Intellectual property protection: Problems and prospects for China

CONTENTS

Executive Summary

1. The Case for IPR Protection

2. IPR in China - A Macro Perspective

3. Towards A Stronger IPR Regime In China

4. Industry View - Technology

5. Industry View - Pharmaceuticals

6. Industry View - Software And Media

7. Industry View - Luxury Goods

8. Conclusion: Living with Piracy

Authors

Other Sources

LIST OF BOXES

The Two Branches of Intellectual Property

TRIPS Agreement - An Overview

The IP violators’ dictionary

Worst Case Scenario: Magnetic Secrets

Research collaborations by multinationals in China

Microsoft and Legal Recourse; the case for “Guanxi”

Green Shoots: the Emergence of Chinese Generated IP - Dali Industries

Bags of Trouble: The Global Appeal of Super Fake Products

LIST OF FIGURES

IPR Enforcement in China - Legal Options

Gross Domestic Expenditure on R&D as % of GDP

Number of Patent Applications Filed - 2005

Number of Infringement Cases Accepted by Chinese Authorities

Breakdown of Infringements Cases in EU expressed as % by Origin

Retail Pharmacy Sales - 12 Months to September 2006

Sales of Leading Pharmaceutical Companies in China 2004-05

Estimated Losses Due to Piracy in China

US Customs Counterfeit Seizures by Trading Partners 2003-04

US Customs Counterfeit Seizures by Type of Product 2003-04

IPR in China: A delicate balance

Executive Summary

The evidence shows China to be an economy in transition, with little motivation to promote a stronger IPR regime in the short-term. UK firms considering entry into the Chinese market or the impact of Chinese competition should not base their strategies on the notion that infringements can be eradicated. But instead, develop strategies that allow them to flourish in the face of this ongoing problem.

There is considerable debate as to whether strong IPR protection is a good thing even for developed economies in terms of promoting innovation and technology growth. But, in the case of developing economies there is evidence that the absence of such IPR regimes is actually desirable.

We expect the situation in China to improve as the economy develops, but the rate of change is unpredictable as the government balances the conflicting objectives of 4 opposing forces:

- International Relations: meeting the entry requirements of the international community to gain access to external markets.
- Short-Term Priorities: mitigating the threat of civil unrest by carefully managing the “gap” between the poor and the wealthy.
- Long-Term Priorities: developing new industries and growing a “knowledge based” economy.
- Chinese New Economy: promoting and supporting original innovation.

The rate of improvement is largely driven by the emergence of innovative Chinese firms. As their IP portfolio increases, the motivation to seek protection for their own innovation grows and will require reciprocal enforcement by the Chinese for international firms. Thus, the IPR environment varies by industry sector:

- In Technology & Pharmaceuticals we see encouraging signs of improved protection and enforcement with demonstrable Chinese innovation.
- In Media, Software and Luxury goods, the situation is getting worse. There is strong motivation to leverage the low cost base and Chinese Brands have yet to establish themselves.

Given the current IPR climate and the prospect of little short-term improvement, UK Firms are advised to adopt a pragmatic approach that recognises the issues but still positions them to benefit from the significant opportunity that China’s emerging economy offers:

- Manage risk by limiting Chinese operations to the least critical aspects of their business and recognise that these will be different for each firm;
- Develop an IPR strategy that can be applied to the unique nature of the Chinese environment and protect their IP vigorously;
- Joint Ventures with Chinese firms provide accelerated access to the market, experience and business connections that take years to build on their own;
- Protecting IP is necessary, but not sufficient to protect their business from Chinese competition. Continual and rapid innovation, Brand development, value added services and talented management must be central to their strategy.

General business concepts still apply and China’s weak IPR regime should not outweigh multiple other factors that determine the value of a new venture. The most successful firms are finding ways to prosper in spite of the IPR issues and are executing strategies that limit their exposure, but still enable them to participate in the significant opportunity that China represents.

