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Sleeping Giant No More

April 5, 2012 | Posts

In 1978 in the United States, President Carter signed a bill allowing for the home brewing of beer; the Dallas Cowboys won the Super Bowl; and, in a Cold War move, computer sales to the Soviet Union were banned. In the People’s Republic of China, an economic revolution was being planned.

At the time, total trade between the U.S. and China amounted to $2 billion a year. By 2010, it rose to an estimated $459 billion – a 22,850 percent increase. China is currently the United States’ second-largest trading partner (behind Canada), third-largest export market, and big­gest source of imports. The U.S. trade deficit with China rose from $10 billion in 1990 to an estimat­ed $273 billion in 2010, which is greater than the trade deficit with the Organization of the Petro­leum Exporting Countries, the European Union, Mexico, Japan, and Canada combined.

For lawyers, conducting business with Chinese organizations presents challenges that require specialized understanding of Chinese laws and culture. But, with billions of dollars of goods and services flowing between the U.S. and China each year, lawyers and firms that do not establish a strategy for embracing this global business reality might be left behind.

“Every firm of every size is going to have deal­ings with China– from large to midsize to even small firms – it is impossible to avoid. You have to have a strategy or be left in the dust. Clients are doing business in China,” said Daniel C.K. Chow, the Joseph S. Platt-Porter Wright Morris & Arthur Professor of Law at The Ohio State University Moritz College of Law. Chow recently published a casebook, “Doing Business in China: Problems, Cases, and Materials” (West 2012).

Understanding trade deficit

In January 1979, the U.S. and China re-established diplomatic relations and a bilateral trade agree­ment, and most-favored-nation treatment fol­lowed within a year. By 1990, Chinese imports to the U.S. rose quickly, with the nation climbing from 26th on the list of nations importing to the U.S. in 1980 to eighth. Since 2007, China has sat firmly at the top of the list. The top five imports from China are computers and parts, miscel­laneous manufactured goods, communications equipment, clothes, and audio and video equip­ment. Perhaps less known: China is the third-larg­est source of U.S. imports of agricultural, fish, and forest products, including seafood and processed fruit and vegetables.

“A trade deficit is when you move more goods from China than you sell to China. At this point, America is bringing much, much more in from China than we are selling,” Chow said. “Whenever that happens, you are living beyond your means – when you are spending more than you sell or more than you earn. It is like an individual with a credit card. There are many reasons as to why the deficit exists. But, basically, American consumers want Chinese goods. They want to go to Walmart and buy a flat-screen television for a cheap price.”

Despite the huge deficit, China has been the fastest-growing market for U.S. exports over the past decade. In 2009, the top five exports to China were oilseeds and grain; waste and scrap; semicon­ductors and electronic components; aircraft and parts; and resins and synthetic rubber and fibers.

“There is good demand for high-quality, high-demand products like Apple iPhones, iPads as well as for IBM products like our servers,” said Steve Mortinger ’89, associate general counsel and trust and compliance officer for IBM’s Growth Markets in China. Mortinger concentrates on the Foreign Corrupt Practices Act and the U.K. Anti-Bribery Act. He also educates and investigates issues surrounding IBM’s business conduct guidelines, including theft of assets and other unacceptable behavior.

While U.S. exports to China continue to grow, this rate of growth is dwarfed by the influx of Chinese imports flowing into the U.S. China uses much of its earnings from selling exports to buy U.S. government securities, such as treasury bonds.

“China is a hybrid market,” Mortinger said. “There is a lot of government investment, but companies do compete against each other. Cer­tainly, there is at least some speculation that the government has some level of control in most companies because of its investments in them. In China, you have to assume almost all companies have some level of government ownership. If you assume a company is a pure private enterprise, it is probably not.”

Chinse banks are owned by the government, for example. As China makes money selling goods to American consumers, it lends the money right back to the U.S. government in form of treasury bonds, Chow explained. By finding revenue from this source, it relieves the U.S. government from creating other revenue streams, such as raising taxes, and keeps interest rates low.

