Authors: Zhiyao (Lucy) Lu and Gary Clyde Hufbauer, Peterson Institute for International Economics
On 18 August 2017, the Trump administration invoked Section 301 of the Trade Act of 1974 to launch an investigation into alleged Chinese violations of intellectual property rights (IPR). In response, China stated that the United States ‘disregards the rules of the WTO’ and that it will ‘take all proper measures to safeguard its legitimate rights’. Alongside investigations into steel and aluminium imports, the new Section 301 case holds the potential to escalate US–China trade tensions.
Counterfeit goods and software piracy have long been contentious IPR issues between the United States and China. China has appeared on every Priority Watch List in the Special 301 Report published annually by the United States Trade Representative since its first review in 1989.
But in recent years, forced technology transfer has been a rising concern. According to a survey conducted by the US–China Business Council in 2015, some 59 per cent of firms were worried about transferring technology to China, although only 23 per cent had been asked to transfer technology within the past three years.
To understand how China may force US firms to transfer technology to domestic enterprises, it is worth taking a look at China’s inward investment regime.
Three major laws govern foreign investment into China: the Law on Sino-Foreign Equity Joint Ventures, the Law on Sino-Foreign Cooperative Joint Ventures and the Law on Wholly Foreign-Owned Enterprises. Other administrative rules on foreign investment are issued by various government agencies at the central and provincial levels, as well as by ministries supervising different industries and regions.
Reflecting these major laws, the Ministry of Commerce periodically updates a catalogue for the Guidance of Foreign Investment Industries to regulate foreign investment in China. The most recent catalogue contains a list of encouraged industries, a ‘negative list’ of sectors where ownership limits or other investment restrictions apply, and a schedule of prohibited sectors.
So how could China’s inward investment regime prompt IPR violations and forced transfers of technology?
The first path stems from restrictions on foreign investment specified in the catalogue. Some industries, such as prospecting and exploitation of petroleum and natural gas, are limited to joint or cooperative ventures. These mandatory business structures may force US firms to transfer valuable know-how to their Chinese partners. One example might be deep sea drilling technology, another might be fracking in folded shale structures.
Second, under China’s investment regime, foreign firms must generally seek prior approval from relevant regulators. Since China has multiple laws and regulations on foreign investment issued by agencies that oversee different industries and regions, the approval process lacks transparency. This creates room for government officials to impose deal-specific requirements, which may include transfer of technology as a pre-condition for market access.
Third, new regulations on the information technology sector to ensure ‘secure and controllable’ standards may infringe the IPR of foreign investors. For example, the Cybersecurity Law, which came into effect on 1 June 2017, requires businesses identified as ‘critical information infrastructure operators’ to store data domestically, and transferring data overseas is subject to security assessments. Such restrictions on cross-border data flow may lead to forced IPR disclosures to local enterprises.
Estimates of the cost of IP theft are highly speculative, but according to the updated IP Commission Report by the National Bureau of Asian Research, the annual cost to the US economy as a result of counterfeit and pirated tangible goods, pirated software, and trade secret theft ranges from US$225 billion to US$600 billion. The trade secret share of this range — estimated between US$180 billion and US$540 billion — is most relevant for forced technology transfer. As a major IP infringer, China (including Hong Kong) accounted for 88 per cent of US IPR seizures in 2016. The figure probably represents a good estimate of the Chinese share of forced technology transfer.
The Trump administration has mixed motives in launching the Section 301 investigation. Foremost, the administration believes that reforms to the Chinese system would reduce the bilateral US trade deficit with China (US$309 billion in 2016) and create more US jobs, especially in the manufacturing sector. The administration also subscribes to arguments advanced by the US business community that the Chinese system is fundamentally unfair to foreign firms.
Given these concerns, how might the United States pursue its IPR grievances with China?
One avenue is to bring a case to the WTO. From the US perspective, this path faces two obstacles: the length of time and the standard of proof. The WTO Appellate Body would take at least three years to reach a final decision. It is also not at all certain that Chinese laws and regulations violate the WTO code on trade-related aspects of intellectual property rights or other WTO rules.
Another avenue, preferred by hawkish voices within the administration, is to impose unilateral restrictions on Chinese exports and investment based solely on the findings of the Section 301 investigation. US imports from Chinese companies might be subject to a penalty tariff, or Chinese companies might be denied permission to acquire US firms. Unilateral penalties could, of course, lead to tit-for-tat retaliation and possibly a trade war.
As a third and probably more productive avenue, the United States could resume the stalled negotiation of a bilateral investment treaty (BIT) with China. The IPR section of the BIT could draw on relevant chapters in the US–Singapore FTA and the South Korea–US FTA, which set the gold standard for IPR terms. The treaty should contain an investor–state dispute settlement mechanism to ensure effective enforcement of BIT commitments.
Whatever approach is taken, changes in Chinese practices will take time. The above measures will not quickly change the dynamics of inward investment, or curb the bilateral trade imbalance. But over a decade, enhanced Chinese respect for IPR has the potential to benefit China as much, or more, than the United States.
Zhiyao (Lucy) Lu is a research analyst and Gary Clyde Hufbauer is Reginald Jones Senior Fellow at the Peterson Institute for International Economics.