1. The Case for IPR Protection

Economies grow and prosper through a constant cycle of innovation. New inventions, technology and services improve quality of life, increase productivity and even save lives. Intellectual property protection offers a legal framework and incentives for people to constantly innovate. However, there are several counter arguments that reject the need for IPR.

Intellectual Property is the result of innovation in industrial and artistic fields. An intellectual property rights system provides a legal framework for protecting the rights of the creators of the property. A fair system guaranteeing a time-limited ownership of intellectual property encourages innovators to invest in, and profit from the innovation¹. Intellectual Property protection is meant to reward individuals and corporations for their investment in innovation, by granting a monopoly on their idea for a certain period of time.

The payoff for protecting intellectual property can be huge. The US Congressional Joint Economic Committee estimated in May 2000 that United Stages gained nearly $2.4 trillion (in 1993 dollars) from increased life expectancy as a result of advances in health care².

Innovation does not come cheap though. It is the result of investment in time, money and skills. Microsoft has spent nearly $6.5 billion in research and development in 2006³. Bloggers estimate the cost of development of Microsoft’s latest operating system, Vista to be in the range of $6 -10 billion dollars over five years of development time, making it one of the most expensive and complex pieces of software engineering. It would take no more than a few dollars to pirate. Steven Paul, Executive Vice President of Science and Technology at Eli Lilly projects that the discovery of a new medical entity drug molecule is expected to cost nearly $2 billion by 2010⁴. Given such high upfront investments required, it is important to guarantee legal rights and protection to the innovators.

The discovery of a new drug molecule is expected to cost nearly $2Bn by 2010

Steven Paul

Executive VP of Science &

Technology Eli Lilly

The Two Branches of Intellectual Property

Intellectual property is categorized in two branches namely, Industrial property and Copyright.

Industrial property deals with new solutions, inventions and industrial designs which are aesthetic creations determining the appearance of industrial products. This also includes property such as trademarks and commercial names.

Copyright on the other hand deals with literary artistic and scientific works. Literary works, music creations, performances of artists etc fall under its purview. The act of reproducing the work can only be done with the approval of the author. It also prevents others from modifying the work without permission from the author.

The Counter Argument

A growing number of people question the necessity for intellectual property protection in the first place. The United States for example began its own journey of innovation two hundred years ago, with weak IP laws. The key accusations against patenting regimes include stifling innovation and fostering monopolies that hurt poor economies.

Standing on the shoulders of giants: Innovation is a result of the collective effort of several people and not just the inventor alone. Intellectual property is seldom created as standalone inventions but on top of earlier work done. Extending the logic forward, granting exclusive rights would prevent others from extending and building on top of this new technology, depriving consumers of advances that might otherwise seem possible. Large public corporations are often accused of suppressing access to new technology through controlling access to patents in that area. For example, AT&T is accused of having bought patents to prevent adoption of new technology that would hurt its monopoly in telephones⁵. Open competition would have forced everybody to constantly innovate or perish.

The Open Source movement: The problem with intellectual property protection in software development is particularly severe. Trivial algorithms when patented present difficulty for other innovators who could have independently arrived at the same solution anyway. This poses a significant challenge for small software companies that are drawn into litigation from larger rivals on account of IP infringement. The legal process is expensive and damaging for the smaller firms.

Software engineering is one of the fields that have evolved flourishing business models that openly discourage intellectual property protection. The open source movement advocates free availability of source code, the right to freely redistribute all improvements of the source code and freedom to use the software any way the user seems fit. This generates powerful network effects, drawing an increasing number of developers to enhance and support open source products. The end users are not locked into a continuous upgrade and maintenance fee cycle that is imposed on users of proprietary software.

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The GNU Unix operating system, Linux operating system and the Apache web server are examples of open source products that have gained wide popularity. Both of these are open source products with no single entity having proprietary access. They have resulted in industrial strength products that are routinely used in business environments. Contrary to the arguments of conventional software companies that open source software users do not get adequate support and continuous product development, these and several other products thrive on a global support network of developers⁶ and commercial service providers.

