When two of the world’s biggest pharmaceutical companies announced a tie-up in Japan, the country’s $78 billion drug industry took note.

In November, the country’s largest drugmaker, Takeda Pharmaceutical Co., said it’d separate its off-patent products and share its extensive Japanese distribution network with Israel’s Teva Pharmaceutical Industries Ltd., the world’s largest seller of generic medicines. Their goal: to gain an edge as Japan’s government seeks to lower costs for its national health-care program by encouraging the use of generics, which are cheaper.

The government’s push is reshaping what was once one of the world’s most lucrative drug markets, where favorable policies have for years aided the sales of international pharmaceutical brands such as AstraZeneca Plc, Roche Holding Ag and Novartis AG. But an aging population and a massive government debt burden now has Prime Minister Shinzo Abe’s government insisting on price cuts on branded drugs and pushing for a speedier transition to generics. The shift began about two years ago, and recently the government has been targeting price reductions with more frequency.

“Nobody imagined that this radical change could happen here,” said Masato Iwasaki, who heads up Takeda’s domestic business unit, in a Tokyo interview. “Everybody had believed the market would continue growing, but now government pressure is changing the focus.”

Huge Opportunity

The government has said that in the next few years it would like to see generics make up about 80 percent of prescriptions in Japan from about 50 percent now. That’s bad news for makers of branded pharmaceuticals, especially those that are off-patent. Meanwhile, the generics industry -- forecast to grow at 10 percent annually by some estimates -- is turning into a rare bright spot.

Sanjeev Kumar, a consultant at market research firm Frost & Sullivan predicts more consolidation in Japan as small and mid-size companies seek to become more competitive and big international firms make deals to get a better foothold in generics.

“The Takeda-Teva deal took people by surprise, and is one that could be a trendsetter in gaining more acceptability for similar deals," Kumar said. “I don’t think any companies -- including domestic players -- can ignore this in any way.”

For example, Indian generics companies like Sun Pharmaceutical Industries Ltd., Dr. Reddy’s Laboratories Ltd. and Lupin Ltd. – long known for being cost competitive – could seek to acquire mid-sized Japanese companies to gain a foothold, Kumar said. Several international companies, including AstraZeneca, Roche and Novartis derive between 6 to 9 percent of their total revenue from the Japanese market, according torecent earnings reports.

Drug spending in Japan, where the population is declining, is likely to rise by 3 to 4 percent over the next five years – the lowest increase of any developed market, according to a November report from the IMS Institute of Healthcare Informatics. In addition, sales tax increases that are expected in the next few years could offset the expected expansion and result in a "zero growth scenario" in those years, it said.

Health Efficiency

Japan has long been ranked one of the most efficient health systems in the world when measuring life expectancy versus per capita cost of care. The government’s national program covers a large portion of health-care costs. Its pharmaceutical industry is huge. While China has ten times the population of Japan, in 2015 the size of the Japanese drug market was $78.3 billion compared with China’s $115.2 billion, according to IMS.

For years, price was not a big factor in the Japanese pharma market as the national health-care system absorbed costs, one reason why the penetration of generics was much lower than other economies. It was also skewed towards domestic players like Takeda. “The burden on the government will reduce drastically,” said Frost’s Kumar about the efforts to lower prices.

Almost all Japanese pharma companies need to take care in such an environment, as “almost all face these difficulties,” said Iwasaki. The 30-year-old Takeda veteran spearheaded the search for a generics partner after the government’s changes and helped the company settle on Teva as the "best partner."

Teva will hold 51 percent of the companies’ joint venture, while Takeda will hold the rest. Sales from the off-patent products to be transferred to the new company were about 125 billion yen ($1.1 billion) in the 2014 fiscal year -- or about 7 percent of Takeda’s global revenue. The products include its treatments for hypertension, peptic ulcers and diabetes, the company announced in December, adding that those sales have continued to decline due to the push for generics.

In interviews, Takeda executives said the venture into the generics market was restricted to Japan due to market conditions there. Globally, the focus will remain on innovative drugs.

Given Japan’s battles with costs and aging, the government’s attempts are a “welcome model,” said Mark Britnell, London-based chairman of KPMG’s global health practice, who’s written a book on health systems. “Any country which tries to thumb its nose at the development of generics is a country that is going to look very foolish in the future.”