A law allowing greater foreign investment in Japanese companies is fueling a merger mania in that country's pharmaceutical industry.

In April, Astellas Pharma will be created by a merger of Yamanouchi Pharmaceutical and Fujisawa Pharmaceutical, which will surpass Takeda Pharmaceutical, currently Japan's largest in terms of sales. This will be followed in October by the just-announced merger of Sankyo, the country's second-largest drug maker, and Daiichi Pharmaceutical, the sixth-largest. A third megamerger between Dainippon Pharmaceutical and Sumitomo Pharmaceutical is also set for October.

Driving the mergers is legislation slated to take effect in 2006 that will allow mergers and acquisitions based on share swaps with foreign companies. With drug development costs steep and the government continuously cutting prescription prices, the pharmaceuticals see themselves as vulnerable to a takeover.

Further, Japanese pharmaceuticals believe they need to allocate approximately $955 million for research and development to compete effectively with U.S. pharmaceuticals. Sankyo spends about $860 million, while Daiichi spends almost $573 million. Combined, their total expenditures would exceed the mark, while consolidated revenues would be around $8.7 billion for the year ended in March 2004, superseding the soon-to-be-created Astella's projected $8.1 billion. Takeda had sales of $9.5 billion for the same period.

Still, these companies are dwarfed by the U.S. pharmas. By comparison, Pfizer (NYSE:PFE), the world's biggest drugmaker with a market cap of $202 billion, is four times the size of Takeda, and it spends $7.1 billion on R&D. There are no giants in the Japanese pharmaceutical industry, and the players are, in fact, seen as cheap with the mergers part of a conscious effort by industry leaders and the government to make them less attractive. Japanese pharmas have often been viewed as takeover candidates for the likes of Pfizer or GlaxoSmithKline (NYSE:GSK), a condition that makes their CEOs nervous.

The immediate effect of the merger announcement was to fuel additional speculation on who might be next. Stocks of companies seen as particularly interesting, including Eisai, Mitsubishi Pharma, and Shionogi, all jumped more than 2%, while Japan's Nikkei average rose by more than 1% on the news before being knocked down by technology sector stocks.

Yet Japan wasn't the only country seeing merger activity. Swiss-based Novartis (NYSE:NVS) agreed to buy Germany's Hexal, as well as its U.S.-based Eon Labs (NASDAQ:ELAB), for around $7.4 billion, while French pharma Sanofi-Aventis (NYSE:SNY) and Israeli Teva (NASDAQ:TEVA) were touted as possible buyers of Stada Arzneimittel, another German pharmaceutical.

As patents expire on blockbuster drugs, and costs for creating new ones continue to spiral, look for the large pharmas to keep on buying up smaller ones with rich pipelines. It's a faster, more cost-effective road to growth.

Fool contributor Rich Duprey would like a rich pipeline flowing with Coors Light. He owns shares in Eisai but does not own any of the other stocks mentioned in the article.