Health crisis in poor countries: The health care industry faces multiple problems with new drug discovery becoming prohibitively expensive on the one side, and a growing public health problem in poor countries, on the other. For example, inability to combat HIV in Africa through affordable means is leading to millions of deaths and loss of productivity, even while the technology is available from the west to alleviate the problem. Arguments of profiteering by Pharmaceutical multinationals in the face of human suffering are easy to make⁷.

The patent land grab - Biopiracy: With increasing focus on intellectual property protection, there is a mad rush to patent knowledge. The hottest race currently is for patenting gene sequences. Gene therapies are showing promise as the future of medicine, to treat a variety of ailments. Nearly 20 percent of human genes have been patented by private corporations and universities in the US⁸. This prevents others from exploring alternative uses for the patented gene, raising concerns on stifling innovation in a promising area of medicine whose full impact to mankind is not yet fully understood.

Countries like India and China have a long history of using natural ingredients for treating ailments. Some of these inventions date back several centuries. The neem plant has been recognized in the Indian subcontinent over centuries for its medicinal purposes. The American company Thermo Trilogy has secured patents on the neem plant for its fungicidal properties. After a protracted legal process, the European patents office has revoked the patent in its entirety, recognizing the need to preserve biological wealth that has been passed down through generations, in the first ever verdict against bio-piracy⁹.

For want of a better system

Given the compelling case for and the arguments against Intellectual Property Rights protection, we believe that there is no one single system that is fair to all nations. Different countries have adopted different intellectual property systems at various stages of their growth. In 19th century, the United Stages adopted a very loose intellectual property rights system, during the infancy of its growth¹⁰. The same appears to be the case with emerging economies of today, such as China and India. Payments of royalties and license fees for services accounts for only 12% of US exports to China whereas it is as high as 20% of US exports to EU or Japan¹¹. The additional costs of IP royalties will most certainly erode the razor thin margins of Chinese manufacturers and possibly hurt growth.

The strong conflict between rewarding innovation and the socio economic justifications against IPR protection do not have an obvious resolution. Innovation costs money, and in some industries, a lot of money. For want of a better system to reward innovators and ensure that the necessary investments flow into continuous innovation, the current framework of intellectual property protection must continue. The implementation cannot however be achieved overnight but gradually, by allowing developing economies to grow through adoption of new technology at a reasonable cost. International aid agencies must evolve a cohesive strategy to alleviate the direct burden of IPR protection on least developed countries, particularly in the area of healthcare.

International intellectual property protection comes under severe strain particularly in fast growing economies such as China. As we will show later in this report, future growth of China would have to come about not through capital accumulation alone, but through productivity growth. China has to invest significantly in innovation. A fair intellectual property system is a pre-requisite for multinational companies and local firms to invest significantly in conducting research and development in China and seeding a culture of innovation.

2. IPR in China - A Macro Perspective

To assess the impact of intellectual piracy on an economy we look at the theory and empirical studies that link IPR to GDP growth. Although not conclusive, studies suggest strengthening intellectual property rights is not in the interest of the poorest nations but that it is increasingly important as an economy develops and becomes more scientifically sophisticated.

China’s economy is transitioning to one increasingly driven by technology and thus IPR is becoming a higher priority. As the transition is incomplete, we see two apparently contradictory sets of evidence: on the one side, a series of reforms to build a stronger IPR regime and on the other, statistics and surveys showing piracy and counterfeiting growth accelerating. The situation is the result of two main issues:

- Inconsistent and ineffective IPR enforcement due to bureaucracy, decentralized government, geography and culture.
- Conflicting government priorities, not always consistent with strong enforcement of IPR laws, especially in design intense industries such as textiles. The problem is the critical balancing of short-term policy, long term development plans and international relations.

