US, China headed for equilibrium in innovation

A crucial bone of contention in the current US-China trade war has been US accusations that China is not abiding by the agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) of the World Trade Organization (WTO). The agreement is aimed at ensuring a freely competitive, open innovation sector.

Broader accusations by US Vice-President Mike Pence of the Chinese government's "wholesale theft of American technology" were highlighted by the high-profile October 2018 case of Yanjun Xu, a deputy division director with the Jiangsu provincial arm of the Ministry of State Security accused of economic espionage and stealing trade secrets; he was lured to Belgium and then extradited to the US for prosecution.

These US actions reflect the inability (or a perception thereof) of existing international structural and legal mechanisms - such as the WTO and TRIPS framework - to regulate and enforce intellectual property (IP) rights globally. This piece presents an overview of China's technological innovation arena, and predicts that the current imbalance between the US and China's technological innovation will gradually evolve into a strategic equilibrium.

Currently, Chinese firms generally benefit from state support, relatively cheaper research and development (R&D) costs, a faster speed-to-market, and a large market for testing new products and technologies.

Despite personal information-protection specifications introduced by the Chinese government last year, the still-nascent and potentially unevenly-implemented data-protection regime in China, together with the large and dense Chinese population, affords Chinese firms the advantages of collecting large amounts of data for R&D purposes, particularly in comparison to the much stricter and legally binding General Data Protection Regulation (GDPR) in the EU. In addition, private Chinese firms adopt increasingly agile business models - such as the common practice of assigning multiple internal teams to compete in developing different solutions for the same product.

China's state-capitalist developmental model confers certain advantages, including:

Those informal ties also apply to many of China's new private technology giants, which are therefore influenced by state directive. For example, after Alibaba bought back its shares from foreign investors Yahoo and Softbank in 2012 and 2016, it sold those shares to the private investment arm of China Development Bank and two investment funds run by "princelings" - descendants of CCP leaders - giving the CCP indirect control over the company's decisions.

Other measures of Party-state control - such as the incorporation of key executives of private firms in the Party apparatus, the purchase of private equity from private enterprises through public resources and the direct establishment of party-branches in companies - have also blurred the boundaries between China's SOEs and private enterprises.

As a result, the Chinese government has often pressured foreign investors to transfer intellectual property to local Chinese firms, partner with Chinese firms, or purchase exclusively from Chinese suppliers. For example, multinational power systems firm ABB, in bidding for a contract from Chinese state utilities operator State Grid Corporation in 1999, was compelled to sign a technology-transfer agreement as a condition for winning the deal.

But to conclude that the cards are (unfairly) stacked against American innovation is premature. Aside from the incumbent advantage and strong technological edge that American firms continue to hold in strategic sectors such as microchip technology, the US as a whole remains an attractive place to live and work in.

This is crucial for two reasons - innovation is not static, and human talent is highly mobile. Present worries that China is on the cusp of leapfrogging the US in technological innovation - in fields as diverse as quantum computing and mobile payments - miss the point. The emphasis should not be on retaining the existing, but assumed soon-to-be-redundant, technological edge that US firms have, but on retaining the human talent necessary to drive future technological innovation.

Currently, occasional cases of individual economic espionage encourage the pervasive fear (perpetuated by the Trump administration) that Chinese citizens and even Americans of Chinese descent, are necessarily bound, or loyal, to Chinese national interests. This is an oversimplification and misses a crucial factor determining future Sino-US rivalry - that the United State's better quality of life and relative academic openness vis-a-vis China, are unquantifiable but no less significant advantages in the long term.

Eventually, we believe that the respective advantages of both China and the US will lead to a gradual strategic equilibrium in technological innovation, as well as relatively common standards in, and enforcement of, IP rights. This relates to academic studies conducted on the relationship between intellectual property and development. As the Chinese economy develops its own globally, technologically competitive firms vis-a-vis their Western counterparts, stronger intellectual property rights help reward domestic innovation and protect Chinese firms' own IP.

To qualify, however - this strategic equilibrium emerges because of market forces, driven by the interests of Chinese firms and the Chinese government. It is not externally enforced and hence does not detract from the persistent structural inadequacies of the existing international legal framework in governing intellectual property rights (such as TRIPS). China's internal drive towards stronger IP protection should not obscure the fact that TRIPS and WTO law are becoming increasingly irrelevant to conflict resolution over IP disputes.

This challenge arises because the Chinese economy includes elements that are beyond the purview of the WTO. Due to the complex relationships between the state functionaries, the CCP, and businesses in China, it is difficult to discern whether a firm in China is linked to state interests, or fully operating as a private firm.

In a 2008 trade dispute regarding the US' retaliatory use of countervailing duties (CVD) on Chinese exports, the WTO's Appellate Body ruled in favour of China, claiming that private companies which receive preferential loans and deals from SOEs and state-owned banks do not qualify as "public bodies". The Appellate Body's narrow definition of "public bodies" as entities that "possess, exercise, or are vested with government authority" excludes many private shareholder companies in China, which nevertheless maintain close ties with the Party-state.

Since the CCP often exerts control over Chinese private enterprises through informal patron-agent relationships rather than formal mechanisms, it is difficult for the WTO to uphold its mandate. Our prediction of stricter enforcement of IP rights in China in the long term should thus not be taken as a broader forecast of free-market reform within the Chinese economy.

Ultimately, current US-China disputes on intellectual property regulation and enforcement will gradually stabilise into a strategic equilibrium, where both governments and their respective competitive private sectors, push for more stringent intellectual property enforcement. However, this future strategic equilibrium is driven by the interests of the Chinese government and Chinese firms, and will not detract from the increasing inefficiency of the WTO and TRIPS. It should also not be extended as a broader prediction of free-market reform in the Chinese economy, as China's economy will continue to embrace a hybrid state-capitalist model with strong formal and informal ties between the Party, the state and the private sector.