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On U.S. Trade Policy and Beijing’s Treatment of Intellectual Property

Hot-off-the-press is this new Mercatus Center Policy Brief – “How the United States Should Respond to China’s Intellectual Property Practices” – written by my Mercatus Center colleague Dan Griswold and me. (Dan did the lion’s share of the work on this paper. I’m proud and honored to be his colleague.) A slice:

Another pillar in the US complaint against China on IP is China’s practice of requiring foreign companies to transfer technology to their Chinese investment partners. As the USTR charges in its Section 301 report of March 2018, “The Chinese government uses foreign ownership restrictions, such as formal and informal JV [joint venture] requirements, and other foreign investment restrictions to require or pressure technology transfer from US companies to Chinese entities.” The USTR notes that foreign companies often decide there are few realistic alternatives to the arrangement because of the size and importance of the Chinese market.

This, too, is a legitimate complaint against Chinese policy, but the practice of requiring technology transfer as a condition of doing business in China is of a fundamentally different nature than outright IP theft. Imposing performance requirements on foreign-owned affiliates is not a unique or even uncommon practice in less developed nations. Multinational companies routinely accept such conditions as a cost of doing business in those markets. In contrast to IP theft, the multinational firms ultimately decide on behalf of their shareholders whether or not the arrangement is acceptable.

The USTR’s main Section 301 report argues that the Chinese practice of “forced” technology transfer threatens to undermine the profitability of US companies in the Chinese market by allowing the indigenous Chinese companies to eventually produce their own competing products based on the transferred technology. The Chinese knock-off products may even enter into global markets, reducing overall sales of US firms and their reinvestment in research and development of new products. Because of China’s technology transfer rules, the USTR warns, US multinational companies “may become less globally competitive in the long-run.”

Like all restrictions on foreign trade and investment, China’s restrictions on foreign direct investment impede international commerce, reducing the gains from economic integration for both China and its trading partners. But despite the technology-transfer requirements, US companies continue to invest profitably in the Chinese market. According to the US Bureau of Economic Analysis, US firms sold $463 billion in goods and services through their affiliates in China in 2016, almost double the total sales for 2009. Those same affiliates earned $34.5 billion in net profits from operations in China in 2016—more than US companies earned through affiliates in such major trading partners as Canada, Japan, or Mexico. The gains from their investment in China still far outweigh any measurable losses from technology transfer.

The Chinese government itself appears to recognize that investment restrictions are not serving its own economic interests. The trend in recent years, again not always in a straight line, is in the direction of relaxing requirements for joint ventures and technology transfer. In its update on China’s IP policies issued in November 20, 2018, the USTR acknowledged China’s “relaxation of some foreign ownership restrictions and certain other incremental changes in 2018.”

Recent positive reforms on foreign investment include the expansion of the “negative list” of industries in which foreign companies can invest without a joint venture. Without a required Chinese partner, the foreign parent company can own 100 percent of the affiliate operating in China, which means no mandated technology transfer. Recent sectors that China has added to the negative list include important and politically sensitive industries, such as automotive, aircraft, shipbuilding, and certain financial services.

In the auto sector, China has agreed to allow full foreign ownership immediately in the production of “new-energy vehicles (NEV),” such as Tesla electric passenger vehicles. Full, 100 percent foreign ownership will be allowed for production of non-NEV commercial vehicles by 2020 and non-NEV passenger vehicles by 2022. In sectors where foreign ownership is still limited, China has also agreed to scrap the limit on a maximum of two joint ventures.

China’s relaxation of investment rules reflects a long-term trend. According to Nicholas Lardy of the Peterson Institute, the share of value of foreign direct investment (FDI) into China that was in wholly foreign-owned affiliates was only about 10 percent in 1987­–1988. But Lardy writes,

“By 2000, on the eve of China’s accession to the World Trade Organization, almost half of actual incoming FDI was in wholly foreign-owned firms. This share rose to an average of almost 80 percent in 2008–14 before falling to around 70 percent in the last few years, as the composition of FDI shifted toward more restrictive sectors. In a wholly foreign-owned firm there is no transfer of technology, and the foreign firm can take the same steps it would take in any other market to prevent its technology from leaking to domestic firms.”

As with IP rights enforcement, China’s rules on foreign investment and technology transfer fall short of international expectations. But those rules and their practical enforcement have been generally improving. In the case of technology transfer, the rules are a cost of doing business in China, a cost that has the effect of actually making China a less attractive place for FDI compared with the United States and other economies around the world.

Put differently, these technology transfer requirements are an in-kind tax on foreign companies seeking to do business in China—a tax that, as with all taxes, discourages the taxed activity. Specifically, this tax discourages non-Chinese firms from setting up shop in China, which acts as a brake on Chinese economic growth. Thus, like IP rights protection, the problem contains within itself strong incentives for the government of China to reform its policies in a market-oriented direction if it wants to realize the full benefits of global economic integration.