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cassindy chao

China's inability to safeguard intellectual property rights limits the manufacturing of high-end technology goods in China and erodes the value of brand names because the public confuses their products with shoddy counterfeits. Because many U.S. exports contain a high degree of proprietary intellectual property, China's failure to sufficiently enforce intellectual property laws may yield a major trade dispute.

Intellectual property rights in China are predominantly honored in the breach. And intellectual property theft in China has a far greater impact than a first glance would suggest. Commercial piracy extends far beyond the rampant proliferation of bootleg DVDs and CDs. In fact, many basic physical goods are greatly impacted by commercial counterfeits in China. For example, leading Western consumer goods firms, many of whom have spent tens of millions of dollar building their brand in China, regularly see knock-offs of their products appearing throughout the country – resulting in a loss of market share, a loss in sales, and a cheapening of their brand in the eyes of a consumer who buys a shoddy knockoff without any awareness that it is fake. Luxury goods manufacturers are especially at risk.

From an investment trends perspective, developments in China’s intellectual property protection regime have several important effects, ranging from lost profits to impacts on foreign direct investment, long-term productivity growth, and whether the country can move up-market in its technology and production.

What Companies are Hurt Most by Digital Media Piracy

Companies developing software, entertainment, intellectual property, or with name-brand recognition all stand to lose from piracy.

• Consumer and small business software companies who do not generate significant support revenue are the hardest hit: Microsoft (MSFT), Apple (AAPL), Electronic Arts (ERTS), Activision (ATVI), and Adobe Systems (ADBE), Nintendo (NTDOY), Autodesk (ADSK).

• Time Warner (TWX), Walt Disney Company (DIS), Twentieth Century Fox (News Corporation (NWS)), Paramount Viacom (VIA), Sony Pictures Sony, Universal Studios General Electric.

• Pharmaceutical companies selling mass market drugs in Asia, Africa, and Latin America are harmed by exports of Chinese counterfeit drugs. The most endangered are makers of mass-market drugs like Viagra and Lipitor (from Pfizer (PFE)), Propecia by Merck (MRK), and Nexium by ASTRAZENECA (AZN).

Who Wins?

Domestic manufacturers and suppliers can benefit initially from copying other software or content but ultimately will face the same problem themselves from smaller competitors if they develop into a larger player.

Fighting Chinese piracy does create a few winners. Investigation firms like Kroll (a division of Marsh & McClennan), Securitas's Pinkerton, and Dun & Bradstreet.

Another winner thus far from piracy may be Chinese search engine Baidu. Baidu offered an MP3 search capability to let Chinese Internet users find songs online, regardless of whether such songs were posted illegally. Analysts suggest this feature greatly enhanced Baidu's popularity.

Companies that sell software, but reap the larger share of their revenue by charging for online community access or transactions are benefited by piracy because it spreads the software that users need to become paying members of the online community. Massive multiplayer online role playing games, such as Everquest (from Sony) and Worlds of Warcraft (from Vivendi) win when users pay their monthly fee, regardless of whether they bought the underlying software. Likewise, even if electronic storefront software is pirated, online exchanges like EBay (EBAY) still gain from transaction fees.

Lost Profit

The U.S. Commerce Department estimates suggest that U.S. companies lose over $1 billion per year of legitimate business due to piracy, while the U.S. Trade Representative calculates that more purchases of legitimate software and entertainment media alone would reduce the U.S. trade deficit with China by $2.5 to $3 billion per year. Understanding which businesses are most vulnerable to these losses is important for investors evaluating a company’s China strategy.

Even casual observers of China are aware that digital media, ranging from movies to software to music, are readily pirated in China due to their cheap duplication cost relative to their retail street price. Increasingly, the Motion Picture Association of America (MPAA) has been training Chinese and Hong Kong law enforcement officials to identify and bust large-scale movie pirates. This is beginning to have an impact in Hong Kong, where the local MPAA representative is a former Hong Kong policeman himself who brings good law enforcement relationships to the table. As a result of pressure from the MPAA, Hong Kong law enforcement has shutdown many malls that specialize in pirated digital media. This drop in the availability of pirated media has coincided with a drop in the price of authentic movies on DVD and VCD, which has absorbed some of the demand for movies from highly price-elastic consumers who only purchase low-cost pirated media before. However Hong Kong is a far smaller market than the mainland.