“Low taxes and low interest rates give U.S. con­sumers more money to buy Chinese goods. It is a circular process with the U.S. getting further and further into debt,” Chow explained.

While lower taxes and interest rates are a ben­efit to American consumers, the question of na­tional debt and foreign ownership are hot-button topics in Washington, D.C. and across the country.

“The consequence of all of this is that China is owning more and more of the U.S. economy,” Chow said. “China is not just buying treasury bonds but has diversified into buying equity in companies in both the U.S. and Europe. The more of the economy they own, the more aggressive they can be in their policies, and the more they can dictate without fear.”

Chow proposes two solutions to reducing the trade deficit with China. The first requires Ameri can consumers to stop buying so many Chinese goods – an unpopular notion for bargain hunters. The second would require China to buy more goods from the U.S. “But China has been saving its money to become a global power. It has been building infrastructure and its military. It has no legal or ethical obligation to buy U.S. goods,” Chow said. “It wants to be a global power, and you do not do that by buying televisions and fashions. You do it by making strategic investments and building relationships.”

There are also questions, however, about whether China is playing by international trade rules and regulations or if some of the exponential growth is caused by unfair trade practices, and currency manipulations.

Questioning China’s currency value

Most advanced economies around the world main­tain a market-based floating exchange rate for their currency. China instead has directly tied the value of its currency to the value of the U.S. dollar.

“This really controls the exchange rate, prevents the Chinese currency from rising in accordance with market forces and, therefore, undervalues it,” Chow said. “This makes Chinese goods cheaper for U.S. consumers and makes the trade deficit go up.”

The Chinese government argues that it is a developing economy and that allowing its cur­rency to be freely floated would lead to economic instability and social turmoil, Chow said. Due to constant pressure by the United States, China has recently allowed its currency exchange rate to float within narrow ranges, but he added, “These reforms are not happening fast enough for the United States.”

While the ratio once was 1 USD-to-8 RMB (the Chinese currency), now it is 1-to-6. But, Chow believes it could easily be 1-to-3 or 1-to-4.

According to the United States Trade Repre­sentative, the Chinese government also directly manipulates the value of the currency by control­ling capital transactions and making large-scale purchases of U.S. dollars. During the global eco­nomic slowdown in 2009 and 2010, the Chinese government stopped any attempt to appreciate the value of its currency in an attempt to limit the economic impact of the sharp decline in the global demand for Chinese products.

By manipulating the currency value, the Chi­nese government is able to ensure it stays artifi­cially low compared to the dollar, making Chinese goods cheaper for U.S. consumers. Some view this policy as a de facto government subsidy for Chi­nese imports to the United States and call for the imposition of a higher tariff or tax, called a coun­tervailing duty, to offset the effect of the subsidy. The rationale is that artificially lower-priced Chi­nese goods, supported by government subsidies in the form of a fixed currency exchange rate, could hurt U.S. manufacturing and cause the loss of U.S. jobs. The issue has once again caught the attention of Congress with multiple bills being introduced and hearings being held in recent months.

“Most multinational companies are quiet on the issue of imposing trade sanctions on goods import­ed from China because they are getting parts from China cheaper and assembling things in China for cheaper, leading to, of course, profits,” said Chow. “If the currency floats, the price of Chinese goods go up in the U.S., and U.S. goods are cheaper in China. The United States buys less and sells more.” Counterfeiting, reverse-engineering, intellectual property rights

China’s application to join the World Trade Organization took more than 15 years to come to fruition. One of the major stumbling blocks was the country’s lack of laws, infrastructure, and understanding of intellectual property rights. When China joined the WTO in 2001, it also was committed to bring its intellectual property laws into compliance with the WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), one of the mandatory disciplines of the WTO. While most observers believe that China’s intellectual property laws conform to TRIPS, the enforcement of those laws often has been questioned.

