ECB) and portfolio investment due to the increasedliberalization of these flows versus foreign direct investment, which is more of a politically difficultarea. (Economist 2008)
  6. 6. Since 1991, India has maintained a managed float policy for the Rupee. The large inflows have putupwards pressure on the Rupee and have led to a series of interventions by the Reserve Bank of India(RBI) in an attempt to keep the Rupee from appreciating significantly against the dollar. Foreignexchange reserves grew at a rapid pace to a peak of approximately $315 billion in May of 2008. Thepartially sterilized interventions by the RBI had also resulted in an increased money supply andinflationary pressure, despite their attempt to actively withdraw liquidity from the market. Otherinflationary factors such as high energy costs had added to this pressure and created significantconsumer price inflation in spite of the high interest rates set by the RBI.In 2009, the global financial crisis caused the RBI to switch gears and intervene to buffer the fallingRupee. Foreign currency reserves fell $65 billion to their current level of approximately $250 billion asthe RBI attempted to remove excess Rupees from the market. Consumer price inflation has alsoeased and the wholesale price index is currently in a deflationary state.HedgingIn order to offset currency risk during the plant build-out phase, BioCo should enter into a foreigncurrency hedge against the Zloty if building in Poland or the Rupee if in India. The expenditurerequired to build a Biotech manufacturing plant is significant, $500M. The plant will also take 4 yearsto build. As funding is being raised in USD, BioCo has significant exposure should the dollar devalueagainst the host currency over the next 4 years. Indeed, with the US running record trade deficits andPoland looking to return to lower target inflation levels or India’s high growth rates, a depreciatingdollar is a strong possibility.As BioCo will likely have to commit to building the plant before payment is made, significantappreciation in the host currency could require BioCo to require greater USD to convert the hostequivalent. The downside of this risk is that BioCo might not have enough funds to complete theproject should the costs go beyond what had been initially raised. The upside, without hedging, is thatif the host currency depreciates, BioCo could end up in an advantageous position where fewer dollarsare needed to complete the manufacturing plant. As the downside, not completing the project, faroutweighs the upside, gain on currency conversion, BioCo should enter into an options contract orhedge in order to minimize risk and ensure sufficient funds are available for project completion. Theeconomic loss that goes to the middlemen in a hedge or options contract, while inefficient in terms ofmaximizing expected profits, acts as a kind of insurance ensuring adequate funding for the project. AsBioCo’s expertise is in Biotechnology drugs and not currency trading, the hedge reduces uncertaintyand allows BioCo to focus on their core competencies.After the plant is complete, BioCo should not hedge revenue from product sales. Hedging productsales will reduce the overall expected return by incurring costs related to the transactionintermediary. Indeed as BioCo does not have any particular expertise in foreign currency markets,hedging may lead to unfavorable situations. One advantage for Poland is its anticipated adoption ofthe Euro (2012-2015). After this transition, expenses in Europe will act as a natural hedge against
  7. 7. revenue from selling HepCure. This natural hedge will reduce currency exposure if the plant isestablished in Poland.c. Trade Policies:BioCo’s aim is to infiltrate the European market with HepCure, which will be greatly impacted by theshort run trade policies of the country in which the production facility resides. Protectionism, tariffs,patent-protection, and even quality control are all important elements to consider in determiningcompetitive advantages between Poland and India.PolandAs a member of the European Union, Poland follows the same trade policy as other EU memberstates. Its territory is part of the “European Union Customs Area” and, as such, trades with other EUmember states are considered “intra-Community” supplies and purchases rather than imports andexports. In accordance to the Single European Market principle, all EU-compliant goods manufacturedin a member state may be freely marketed to any other member state. However, some member statesmay impose safety standards and other requirements that exceed those of the European Union. Boththe European Union Council and the European Commission set the common trade policies and the EUCommission alone enforces it. According to the World Trade Organization (WTO), the EU Commissionhas an excellent record implementing and enforcing trade policies, including those surrounding anti-dumping, anti-subsidy, and safeguard proceedings.To see where EU’s Intra-Community trade policies will go in the future, one must look at the past. Akey ingredient for the successful creation of the EU was the harmonious integration of economic andpolitical entities from its member states. This was accomplished by constructing a single market inwhich a set of common laws applies. These laws guarantee the freedom of movement of people,goods, services, and