IPR Enforcement in China - Legal Options¹²

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Like all governments, China’s primary concern is one of self-interest. Its policy of “gradualisation” has (so far) been successful in managing the high levels of GDP growth, FDI and R&D spending. Nevertheless, IPR enforcement must continue to improve to enable further economic development.

For design intense industries (such as luxury goods) we conclude that China will not be an IPR ‘friendly’ environment in the short to medium term. Even in the long term it is doubtful that piracy and counterfeiting in design intense industries will slow down unless Chinese firms capable of patentable innovation emerge and establish themselves as international brands.

The impact of Intellectual Property Rights on developing countries

The crucial question is to what extent IPR promotes growth in developing economies like China. Analysis of the available evidence on the economic impact of IPR regimes is a complex task. Much of the evidence is either indirect or based on proxies. The use of econometrics to isolate the independent effect of IPR on economic variables is often contested, particularly as to whether it demonstrates causation.

Some economists argue that the absence of IP protection accelerates technology transfer and learning (through copying and imitation). Others argue that IP protection encourages technology transfer from abroad through direct investment or licensing.

The evidence does not suggest strong direct effects of IPR on economic growth in developing countries.¹³ One study found that the more open an economy is to trade, the more likely that patent rights would affect growth¹⁴. But there is debate about causation, because both openness to trade and the strength of the IPR regime tend to increase in any case with per capita income - though this does not occur until quite high levels of per capita income. This association is not necessarily causal but it does indicate that IPR protection should not be a high priority in developing country policy¹⁵ until relatively upper middle levels of per capita income are achieved.¹⁶

The conclusion is that in low-income countries with a weak scientific and technological infrastructure, IPR protection at the levels mandated by TRIPS (see box) is not a significant determinant of growth. In fact, rapid growth is more often associated with weaker IPR protection and in terms of what the WEF calls “stages of development” that IPR becomes relevant only for countries in the 2nd to 3rd stage of development¹⁷.

Trade Related Aspects of Intellectual Property Rights (TRIPS) Agreement - An Overview The principal motive for including intellectual property rights as a subject of the Uruguay Round of the GATT was the perception that the existing international intellectual property regime lacked effective enforcement. The Ministerial Declaration of 20 September 1986, which launched the Uruguay Round, explained that:

In order to reduce the distortions and impediments to international trade, and taking into account the need to promote effective and adequate protection of intellectual property rights, and to ensure that measures and procedures to enforce intellectual property rights do not themselves become barriers to legitimate trade, the negotiations shall aim to clarify GATT provisions and elaborate as appropriate new rules and disciplines.

Negotiations shall aim to develop a multi lateral framework of principles, rules and disciplines dealing with international trade in counterfeit goods, taking into account work already undertaken in the GATT.

Consequently, Part III of the TRIPS Agreement obliges Members to establish a comprehensive enforcement regime. The TRIPS Agreement aims to ensure a multilateral rule of law in relations between countries in the area of intellectual property. It does so by setting minimum standards and rules for each key area of intellectual property while at the same time embodying exceptions and other forms of flexibility. There are different transition periods for developing countries and least- developed countries, with minimum protection in place by 2006.

Major concerns of developing countries in the context of implementing TRIPS focus on 4 main areas:

- Access to medicines
- Biotechnology
- Biodiversity and traditional knowledge
- Transfer of technology.

Although the direct impact on growth is difficult to discern, much effort has been devoted to establishing the impact of IPR protection on trade and foreign direct investment (FDI). The rationale is that FDI is a critical source of know-how, skills and technologies for developing countries and that poor IPR protection discourages FDI.

Some studies show that stronger patent rights in developing countries would significantly increase imports from developed countries (or indeed other developing countries).^{18 19 20} But strengthening IPR is also particularly effective in increasing imports of low technology consumer items and is associated with the decline of indigenous industries based on imitation. This effect is clearly a mixed blessing for a developing country. There may be more access to high technology imports but the costs in terms of lost output, employment and slower growth may be very substantial. This issue is now a very real one in countries such as China.

