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STRATEGY

How to Stop Intellectual Property Theft in China

America's most innovative industries are being robbed every day on the floors of Chinese factories. Here's how to make it stop.
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William J. Jones has money worries. Of course, all CEOs worry about money, and as chairman of Cummins-Allison, a business that's been in his family for three generations, Jones frets about keeping his customers, paying his 1,000 employees, and financing his company's plans to keep growing. But Jones also worries about money itself, the physical stuff you hold in your wallet or let jingle in your pocket. He worries about how to tell the real stuff from a profusion of fakes, and he wonders whether his customers are using the best ways to check and count the money they collect. He worries that the United States isn't doing enough to ensure that the money that runs our economy is secure from the machinations of rogue foreign governments and crime rings that work every day to undermine the integrity of the dollar with counterfeits. Cummins-Allison is America's only domestic producer of advanced currency processing machines. These are the machines deployed by banks, casinos, big retailers, and the U.S. government to count and verify currency. Jones believes, with reason, that his company makes the most advanced currency processing machinery in the world, and he sees his primary job as making certain that Cummins-Allison has the culture of innovation to keep its lead.

And therein lies Jones's biggest money worry of all. Every day the company sees evidence that its competitors around the world will go to nearly any length to copy or to finagle a transfer (that is, a theft) of its core technologies. "Cummins survives," says Jones, a lean, scholarly man of 49, "by protecting our intellectual property." Jones knows he's not alone in his worries; his peers in every manufacturing sector feel the same pressure. Jones fears that America's weak efforts in taking on the world's intellectual property pirates will, over time, gut the American economy.

Jones wasn't able to make it the first time we were to meet. That was in Beverly Hills late last year at Senator Tom Coburn's hearings on China's intellectual property practices. I was invited because of the arguments I made regarding the IP issue in my book China, Inc. Coburn was interested in hearing what I had learned since the book was published last year. I went to Beverly Hills to say that the problem is one of the most serious challenges to American competitiveness and is growing worse.

The World of No-Cost Competitors

Beverly Hills had the honor of hosting the hearings because to date the entertainment industry has been the most outspoken critic of China's policies. Dan Glickman, CEO of the Motion Picture Association of America, reported to the committee that for all its success around the world, America's entertainment industry makes almost no money in China. He noted that nearly any movie available in U.S. theaters and video rental shops is for sale on pirated DVDs in China. Glickman and other witnesses offered a sobering picture. Much of American industry has seen its trademarked, patented, copyrighted, and otherwise proprietary products get copied in China. Globally, the trade in pirated and counterfeit goods rakes in more than $500 billion annually. Chinese factories are responsible for as much as 70 percent of the world production of bogus goods.

Word was that William Jones had some chilling tales. Candor in this area is unusual; public silence is the preferred stance of most companies that have problems preserving the integrity of their intellectual property. In preparing for the Beverly Hills hearing, I talked with an executive at the Society of the Plastics Industry, a trade organization whose members tend to be smaller, owner-run firms. This executive told me that one of the group's members was recently negotiating in China with a potential partner. The Chinese partner simply refused to offer any assurances that the American company's proprietary goods and methods would be safe. When I asked for the name of the aggrieved American company, I was told it would be too dangerous to the company to have its name mentioned at the hearings. The perception is that complaining loudly about anything that pertains to the Chinese government will lead to penalties, overt or otherwise, that will place companies at a disadvantage in present or future dealings with China. Jones was willing to be a lone voice because he had concluded Cummins-Allison was better served by staying out of the Chinese market. There is a price to his advocacy, however: displeasure among the significant number of American executives who believe public criticism of China hurts American business interests broadly and helps more accommodating foreign competitors gain favor with Chinese officials.

China's telecom giant, Huawei Technologies, grew into a multibillion-dollar competitor by stealing technology as its rivals stood by outraged and helpless.

Jones would have been at the Beverly Hills affair, except that he was stuck in Texas at a hearing for a suit Cummins had brought against an alleged Japanese infringer. (The Japanese company settled for $20 million.) His absence in Beverly Hills left the spotlight on the entertainment industry. Its concerns are legitimate and merit action, but the harm it suffers is but a small part of the damage being done to the American economy. The true harm comes not from Chinese consumers buying cheap entertainment but from Chinese companies acquiring world-class technology at little or no cost and then, once enriched, going head-to-head with foreign competitors that remain saddled with paying the legitimate cost of technology. China's telecommunications giant, for example, Huawei Technologies, grew into a multibillion-dollar competitor by stealing the technology of advanced rivals, which stood by outraged and helpless. Huawei has never admitted anything, but when it reached a certain size it began settling with those rivals--it settled with Cisco Systems when it decided to open shop in the U.S. American telecoms compete with Huawei all over the world today.

IP theft also serves to throw up a trade barrier. How many companies avoid the Chinese market because they fear they could lose their most valuable assets, their intellectual property? That fear prevents American businesses from wading into the world's fastest growing economy with valuable products they would otherwise be enthusiastic about selling.

