Introduction from TradeVistas:

Every April, the Office of the U.S. Trade Representative (USTR) releases its Special 301 report, which reviews new and longstanding concerns about other countries’ protection of U.S. intellectual property (IP). This year, as in prior years, USTR cited China as a priority country. The complaints include China’s “coercive technology transfer requirements, structural impediments to effective IP enforcement, and widespread infringing activity – including trade secret theft, rampant online piracy and counterfeiting, and high levels of physical pirated and counterfeit exports to markets around the globe.”

In mid-August, President Trump asked the USTR to make a determination about “whether to investigate any of China’s laws, policies, practices, or actions that may be unreasonable or discriminatory and that may be harming American intellectual property rights, innovation, or technology development.” The following day, USTR self-initiated the investigation under the authority of Section 301 of the Trade Act of 1974 (read our Essential on Section 301 here).

In this commentary, Jim Lewis takes an unvarnished expert look at the balance between deploying commercial diplomacy to try to improve the environment in China for American companies to market and profit from their intellectual property on the one hand, and a proactive approach to keeping America’s lead as an innovative economy on the other. He argues that trade tools offer only part of the solution.

China’s technology transfer and other protections put a thumb on the commercial scale.

China has long-standing policies to extract intellectual property (IP) from Western companies, and its companies often show scant respect for IP protection. Confronting China over these practices is long overdue. The central issue, however, is not IP theft but the unfair treatment of U.S. companies in China. Compare the treatment of U.S. companies in China to Chinese companies in the United States. When Alibaba built a data center in Seattle, it was not forced to do this as a junior partner in a joint venture, nor to provide source code as is the case for U.S. companies in China.

China uses a variety of policies to displace Western companies, including investment restrictions, subsidies, barriers to trade, security regulations, procurement mandates, acquisition of foreign technology and Western firms. Western companies find themselves under pressure to make concessions in technology transfer or services like cloud storage in exchange for market access. Huawei is the best example of a globally dominant company built along these lines, but there are others. Lu Wei, the former head of China’s Cyberspace Administration, once said that if China had not blocked Google, there would be no Baidu.

The true cost of IP theft is unfair competition in the marketplace.

Calculating the value of intellectual property is difficult. One way is to estimate what stolen IP would fetch on the market if offered for sale or licensing. Companies can value their intellectual property by estimating the income it produces or is expected to produce. The most common error is to value IP at what was paid to develop it. The real value (and hence the cost of IP theft) is how much a product made with the IP will earn on the market. If I spend a billion dollars to develop a square car tire, its market value is zero, not a billion, and the loss from IP theft is zero. Similarly, if I steal IP and can’t figure out how to make a product with it, the loss from the theft is zero.

The most accurate measure is to look for competing products. If there aren’t any, the harm to the victim is zero. A country could steal “$600 billion” in IP and not gain $600 billion in value. Stolen IP does not mean that the victim company has lost the ability to make products. What has happened is that it now faces a new competitor. This is the real problem, since China has created a protected Chinese market, provides subsidies for foreign sales, and imposes nontariff barriers to hobble foreign competition. Subsidized Chinese companies have an immense advantage operating from a closed domestic market and selling to an open international market.

Technology transfer as a requirement for market access is the real culprit.

The Chinese did licitly and illicitly acquire American IP from the start of the opening of their market, and it reached a fever pitch through cyber espionage between 2000 and 2016 (more a reflection of our inattention and lax defenses than of Chinese skill). But China has developed its own innovative capabilities because of past technology transfer combined with heavy, sustained government investment in science and research.

China’s recent development of a commercial airliner is a good example of the declining importance of IP theft and the central role of technology transfer. China’s old Soviet-supplied aircraft factories made shoddy aircraft. When China opened its market, Western firms rushed to sell it aircraft, and part of the requirement for market access was coproduction, where Chinese companies worked with Western aircraft firms to make parts for Western commercial aircraft. Coproduction, over 20 years, taught Chinese companies essential production know-how, and the quality of Chinese aircraft has improved markedly. Most of this transfer did not involve IP theft, and the problem now is that China will be tempted to use subsidies, pressure on domestic airlines to buy Chinese, and barriers to foreign companies to give their manufactures an edge in China and in the global market.

The lessons from the aircraft story are that the United States needs to push back hard on Chinese requirements for transfer technology for market access and on Chinese barriers to trade. Steady diplomatic pressure accompanied by skillful use of existing trade authorities (like Section 301 of the U.S. Trade Act of 1974) can change China’s behavior. With skilled diplomacy, we can probably gain support from Germany, Japan, and other major Western economies.

China is pulling ahead because it has a strategy to build a high-tech economy.

One reason that China has gotten away with this for so long is that U.S. companies have been ambivalent about pushing back. They fear retribution from China—a reasonable concern—and do not believe the United States will take action to support them against such retribution. China is a huge market that companies are reluctant to risk.

If the Trump administration confronts China over unfair trade practices it will need to ignore handwringing from trade groups, but the action will still offer only half of a solution. It generally doesn’t help when you are losing a race to complain that your competitors are running too fast. To stay in the lead, you have to pick up the pace.

China is pulling ahead because it has a strategy to build a high-tech economy and is willing to spend heavily and consistently over years. We do not always want to take Chinese pronouncements of technological success at face value, but China commits to programs and spending for decades, while our spending is often limited to fits, starts, and cuts. After decades of spending, China is creating its own culture of innovation, not as effective as America’s but better than most countries and lavishly resourced. China will increasingly make its own IP, so stopping IP theft will not keep the United States competitive.

Trade policy without innovation is only half of an effective strategy.

A U.S. effort to get China to follow global norms on technology, trade, and investment is long overdue, but it will not work without a strategy on how to move ahead in technology. The United States has innate advantages, with the strongest scientific base in the world, leading technology companies, and an innovative culture that others find difficult to match.

Strengthening and revitalizing the partnership among companies, universities, and government can reignite U.S. technological innovation, but it will require a willingness to invest seriously in growth. America lives in a post-innovation environment of its own making. Trade policy can address part of the problem. The other half of the equation is a U.S. strategy to speed and increase its own creation of intellectual property.