Pirated DVDs in ChinaU.S. Secretary of State Hillary Clinton lectured China Sunday on the importance of protecting intellectual property (IP). China is, of course, notorious for knock offs -- just witness the DVDs of popular first-run movies available on the streets of major Chinese cities. But China says by 2030, it'll upgrade its protection of IP, just as Clinton requested.

Her message to China featured a worshipful recitation of the benefits of free trade. According to Voice of America, Clinton said, "Transparency in rule-making and standard-setting, nondiscrimination, fair access to sales to private sector and government purchasers alike -- and the strong enforcement of intellectual property rights -- are all vitally important. That's what drives innovation, benefits consumers, and ultimately stimulates broad-based and sustainable growth."

Clinton is certainly right that China doesn't respect IP. According to Audioholics, DVD piracy is rampant in China, with DVDs of movies on the street for as little as $1.25. Since the vendors selling these knock-offs don't pay a licensing fee, they probably earn a nice profit on these transactions.

Still Attractive for Foreign Capital

But just because China doesn't respect IP, it doesn't mean investors aren't flocking there. For example, according to the Emerging Markets Private Equity Association, $6.3 billion of private equity went into to China in 2009.

And venture capitalists are also placing bets there, despite China's lack of respect for IP. According to Michael Greeley, a venture capitalist I interviewed for my new book, co-authored with Srini Rangan, Capital Rising, his former employer invested in China in a way that took advantage of the huge market and growth potential while avoiding the IP problem. His firm did this by investing in ventures that provided a service, such as buying music online, that didn't depend on unique IP for its success. Greeley says one such company was worth 100 times the investment.

Despite Clinton's efforts to jawbone China, it will get around to protecting IP when such protection suits its interests. This is what happened with Japan and then India. In both countries, the governments decided that they could build profitable generic-drug industries by affording very weak protection for IP.

This IP regime enabled Japan and India to start companies that could manufacture copies of patented drugs at far lower costs and sell those cheap copies around the world, according to a Harvard Business School case I teach, India's Intellectual Property Rights Regime and the Pharmaceutical Industry. Thanks to these countries' low labor costs and good manufacturing skills, the generic-drug industries grew large and profitable.

But when those home-grown generic-drug manufacturers saw the profits available from patented drugs, they urged their governments to upgrade IP protection so they could make more money from being innovative.

A Long Way to Go

For the time being, China's pharmaceuticals industry is exporting huge quantities of drug raw materials. According to the American Enterprise Institute, from 1998 to 2007, China's pharmaceutical exports rose at a 24.6% compound annual growth rate from $3.4 billion to $24.6 billion.

Some of these exports have caused health problems. The AEI noted that between November 2007 and May 2008, "95 Americans died from heparin believed to have been 'deliberately contaminated' in China. Melamine-laced milk powder sickened over 294,000 babies (and killed at least six) in China."

And China is also a big seller of counterfeit drugs. EU customs officials collected data that ranked China "among the world's top four exporters of counterfeit pharmaceuticals. In 2005, China ranked third, with 6% of all drugs seized by European Union customs officials originating in the country. In 2006, that number shot up to 20%."

China also faces serious challenges in improving its reputation for less than honest dealing. A colleague who works in the medical device industry told me that three weeks ago he attended a conference at which an expert who investigates problems between U.S. companies and their Chinese partners claimed that "some degree of fraud can be found in at least 80% of transactions between U.S. companies and their 'partners' in China."

The problem is that the Chinese partner tells the U.S. company what it wants to hear but in fact delivers less than what the U.S. company expected. As my colleague said, in medical devices "it is common for everyone in the supply chain (from raw materials suppliers to end product manufacturers) to claim that they have used the prescribed materials, built the devices to spec, obtained the necessary regulatory clearances, etc.; however, more often than not, some level of deceit has occurred. Perhaps the raw materials are second rate, corners were cut in manufacturing, inspection documents were forged, etc."

My colleague is amazed that so many people keep flocking to do business in China but his company has found better places to manufacture. He concluded, "The resulting horrors we hear about -- tainted baby formula, lead paint, unparalleled environmental degradation -- are only the tip of the iceberg. It amazes me that, despite all these issues, companies still flock there to do business. We're finding that there are plenty of other low cost countries in which to conduct business that do not pose nearly the same degree of risk as one finds in today's China."

So, China clearly has a long way to go before it can get to where India arrived in the 1990s when its generic-drug industry was ready to start making money from patented drugs. In India, this process took about 20 years, and if China were to follow suit, it too would begin to protect IP -- by about 2030.

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