capital. There is little indication Intra-Community trade policies will change in theShort Run for the following reasons. First, history has shown policies related to trade among memberstates had been largely unchanged. The basic premise of guaranteeing freedom of movement forpeople, services, and goods continue to be the core of the policy. In fact, the changes that did takeplace were designed to make Intra-Community trades more efficient and less costly (for example, theelimination of customs borders between EU members). Second, as the EU continues to grow inmembership, the benefits of becoming a EU member state continues to serve as incentives foreconomic reforms for countries trying to fulfill accession requirements. As a measure to maintainpolitical and economic stability in the region, the benefits of becoming a member state must stayattractive and largely the same for “would-be” members, discouraging drastic economic policychanges. Lastly, changing Intra-Community trade policies will not only create economic disruption for
  8. 8. existing member states, it will also create political disruption in the region. Political powers from thevarious member states have vested interest to keep political and economic relationships strong. To dothis, they must maintain Intra-Community trade policies that are largely the same as they are today.This projection provides a very favorable outlook for a Poland based facility. Since HepCure’sdestination market is the EU, if BioCo were to set up a manufacturing facility in Poland, a zero-ratedVAT would translate to lower prices for the consumers and higher profits for the firm. BioCo will alsoenjoy many Intra-Community trade benefits set out by the EU Commission. This includes theabolishment of Border Customs, market access to all EU member states (given HepCure passes allrequired safety test), and many common trade laws and standards. To ensure BioCo can reap themaximum amount of benefits from being in a EU state, management is advised that all of the firm’sbusiness practices, including compensation scale, safety standards, and testing procedures meet orexceed those from the EU Commission and its target member states. It is also advisable to purchasesupplies and equipment from other EU member states as a cost saving measure to minimize VAT –given the savings from zero-rated VAT exceeds the difference in price.IndiaUp until 1992, Indian trade policy was extremely protectionist, but since then it hasunilaterally lowered tariffs, removed import controls and liberalized some of its servicesectors. Over the 1990-2005 period, India cut its tariffs from an average of about 80% to 17%.India’s export-to-GDP ratio, now near 20%, has tripled since 1990. In India, the mainlegislation concerning foreign trade is the Foreign Trade (Development and Regulation) Act,1992. The Act provides for the development and regulation of foreign trade. The “Ministry ofCommerce and Industry” has been set up as the most important organ concerned with thepromotion and regulation of foreign trade in India. With economic reforms in the recentyears, globalization of the Indian economy has been the guiding factor in formulating thetrade policies.Specific to India’s trade policy with the EU, since June 2007 there has been an ongoingnegotiations for a free trade agreement between India and the EU. Currently the EU isalready India’s largest trade partner and with India’s rapidly expanding role in the worldeconomy, the free trade agreement would make it important for the EU. However theongoing negotiations have not shown sign of conclusion and as of the latest status report onMarch 2009, it shows that the prospect of the two nations coming to an agreement is stilllong in waiting. The EU desires much deeper liberalization than India’s proposals, especiallyin sectors such as services, investments and banking. Although the benefits of a FTA for thetwo nations are difficult to measure at this time, it would be important for BioCo to pay closeattention to the development of the negotiations.
  9. 9. In term of India’s trade policies regarding pharmaceutical products, the most significanthistorical policy change affecting the pharmaceutical industry was the 1994 TRIPs (trade-related intellectual property rights) agreement, by which India finally started to recognizeproduct patents issued after 1995. The protective legal environment makes India an attractivesite for preclinical research activities and clinical trials, because discoveries made in India canthen be protected by patents globally. More recently in July 2008, the PharmaceuticalsExport Promotion Council(Pharmexcil), which represents major pharmaceutical companies inIndia, proposed the establishment of a registration office in Brussels for pharmaceuticalscompanies that want to market their products in Europe. This was supposed to be a step tostrengthen Indian pharmaceutical exports. Unfortunately around the same time Pakistanigovernment blocked the proposal to import around 400 drugs from India due to qualityissues. Other negative developments for Indian exports around the same timeframe includethe recent spate of accusations of sub-standard manufacturing by the US FDA, leveled againstIndian pharmaceutical facilities.Overall, although Indian government is considered conservative, when it comes to tradepolicies, it is doing