“Chinese companies have reverse-engineered products, which saves them a lot of money on re­search and development,” Chow said. “If they copy the technology, they have fewer costs because there is little research and development, and they pass the savings on to consumers. This can be illegal and unfair. The Chinese laws in this area meet world standards, but the problem is with enforcement of these laws. There is a lot of local protectionism in China. If a company helps the lo­cal economy, officials do not want to shut it down and lose revenue and taxes. There is hostility toward enforcement, and IP theft happens every day. There is very little respect for IP.””

According to Chow, companies often hire em­ployees away from other companies for the trade secrets. The evidentiary burden for enforcing rights in trade secrets in China is quite high and often impossible for companies to meet.

According to the International Intellectual Property Alliance, China has one of the highest piracy rates in the world, with an estimated 90 percent of all records and music and 80 percent of all business software pirated in 2009. The alliance estimated that the piracy of business software cost American companies $3.1 billion in lost trade in 2009.

Since 2001, the U.S has filed 11 complaints against China with the WTO and has had mixed results. In 2007, for example, the U.S. filed a complaint against China alleging a multitude of complaints:

The thresholds for criminal prosecution were too high, and the country would only consider high-profile or large cases.

The government allowed pirated goods to re-enter the marketplace instead of dispos­ing of them.

There was no protection for goods under review by the censorship authority but in the marketplace.

Producers of pirated goods could not be pros­ecuted unless they also distributed products.

In 2009, in Panel Report, China — Measures Affecting the Protection and Enforcement of Intellectual Property Rights, WT/DS362 (Jan. 26, 2009)(adopted Mar. 20, 2009), the WTO ruled in favor of the United States on the second and third points and in favor of China on the first and fourth. Many experts believe that China won on the more important points.

“Most of the counterfeit products I see are con­sumer goods like purses, low end electronics and DVDs. They aren’t really making IBM products – it is much harder to make counterfeit servers and corporate-grade software,” said Mortinger. “We talk a lot with our employees of Chinese heritage about our policies against downloading software illegally. Because of IP concerns, most multi-national companies, at least for now, are much more comfortable keeping their sensitive patent­able work in Europe or the U.S.”

While some experts point to China’s lack of re­spect for intellectual property rights as the major culprit for ongoing problems, others argue more conscious and concerted policies are at work. The Chinese government’s most recent five-year plan states that its central goal is to change China from a major manufacturing center to a global source of innovation within 15 years. According to R&D Magazine, this has led to large-scale invest­ments in space programs, aerospace development, renewable energy, computer science, pharmaceu­ticals, and high-tech manufacturing.

A major part of these policies are a series of government procurement guidelines that favor the government purchase of products containing intellectual property that was entirely developed in China. These policies are viewed by many U.S. industries as forcing them to transfer their intel­lectual property rights to their enterprises in Chi­na in order to be able to sell goods to the Chinese government, which has a massive government procurement budget of $80 billion per year. Once the intellectual property rights are transferred to their enterprises in China, these rights are then at risk of being copied or stolen.

Prior to 2011, for example, the Chinese govern­ment required foreign automakers to transfer technology to Chinese enterprises or establish Chinese brands in order to invest and sell electric vehicles in China. After extensive negotiations, the Chinese agreed to reverse this policy to some extent in 2011.

“China does have some regulations that require intellectual property to be invested with China, and there is a question whether intellectual property will be protected. In general, don’t bring intellec­tual property into China if you can avoid it,” said Stephen F. Vogel ’78 of Fulbright & Jaworski LL.P. Vogel has spent his career in international business, working in the firm’s London office for 22 years before opening offices in Hong Kong and Beijing.

In 2011, the Office of the United States Trade Representative announced that after extensive negotiations, China agreed to establish a new, permanent, vice-premier-led intellectual property enforcement structure.

“China is a very proud country, and it should be,” Vogel said. “It has a history spanning more than 4,000 years, and it has certainly been a principal economic power for many of those years. There is a great desire in China to re-establish the prominence of its civilization. It is not for power, but for pride.”