What is clear from the literature is that strong IPR alone does not provide sufficient incentives for firms to invest in particular countries. As evidenced by countries with high growth rates but weak IPR regimes that have been and continue to be the recipients of large FDI inflows. These include many of the East Asian and Latin American economies, which have received the bulk of such flows.²¹ If the question is addressed in terms of what factors are most important in determining FDI, it is quite common for IPR to be omitted entirely. But there is evidence that for particular industries (such as chemicals) and activities (such as R&D) IPR may be a significant factor in the decision by firms to invest.²² Technology owners may opt to license their technologies, protected by the IP regime, rather than invest directly in production. Thus strong rights may deter investment flows but facilitate technology transfer through licensing²³.

In synthesis the main conclusions are:

For more technologically advanced developing countries, IPR is increasingly important to facilitate access to more advanced technology through FDI or licensing.

There is some evidence that FDI is influenced by the strength of IPR, particularly for those industries that are “IPR sensitive” e.g. pharmaceuticals, but the evidence is far from clear.

FDI may contribute to productive capability, but this may be at the expense of domestic output and employment. Developing countries with weak technological infrastructure may be adversely affected by the higher prices of importing IP protected goods.

With some industries able to benefit from IP protection offset by the shortterm negative impact on domestic firms and consumers, achieving the right balance is difficult for countries like China.

Determining the optimal level of IPR protection for a developing country is an empirical question which depends crucially on the level of economic development, the technological and innovation capability of the country, and thereby its need to access foreign technology.

IPR and the Chinese Economy

As China continues to modernise its science and technology system and sustain its economic performance IPR issues are of growing importance.

There are potentially great benefits for China from developing intellectual property as part of its modernisation strategy based on technological upgrading and integration into the world economy. With the right policy framework, there is every reason to believe that IP can increasingly contribute to boosting the share of value added along the value chain in China and to its economic development in general.

Two issues are central to the Chinese economic situation:

IPR, foreign direct investment (FDI) and access to foreign technology: China needs good access to foreign technology, because at its current level of development it depends on this knowledge to construct its own innovation capacities.

Policy coherence in this context would require proper protection for foreign as well as national inventions (e.g. implementing TRIPS) and to fight systematic counterfeiting, which inhibits the transfer of foreign technology and undermines the effect of China’s export-led development strategy.

IPR and encouraging business R&D: Patents are essential instruments to protect commercialisation on the national market and as national patents are used by companies as “launching pads” before seeking protection abroad.

Since the government adopted the strategy of “Revitalising the nation through science and education” in 1995, China has paid increasing attention to improving its national innovation system as part of the country’s overall development strategy. R&D expenditures have grown rapidly over the past decade, with gross domestic expenditures on R&D (GERD) reaching USD 92 billion in 2004 (OECD, 2005), up from USD 17 billion in 1994. Recent OECD estimates show that at the end of 2006 China passed Japan in absolute terms with USD 136 billion versus USD 130 billion, respectively.

GERD as a share of GDP climbed up from 0.64% in 1994 to 1.23% in 2004. While this level is significantly below that of OECD countries as a whole, it exceeds that of some OECD members, such as Greece and Mexico.

In launching their “National Medium and Long-Term Programme for Scientific and Technological Development (2006-20)”, Mr Hu, the Prime Minister, Wen Jiabao, and other top officials have vowed to spend more on science and technology and to insist on business reforms. Their goal is to move China beyond its dependence on natural resources and cheap labour, and stake its place among the economies that depend on education and information technology.

Chart 1 - Gross Domestic Expenditure on R&D (GERD*) as % of GDP

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One target is to reduce China's dependence on imported technology to 30% or less by 2020. According to Professor Fang Xin, of the Chinese Academy of Sciences, the initiative is a matter of necessity. China must learn to innovate if it is to sustain growth.