Mainland China limits the legal importation of foreign movies to twenty per year. Accordingly, it is only pirated movies that can fulfill excess demand - as well as provide copies of the 20 “allowed” films during the time the state censors are editing them. Movie industry estimates are that 95% of all videos sold in China, an estimated $1.3 billion market, are pirated. Investors in media-driven companies aspiring to make a profit selling content in China should not hold their breath because, in order for U.S. media companies to significantly profit from a crackdown in piracy in China, it may also be necessary for China to increase the number of legitimate imports of foreign films allowed each year. China’s WTO commitment under the General Agreement on Trade in Services (GATS) allows China to maintain this twenty film limit legally.

Statistics highlight the high degree of software piracy in China. As of 2004, China was the sixth largest market in the world for personal computers, yet only the twenty-sixth largest for software sales. U.S. business software publishers calculated a loss of $1.47 billion in sales in China that year due to piracy. If personal entertainment software were included added to this calculation, this number would be even higher.

There may be hope over the long-term however. A few companies have sought to use piracy to their advantage over the long run. Microsoft is a leading example of this approach. While pirated copies of the Microsoft Windows operating system abound throughout China, Microsoft has met some limited success capitalizing on this by:

1. “Upselling” genuine copies of the software for a very low price to users of pirated copies
2. Using the widespread distribution of pirated software to train the populace how to use your product. Thus, as a result of piracy, tens of millions of Chinese became competent using Microsoft Windows and Microsoft Office applications.

Because Microsoft regularly offers new upgrades of its operating system and applications, it can profit from the sales of later upgrades even if current users have not developed the belief that they should have to pay the retail price for their software.

Likewise, online games that provide free desktop software but require a monthly usage fee, such as Worlds of Warcraft, are less susceptible to piracy in China. These games are able to limit access to the gameplaying community, which is essential to enjoyment of the game, to those who actually pay the fee. However desktop productivity software, such as Google Apps, that are provided online in exchange for a recurring fee, may not be able to turn its rental-based income stream into profits in China because desktop-based substitutes are readily available.

The Cost of Private Battles

The pursuit of pirates and counterfeits is expensive. Because Chinese law enforcement may not pursue such cases aggressively, often aggrieved Western companies will hire their own private detective to gather evidence of the counterfeiting, trace its source, and then bring a civil suit in China’s court system. However nearly 80% of U.S. firms that export to China are small and medium sized enterprises, rather than Fortune 500 companies. The cost of hiring private detectives and waging a lengthy legal battle in the Chinese court system can be particularly daunting to businesses of that size.

Large exporters to China, despite having deeper pockets to fight pirates, are also larger targets because pirates want to leverage the brand name of larger companies. Pharmaceutical industry experts, for example, estimate that China is the source of thirty percent of all counterfeit drugs produced worldwide, with a particular emphasis on bestsellers like Pfizer's Viagra. Similarly, well-known auto parts manufacturers face billions of dollars of Chinese counterfeits each year – resulting in both reduced sales and damage to their own brand name.

Trade War

On April 9, 2007, U.S. Trade Representative Susan Schwab announced that the United States will begin World Trade Organization (WTO) dispute settlement consultations with the People’s Republic of China over 1) deficiencies in China’s legal regime for protecting and enforcing copyrights and trademarks on a wide range of products, and 2) over China’s barriers to trade in books, music, videos and movies.

The WTO consultation request focuses on provisions of Chinese law that create a “safe harbor” for wholesalers and retailers who distribute or sell pirated and counterfeit products in China below a certain quantity. These safe harbors seem to allow sales of sufficient quantities of counterfeit goods that many large-scale wholesalers and distributors can operate below high thresholds without criminal liability, thus permitting large-scale piracy and counterfeiting. The U.S. also seeks that China destroy seized counterfeit goods, rather than allowing them to be sold into the marketplace after removal of their label. And that China protect foreign copyrights while such works are being reviewed by Chinese censors; and allow a greater importation of foreign media, such as movies.

