By Minxin Pei
FORTUNE -- "If you walk along the river often," the Chinese are fond of saying, "you cannot avoid getting your shoes wet." This aphorism refers to the difficulty of staying clean in a corrupt culture. GlaxoSmithKline (GSK), the Western pharmaceutical giant recently accused by the Chinese government of engaging in a massive bribery scheme in the country, seems to have fallen headlong into the dirty water.
Of course, at this stage, we are hearing only one side of the story -- the allegations against GSK by the Chinese police. So it would be prudent to withhold judgment on this specific case.
Nevertheless, the allegations against GSK raise two important challenges for Western multinationals eager to take advantage of China's fast-growing consumer market. The first one is how to survive in an environment with unclear rules, anti-market government policies, and local competitors habitually engaging in unethical or outright corrupt practices. The second one is how to ward off protectionist measures once you become successful and gain a significant share of the Chinese market.
As for the first question, GSK has the good fortune of being in the right business (there's significant demand for Western pharmaceuticals in China) but the bad luck of having to work in a health care system with a dysfunctional financial model that forces honest people to be crooks. Judging by the numbers, the Chinese health care sector, a roughly $400 billion market expected to reach $1 trillion by 2020, is one no Western pharmaceutical firm can afford to ignore. Sales of pharmaceutical products in China in 2012 reached $82 billion, including roughly $10 billion of which were imported drugs. Western pharmaceutical firms, which also have over 1,500 joint ventures in China, have gained enormous market share with both imports and locally manufactured drugs. In most large cities, they account for 60-65% of the sales.
Unfortunately, Western pharmaceutical firms must live with the dark side of the health care industry in China. Unique in the world, the Chinese government has opted for a financing model that relies on high drug prices to subsidize health care. There are three income streams for public hospitals: government appropriations, medical services, and prescription drugs. The government provides only 10% of the budget of Chinese public hospitals. To make health care accessible, the government keeps the prices of medical services very low. Hospitals lose money providing such services. To keep hospitals afloat, Beijing allows them to charge high prices on prescription drugs. As a result, income from prescription drugs accounts for 40-50% of a public hospital's income in the cities and a much higher percentage in the countryside.
This financial model pushes up health care costs (through excessive prescriptions) and encourages corruption. To get a piece of the lucrative market, pharmaceutical firms have resorted to bribing doctors to prescribe their products. GSK, which is apparently subject to more strict internal rules, opted to travel a tortuous route, according to China's allegations: holding fictitious conferences that reimburse doctors' non-existent travel expenses.
GSK, with its checkered history of corruption scandals, seems to deserve little sympathy. However, given the pervasive corruption in Chinese society and the irrational health care financing model, GSK -- along with other Western pharmaceutical firms -- may have little choice but to dip into murky waters – unless they stay far away from the proverbial river of profits of China's burgeoning health care market.
For most Western firms, the second issue raised by the GSK case is far more relevant and alarming. The way Chinese authorities are cracking down on widespread corruption in the pharmaceutical industry suggests that they are selecting their targets discriminatively and may have a protectionist agenda. GSK may have committed bribery in China, but so have its Chinese competitors, many of whom perpetuate even more brazen forms of bribery. But why is Beijing only singling out GSK, a dominant Western firm in the sector?
If we look at how well Western firms have fared in China once they have gained significant market share, we may detect a worrisome pattern. They face unfair scrutiny from Chinese authorities and are often penalized for the same infractions for which their Chinese competitors suffer no consequences.
The most recent example of this pattern is the Chinese government's anti-trust investigation of Western baby formula makers like Wyeth and Nestle in China. Tainted baby formula made by Chinese dairy firms has destroyed these Chinese company's brands and sales, allowing Western baby formula makers to claim a huge market share. What's the reaction of Beijing? Instead of enforcing tighter food safety rules on Chinese baby formula makers, they are attempting to hurt Western firms. The victims will be Chinese babies denied safe nutrition.
Also consider Yum Brands (YUM), which runs the wildly popular KFC franchise in China. A few months ago, KFC sales in China plummeted after press allegations of the use of antibiotics in the chickens it sold. KFC's Chinese competitors, which adhere to less rigorous food safety standards, were spared.
If there is one valuable lesson to be drawn from the unfolding GSK corruption scandal in China, it is that Western multinationals ought to increase the risk premium for doing business in China and have careful plans in place for managing both routine risks and crises, lest they fall into a river of business muck.
Minxin Pei is the Tom and Margot Pritzker '72 Professor of Government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Fund of the United States
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