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¹ WIPO Intellectual Property Handbook: Policy, Law and Use (http://www.wipo.int/about-ip/en/iprm/index.htm)

² A Plan to Ensure Taxpayers' Interests are Protected (http://www.nih.gov/news/070101wyden.htm)

³ Microsoft Reports Fourth Quarter Results and Announces Share Repurchase Program (http://www.microsoft.com/msft/earnings/FY06/earn_rel_q4_06.mspx)

⁴ The $2 Billion Pill? Kevin Davies (www.bio-itworld.com/issues/2006/sept/2-billion-pill/)

⁵ Information Liberation - Challenging the corruptions of information power by Brian Martin (www.uow.edu.au/arts/sts/bmartin/pubs/98il/)

⁶ Free Software / Open Source: Information Society Opportunities for Europe? Working group on Libre Software (http://eu.conecta.it/paper/Contents.html)

⁷ Health and 'intellectual property': Poor nations and drug firms tussle over WTO patent provisions, Gumisai Mutue (www.un.org/ecosocdev/geninfo/afrec/vol15no1/151aids8.htm)

⁸ One-Fifth of Human Genes Have Been Patented: Stefan Lovgren (http://news.nationalgeographic.com/news/2005/10/1013_051013_gene_patent.html)

⁹ European Patent Office Upholds Decision to Revoke Neem Patent (www.ifoam.org/press/press/neem_patent_victory.html)

¹⁰ Debate on Intellectual Property (http://www.iprcommission.org/graphic/Views_articles/New_York_Times.htm)

¹¹ China's Trade Performance, April 2006 (http://www.uschina.org/info/chops/2006/foreign-trade.html)

¹² Source: Chloe Lee, (Head of IP practice at Stephenson Harwood), December 2006 For an exhaustive review of the system see also: The legislation protecting intellectual property right and its enforcement in the EU and in China, a comparative study, December 2005, P Ranjard, H Hui and B Misonne.

¹³ See discussion in Kumar, N. (2002) “Intellectual Property Rights, Technology and Economic Development: Experiences of Asian Countries”; Maskus, K. (2000) “Intellectual Property Rights in the Global Economy”, Institute for International Economics, Washington DC and “Growth and Intellectual Property Michele Boldrin and David K. Levine” NBER Working Paper No. 12769 December 2006.

¹⁴ Gould, D. & Gruben, W. (1996) “The Role of Intellectual Property Rights in Economic Growth”, Journal of Development Economics, vol. 48, pp 323-350.

¹⁵ See Maskus (note 13).

¹⁶ With per capita incomes between $2976 and $9205 in 2001, the World Bank’s upper middle income group of developing countries. Source: http://www.worldbank.org/data/countryclass/countryclass.html

¹⁷ Global Competitiveness Report, WEF, 2006

¹⁸ Maskus, K. & Penubarti, M. (1997) “How Trade-Related Are Intellectual Property Rights?” Journal of International Economics, vol. 39, pp. 227-248; and Smith, P. (1999) “Are Weak Patent Rights a Barrier to US Exports?”, Journal of International Economics.

¹⁹ Maskus, K. (2000) “Intellectual Property Rights in the Global Economy”, Institute for International Economics, Washington DC.

²⁰ Commission on Intellectual Property Rights (CIPR), UK, 2002, Integrating Intellectual Property Rights and Development Policy, London. (http://www.iprcommission.org/papers/text/final_report/reporthtmfinal.htm)

²¹ Maskus, K. (2000b) “Intellectual Property Rights and Foreign Direct Investment”, Policy Discussion Paper No. 0022, University of Adelaide, Adelaide, pp.2-3. Source: http://www.adelaide.edu.au/CIES/0022.pdf

²² Mansfield, E. (1994) “Intellectual Property Protection, Foreign Direct Investment, and Technology Transfer”, International Finance Corporation Discussion Paper 19, IFC, Washington DC. Source:http://www.ksg.harvard.edu/dvc/ifcintellprop.pdf

²³ See note 22