A request for consultations is the first step in a WTO dispute. Under WTO rules, if the parties do not resolve a matter within a 60-day consultation period, then the complaining party may refer the matter to a WTO dispute settlement panel. Ultimately, this could trigger a trade war between the U.S. and China. See U.S. – China Trade Dispute

Damage to Brand Names

The U.S. Commerce Department estimates that, on average, twenty percent of all consumer products in the Chinese market are counterfeit. When counterfeit products fail, it can impact the real brand’s reputation as well. In China and around the world, counterfeit Chinese medicines have injured and killed hundreds of thousands, ranging from toothpaste and cold medicine in Panama to diet pills in Japan. Chinese authorities estimated that nearly 200,000 people were killed in China in 2001 due to counterfeit medicines. In a recent raid on a printing factory in the southern Chinese province of Guangdong, police seized bogus packaging and labels for Coca Cola bottles, Wrigley's chewing gum, General Mills'Trix breakfast cereal, and Nestle's Purina cat food. In order to prevent a scare similar to the Tylenol-tampering episode in the U.S. many years ago, foreign companies need shift into publicity overdrive to discredit and distinguish dangerous or shoddy counterfeit goods, lest their own products be tarred.

Similarly, counterfeit products impinge on the ability of Western companies to select and control their own distribution channels. Thus, even though Starbucks (SBUX) invested heavily in training its Chinese workers, it had to rush to court in 2003 to stop a copycat rival from misappropriating its logo and store look under the name “Xingbake” in 2003. "Xing" means "star" in Mandarin and "bake" sounds like "bucks" when pronounced in Chinese.

Effects Outside of China

The Motor and Equipment Manufacturer’s Association estimates that eighty percent of all counterfeit automobile parts imported into the U.S. originate in China or Hong Kong, costing the auto industry over $9 billion per year in lost sales. Likewise, hundreds of millions of dollars per year are lost to due to the export of China pirated DVDs and CDs each year; this figure may accelerate with the proliferation of new digital movie formats, including HD-DVD and Blu-Ray. U.S. Department of Homeland Security (DHS) agents, working in conjunction with the Chinese government and private industry, conducted the first ever joint U.S.–Chinese enforcement action on the Chinese mainland and seized more than 210,000 counterfeit movie DVDs. Similarly, DHS agents recently stopped a combined Chinese and Middle-Eastern organization that was responsible for the smuggling and nationwide distribution of over 100 containers of counterfeit trademark merchandise, valued in excess of $400 million, that had already been smuggled into the U.S in less than a year..

Impact on Chinese Innovation and Future Export Potential

Chinese counterfeits are hurting the country’s own future export potential. A recent case of counterfeit ingredients poisoning medicines in Panama and Australia has put authorities there on guard against all Chinese imports of food and medicine. Similarly, dangerous fake dog food ingredients from China have made U.S. consumers wary of any foodstuffs coming from there.

Impact of Foreign Direct Investment

Foreign direct investment in China is limited by fears of counterfeiting. Many Western companies who possess proprietary technology are hesitant to move production, let alone research and development to China, for fear it will be copied. This means China is losing valuable opportunities to move its production to more sophisticated, higher value-add and higher margin products, as well as missing opportunities to train its workforce on more sophisticated product development techniques. As low-wage competitors like Vietnam develop their industrial output, China will be forced to compete solely on the basis of wages if it cannot improve its know-how and export product mix.

Future of China's Piracy & Counterfeiting problems and TRIPS laws

The Chinese have taken some steps to combat piracy and counterfeiting, although there remains much more to be done in actions vs. issuing statements. The recent creation of the State Intellectual Property Offices, is one small step.

China only joined the WTO in 2001, until recently the country was in a discretionary period which that have just gotten out of. This period gave them some leeway in terms of which of the organization's rules the country had to adhere to. Now that the probationary period has ended the country is trying to demonstrate an effort towards compliance. Universities are endeavoring towards IP law and there is some effort by the National Copyright Administration to close down unlawful websites and servers.

China has dramatically increased its patent filings producing over 100,000 patents in 2006. While some would say that this increase of patents gives them more reason to abide by international law, it remains to be seen whether this is proven.