what it can to help the exporting sector. The more recent interim policyannounced several additional trade-facilitation measures and procedural simplificationsaimed at reducing transactions costs and delays. We can deem India’s trade policy favorablefor BioCo’s new establishment and it is unlikely for any drastic changes in the near terms.Nevertheless BioCo needs to ensure its quality standard in compliance to all Europeanregulations and not just that of India’s and be extremely cautious for any bad PR and qualityissues of other Indian pharmaceutical plants that can potentially impact the entire Indiapharmaceutical export.d. Wages and Labor:PolandThe average annual salary of a product manager in Poland is $35,000, according toPayScale.com. Only a few years ago this average was closer to $20,000; however, whenPoland joined the EU in 2004 two occurrences resulted: first, hundreds of thousands ofworkers left the country in search of higher paying wages in Germany, England, and Ireland;and second, hundreds of European companies flooded Poland in search of cheap labor. Theconsequence has been a shortage of skilled labor and therefore a dramatic increase in wagesover the last five years.The recent economic downturn has actually begun to reverse Poland’s labor shortage sincePoland is one of the only European countries with an economy expected to continue to growdespite the downturn. This has created a reverse exodus of workers. In fact, a recent poll inIreland showed a third of that countrys estimated 200,000 Polish immigrants plan to leaveIreland within a year, many to go home. This has resulted in a about a 1% decrease in overallwages for both January and February of 2009, according to data released by the CentralStatistical Office of Poland. However, the same data suggests that corporate wages haveremained steady and are expected to reach 5% growth in March. This finding suggests that
  10. 10. unskilled labor wages will maintain or even decrease, but that there is still a shortage anddemand of skilled labor.Unemployment in Poland edged up to 10.9 percent in February, according to labor ministrydata, up from around 9 percent in 2008 but still only about half the level seen as recently as2004.Poland clearly has a history of drastic fluctuations and recent increases in wages. The upsideis that the poor economy in the rest of Europe along with the subsequent influx of laborsuggests that wages for unskilled labor will not increase –and may even decrease - for thenext several years. The downside, however, is that the cost of skilled labor, such as chemists,attorneys, and managers, will continue to rise at an estimated 5% per year and that Poland’shealthy economy in a poor world economy will cause a greater demand for such labor.IndiaThe average annual salary of a product manager in India is $16,000, according toPayScale.com. Additionally, India is expected to see the highest salary increases amongnations in the Asia-Pacific region, of around 10.8 percent this year, due to the huge demandfor talent in the country, despite the global economic crisis severely impacting overall wageincrements in the region. This wage increase is expected to continue at a similar rate for thenext five years.Much of the increase is due to what many economists consider to be a saturation ofcompanies in India. The attractive low wages, infinite unskilled labor force, and growingskilled labor force has caused thousands of companies to establish production or servicefacilities in the country and has therefore created a demand for such labor.The upside to establishing a plant in India is that average wages are still low on the worldscale (and nearly half as much as Poland) and will continue to be relatively low over the nextseveral years. The downside is that wages are continuing to grow at a rapid pace and mayeven escalate at a higher rate due to increased labor demand. Also, recruitment couldbecome a major obstacle doe to the saturation of companies.e. Political Forces:The political environment in India as well as Poland will have a huge impact on businessadvantages in the country. Specifically, the government’s policies towards unions, corruption,and stability are the main driving forces of competitive advantage. Many decisions taken bythe present as well as future governments could have material impact on Bio-Co’s investmentin these 2 countries. Hence, understanding the political forces within India and Poland in theshort run is important to our decision-making.Poland
  11. 11. Poland’s current government is a coalition between the centre-right Civic Platform (PO) andthe small Polish Peasants Party (PSL). Together, they command a safe parliamentary majority,and as such offers good prospects for political stability, at least in the short term.Upside:The PO-PSL government has adopted a more liberal approach to economic policy thanprevious administrations. They have also shown interest in trying to rebuild relations withGermany, which deteriorated sharply under the previous administration. Improved relationswill likely be more beneficial to Poland and its markets. The crisis in Georgia in 2008 as well asthe recent gas dispute between Russia and Ukraine is also likely to lead to an even closersecurity relationship with the US, which may mean more political stability within the country,and clout in the region.Downside:Tensions