I had been asserting these arguments around the country, based on what I had witnessed inside Chinese factories and been told, in confidence, while meeting with business groups all over the world. But Jones was willing to put meat on the argument. So, if he couldn't make the hearing, I thought I could at least meet him at his company headquarters in Mount Prospect, Illinois. I was greeted in the company's conference room on a bright, warm winter day. Cummins is growing, adding buildings and employees at a rapid pace to serve its growing base of bank and casino customers. Its new quarters in a business park are still sparely decorated, though the company proudly displays framed notes from U.S. and foreign dignitaries thanking Cummins for its help in defending the integrity of money. The Jones family began manufacturing in a patriotic gesture. Franklin Roosevelt personally beseeched William Jones's grandfather, then the owner of one of the first businesses to provide automobile financing, to enter manufacturing in aid to the U.S. war effort against the Axis powers, and framed souvenirs and testimonials to the family's patriotism are spread throughout the office. The room we met in was full of them. Jones entered with a folder containing the testimony he would have given in Beverly Hills.

Theft as a Matter of Industrial Policy

"I am not mad at China," Jones began, "I'm mad at our own government for making bad trade agreements." The essence of Jones's complaint is that when the U.S. government works to pry open markets around the world, as it did by advocating that China be granted membership in the World Trade Organization (it became a member in late 2001), intellectual property is one of the areas where negotiations tend to bog down. He's not wrong. The often elaborate apparatuses built into the agreements have proved cumbersome and weak in practice.

Jones offered a disturbing story about how China's national industrial policy facilitates forced technology transfer to Chinese industries. One new mechanism is the so-called CCC safety certification. Every electronic component or piece of equipment to be sold in China must be submitted to the Chinese government body overseeing the CCC certification. The process requires the foreign manufacturer to give Chinese officials full access to engineering drawings and schematics and to provide a complete finished product for evaluation. In addition, the applicant companies must pay for Chinese officials to visit and inspect their factories outside of China.

Not long ago, Jones learned that China's banks would be shopping for 10,000 currency machines. The Cummins machine that met the Chinese specs sells for about $1,000, and Jones felt obliged to explore. When he learned the details of CCC certification, he walked away. He felt certain that the Chinese government itself would have been involved in the reverse engineering of Cummins-Allison's technology for the benefit of Chinese companies.

Jones says one reason he can hold the line is that Cummins-Allison is privately held and has the luxury to think long-term. He believes that the leaders of public companies, who are compensated based on their results within short windows of time, are willing to trade technology to China if they can achieve a short-term gain from it. One of the most confident speculations in my book was that the largest automakers in China, which were already engaged in partnerships with leading global car companies, would soon offer their own lines of world-class cars that borrowed liberally from their more advanced partners. It was not hard to anticipate, and in April 2006 Shanghai Automotive Industry Corp., or SAIC, which is a majority partner in joint ventures with both General Motors and Volkswagen, announced that it would soon build cars under its own nameplate. There is no word yet on how seriously the new SAIC venture takes its responsibilities as a technology licensee, but I've yet to talk to a person in either Chinese or American industry who doesn't assume that the government-run Chinese company had its eyes on a comprehensive transfer of technology from the beginning. Its partners knew as much, and like many top world companies they saw little alternative but to go along, because participation in the Chinese market often demands such technology transfer as a condition to access.

I wanted to test with Jones an argument I had been making about the value of pirated technology on the shop floor. I'd been saying that in some industries IP theft seemed to be a crucial part of China's comprehensive low-cost advantage, more significant even than cheap labor. I've heard American manufacturers marvel, bitterly, that Chinese manufacturers sometimes deliver finished products for less than American companies pay just for parts. "This, too, is a function of China's no-cost technology environment," Jones said. "At every stage of the supply chain you have companies that do not have the technology costs American firms have. Chinese companies run counterfeit software, reverse-engineered machines, and other proprietary processes they need not pay for. So by the time a Chinese company assembles a product from Chinese parts, there is a big savings that has accrued all along the way. We have to pay for parts that are made in places that pay a lot for their technology, so naturally we pay more."

When the harm stemming from China's intellectual property regime is calculated, the number is tallied in two ways. One, like the $500 billion figure cited above, is from the estimated gross sales of counterfeit and pirated goods. Another approach is to add up the sales that legitimate sellers would have racked up had they sold a like amount of goods at the prices they normally command. Allowing that copied goods undercut their legitimate competition by between 20 and 99 percent, the number gets huge very fast. Yet even that method doesn't begin to measure the cost to companies that dare not introduce their products to China. That price is harder to add on, since it is impossible to tally the value of plans not made. It is not hard, however, to understand that when American companies must pay full dollar for technology that Chinese companies can get for little or nothing, that dynamic can contribute to the weakening, or near disappearance, of whole American industries.