between the PO and the more statist PSL are starting to appear, and growing, andthe coalition may not survive to the end of the parliamentary term in 2011. Allegations ofnepotism and unethical behavior have created rifts within the government at a time ofgrowing tension between the two coalition partners. Recently, the PSL has been demandingspecial treatment for its supporters, which is one reason for the strain between the two.While controlled for now, they are nevertheless likely to increase over time.The current government is considered soft on corruption, and give-and-take is expected toget things done. This can mean additional bureaucratic hurdles within the govt. structures aswe seek the necessary permits to setup the Bio-Co plant. In addition, the coalition is not ableto overturn any presidential vetoes without the support of the centre-left opposition parties.This limits its ability to make radical changes in economic policy.Finally, Poland’s alignment with US interests however will likely lead to tensions with Russia.This may impact Bio-Co’s distribution capabilities within Russia if it arm-twists Poland withrestrictive trade policies.Overall Impact:Poland’s government is probably the least feeble in Eastern Europe. It does not have to copewith either a collapsing property bubble or a highly leveraged financial system. Neither the POnor the PSL appear to have any wish to see the coalition break up. However, given theircompeting agendas, the coalition is on shaky grounds. Tensions between the PO and themore statist PSL are likely to rise over the short run period, and the coalition may not surviveto the end of the parliamentary term in 2011. We are unable to forecast what impact the nextgovernment (if this one falls) will have, and the policies they will lean towards. However, wedo expect that the liberalization policy that has benefited Poland will continue under this andthe next administration, the chief driver being Poland’s need to integrate within the EU.India
  12. 12. India is electing a new government as this report is being written. Elections are being held forthe Indian parliament in a five phase election starting on the April 16th with the last phaseending on May 13th 2009. The results of the election are expected to be announced on May16th, 2009.In the recent years India has moved towards politics of coalitions with no party able to gainabsolute majority and parties horse-trading and cobbling together a government dependenton many parties, each tugging the government in a different direction.Upside:If the UPA government headed by the Congress party or the NDA coalition headed by the BJPparty is able to win an absolute majority we can expect rapid movement on the liberalizationfront which will reduce protectionism and provide conditions more favorable to foreigninvestment.Downside:If neither UPA nor the NDA is able to gain an absolute majority, both parties are expected tomake concessions to either the Communist parties or the Regional parties. The Communistparties are expected to stress on labor rights and unions while the Regional parties areexpected to make the government look inward and promote protectionism and oppose rapidchange. If the communist parties do retain some power then they may reduce some of thetax benefits for Bio-tech industry and SEZs which may materially impact the attractiveness ofIndia as a destination.Overall Impact:The results of the election are difficult to predict; however, the outcome will greatlydetermine the competitive advantages in India’s political environment. Concessions made tothe Communist and Regional parties could have substantial detrimental impacts by creatingstricter labor regulations and a pro-union bias.
  13. 13. The Economist, Reform needed, 6 Nov 2008. 4 May 2009<http://www.economist.com/displayStory.cfm?story_id=12581192>Hume, Richter, Indias Record-High Capital Inflows Pose Policy Challenge, 4 Feb 2008, 4May 2009 <http://www.imf.org/external/pubs/ft/survey/so/2008/CAR02408A.htm>Srivastava, Mehul, Indias Deficit Threatens Junk Rating. 25 Feb 2009, 4 May 2009,<http://www.businessweek.com/globalbiz/content/feb2009/gb20090225_145994.htm>Fabricating & Metalworking, As Steel Prices Drop, India Slashes CVA Tax Rate by 4 percent;Outlook Slightly Positive for 2009, 5 May 2009, 5 May 2009,<http://www.fandmmag.com/web/online/Industry-News/As-Steel-Prices-Drop--India-Slashes-CVA-Tax-Rate-by-4-percent-Outlook-Slightly-Positive-for-2009/1$2797>Poland - Your business partner<http://washington.trade.gov.pl/en/doingbusinesspoland/article/detail,322,POLAND_YOUR_BUSINESS_PARTNER.html>The Economist - Country Briefings - Economic Data<http://www.economist.com/countries/Poland/profile.cfm?folder=Profile-Economic%20Data>The Economist - Country Briefings - Political Forces<http://www.economist.com/countries/Poland/profile.cfm?folder=Profile-Political%20Forces>"Trade - Foreign Tradie Policy"<http://business.gov.in/trade/foreign_trade.php>"Indias Trade Policy Choice2008"http://www.carnegieendowment.org/files/indias_trade_policy_choices_final.pdf"India Pharmaceuticals & Healthcare Report Q1 2009"<http://www.researchandmarkets.com/reports/696354/india_pharmaceuticals_and_healthcare_report_q1>"Position Paper - EU Trade Policy with India Feb. 2008"<http://www.bdi-online.de/download/India.pdf>

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