I was asked in Beverly Hills what would improve if the amount of IP theft in China began to diminish. I pointed to three benefits. First, IP protection would chip away at China's low-cost manufacturing advantage. Second, it would create a large market for America's high-value technology and entertainment products. Third, it could also work to convince the Chinese to revise their currency policies, which today economists widely believe keep the Chinese yuan below its presumptive market value against the dollar. If China were to find that it had to pay to import technology it now simply takes, it might also have incentive to increase the value of its money and make the world's capital goods more affordable to Chinese buyers.

The creation of a compliance program can only come from political pressure here. But it won't come from consumers. Business will have to lead.

How should the United States go about enforcing a fairer system? William Jones believes stronger trade agreements and a willingness to enforce them is a crucial start. On that score, there have been some promising declarations from the Chinese government in response to recent U.S. pressure. Last spring, China prepared for an April visit to the United States by its president, Hu Jintao, with measures meant to warm the diplomatic atmosphere. Among those were announcements of stepped-up enforcement against pirates and counterfeiters. So yes, China will probably launch very public campaigns against knockoff polo shirts and handbags. But there is no sign that its more sophisticated policies designed to facilitate technology transfer, such as the CCC regulations, are up for change.

The problem is this: China's extremely loose intellectual property regime has been a key element in the country's growth. From the perspective of a national leadership looking to increase the wealth, health, happiness, and global competitiveness of 1.3 billion mostly poor people, co-opting intellectual property looks like a nice fast track out of the Third World. It's not surprising--in fact, it's entirely defensible, I've heard people in China say--that the Chinese would make this choice.

So change in China will depend significantly on the attitudes and practices here at home. American businesses will have to insist that the Chinese goods they buy emanate from factories that are legitimate users of technology. That won't be a simple thing. As with many of the grumblings Americans offer about China, we are party to the very dynamic that bedevils us.

China's ability to produce at low prices gives it strong allies in the U.S. among businesses and consumers. This is no secret. The Chinese know that our official expressions of unhappiness are rebutted by our willingness to trade on their terms. We buy $200 billion more in goods annually from China than we sell to the country because China gives us ever lower prices. China's participation in the U.S. market is not an invasion; it is by invitation. When orders come from powerful American buyers, they are usually accompanied by strong demands to keep prices low.

The question of how those prices are achieved is rarely asked. Never does a powerful American customer insist that costs not be cut by means of technology piracy. Instead, with a wink and a nudge, American buyers insist that Chinese producers cut costs any way they can. Where, one might ask, do our vast volume purchasers, including the big-box stores at the edge of town and all of us who go there to shop and save, think these savings will come from? When the pressure on suppliers is strong enough, respect for intellectual property isn't much more than a nicety.

No One Said It Was Going to Be Easy

A new regime that certified imported goods as "IP Compliant," and restricted goods that were not compliant, would have dramatic effects. Chinese producers would have economic incentives to comply with their country's legal commitments and to international norms. American companies that insisted on compliance from their suppliers would not be placed at a disadvantage relative to competitors that made no such demands.

And some consumers would holler. Would it cost money to protect American intellectual property abroad? Probably so. The rise of China's low-cost manufacturing machine has meant real savings for American consumers. Currently, China's low prices, and the prices it forces competitor nations to produce at, save each American, on average, around $600 a year.

Analogous compliance regimes exist already. They work. American companies in the toy and garment industries require certification that the factories do not employ children as workers, and executives at the Gap say that the company's efforts to make sure its foreign factories meet international workplace standards not only are manageable but actually help both the company's internal morale and its image in the marketplace. America's biggest home improvement companies work with lumber suppliers to ensure that the wood they import does not come from protected rain forests. And, of course, companies already routinely certify their suppliers on cost, quality, and delivery.

A compliance regime created in America can also create a culture of compliance in China. One of every eight dollars in the Chinese economy cycles through China-U.S. trade. If the Chinese companies that do business with Americans find they must improve their practices, they will likely exert political pressure on their governors so that their domestic competitors are forced to play by the same rules. The change in China could be swift and wide-reaching.

The creation of a compliance regime can only come from political pressure here. But it won't come from the usual source, which is consumers. Consumers are by and large contented, as they should be. That means political pressure on the subject of China will have to come from importers. They should be keen to get started--including the big-box importers, which can certainly use a dose of good news. They should be enthusiastic about leading an effort that helps keep American companies competitive.

American economic policy, unlike the policies of nearly every other industrialized country, tends to put the interests of consumers first. Experiences like William Jones's argue for a reevaluation of our approach. It's time to look at the strength we get from making sure our businesses can compete, even if it means higher prices in the near term for American buyers. American industry can do for itself what government has failed to do. It can create an economic reason for China to protect intellectual property, the knowledge economy, and America's great, innovative industries.

Ted C. Fishman's book China, Inc.: How the Rise of the Next Superpower Challenges America and the World has been printed in 24 languages. A revised edition is available in paperback.

Last updated: Jun 1, 2006




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