Xinhua Xinhua/Eyevine/Redux

How to Stop China’s Technology Heist

 

lee branstetter is a professor of economics and public policy at Carnegie Mellon University and a senior fellow at the Peterson Institute for International Economics.

Published April 26, 2019

 

At the time of this writing, U.S. equity markets are bedeviled by volatility, at least in part driven by fear that President Trump’s trade war with China will escalate out of hand. While America’s mercurial chief executive may well call a truce in coming weeks — or even declare victory — the chances that broad-based punitive tariffs will persuade China to eschew misappropriation of foreign technology seem remote.

However, there is a promising alternative strategy for dealing with the genuine problem of containing forced transfer of technology from American companies seeking to do business in China – one that carries with it less risk of collateral damage and a greater chance of success. I outlined the basic idea in a Peterson Institute Policy Brief last June. And in the interim, the prospects for success of this alternative strategy have brightened. For one thing, Congress has significantly strengthened the government’s ability to accomplish this strategy. For another, the concerns of America’s allies regarding China’s technological ambitions have grown, opening the door to a coordinated Western response. It would thus be possible for the Trump administration to back away from its expensive, ineffective trade war while, at the same time, ratcheting up the pressure for China to constructively address technology transfer.

Forced Technology Transfer:
Ways, Means, Consequences

To its credit, the Trump administration’s trade team began its campaign to change China’s polices by focusing special concern on China’s infringement of American intellectual property rights and its practice of insisting that American companies transfer advanced technology as the price of manufacturing and marketing in the Middle Kingdom. There is broad agreement that these are real problems – and this consensus extends across both major U.S. political parties and most of America’s leading trade and investment partners and is shared by a large number of independent experts on China.

In many cases, technology transfers are effectively required by China’s foreign direct investment regime, which closes off important sectors of the economy to foreigners unless they enter into joint ventures with Chinese entities that the foreign firm does not control. The auto industry is a key case in point: foreign ownership restrictions (and high Chinese tariffs) have historically forced foreign carmakers to serve the booming Chinese auto market – now the world’s largest – through joint ventures in which they are barred from holding a controlling interest. Now, as China seeks to build up its capabilities to produce electric vehicles, European automakers complain they are being pressured to turn over sensitive technology, including proprietary software, to joint venture partners who may later compete with them.

Even in officially “open” sectors, foreign firms must obtain approval from regulators in a process that lacks transparency. This process, moreover, is subject to political influence; foreign firms can be quietly pressured to transfer technology to local firms in order to obtain these necessary approvals.

State-owned enterprises, still prominent players in key sectors of the Chinese economy, often spearhead the effort. While nominally independent, the top executives of the major SOEs are effectively appointees of the Chinese Communist Party, and their success is defined, in part, by the extent to which they contribute to the party’s broader objectives. If Beijing wants to create an indigenous industry capable of manufacturing advanced turbines for electricity generation that can compete with the products of GE and Siemens, then the head of a Chinese power utility can insist that any supplier of turbines transfer valuable technology to indigenous Chinese suppliers as the price of winning contracts.

Note, moreover, that this can happen even if the demand undermines the utility’s interests by raising the cost of turbines, reducing reliability or creating longer delivery times. A truly private firm would be unlikely to endure such costs for the sake of promoting government industrial policy, but an SOE may see the matter differently. For their part, GE and its multinational competitors all realize that the short-term costs of refusing to play by Chinese rules are quite high: even if one firm balks, another is likely to acquiesce.

 
China Stringer Network/Reuters
 

China’s critics say this dynamic is playing out in industry after industry, with SOEs determining which products and services will be incorporated into China’s energy, communications, transportation and health care systems. The scale of the Chinese market gives these SOEs considerable leverage, which is being exercised in service to Beijing’s ambition to replace the leading multinationals with Chinese national champions.

The SOEs thus function as a de facto cartel, colluding to expropriate key technologies from foreign suppliers. If a Chinese firm “licenses” an extremely valuable technology at a price that is a small fraction of its commercial value by exercising monopsony power over its foreign supplier, its actions are conceptually quite close to intellectual property theft.

Note that this is not a zero-sum game in which Chinese companies and their foreign suppliers bargain for shares of a fixed pie. Far more is at stake. To the extent that China’s forced technology transfer practices (or the expectation of intellectual property theft) deter multinationals from investing or operating there, it can harm both China and the broader global economy. Formal models by Lai (Hong Kong University of Science and Technology), Branstetter and Saggi (Vanderbilt) and Gustafsson and Segerstrom (Stockholm School of Economics) show how fear of losing control of key technologies could prevent multinational corporations from shifting production to lower-cost countries.

 
Bob Henry/Alamy
 

This outcome would prevent low-cost countries from fully realizing their comparative advantage in manufacturing existing products, and also prevent advanced economies from fully realizing their comparative advantage in developing new products. As a consequence, production costs are higher, efficiency is lower, and the pace of innovation in the global economy is slower than it would be in an equilibrium in which multinationals are able to retain control of their technology without sacrificing the Chinese market.

When forced technology transfers enable Chinese firms to displace the Western enterprises that created the technology in the first place, the global economy can be harmed in yet another way. The forced transfers described here amount to a subsidy of Chinese producers and a de facto tax on foreign enterprises. If Chinese government intervention succeeds in tilting the playing field in favor of less innovative Chinese firms, and thereby limits the resources flowing to the world’s most innovative firms, then, in the long run, innovation will slow and consumers around the world will suffer.

Past efforts to resolve the issue through bilateral negotiations have failed. In theory, foreign companies could challenge forced technology transfer through the World Trade Organization, since the coercion violates China’s obligations under its accession agreement to WTO. But the realities of the WTO dispute-resolution process make it extremely difficult to sanction China’s behavior this way. That’s because China’s requirements for technology transfer are not stipulated in law and are instead imposed through extralegal means. Hence, few foreign firms are willing to make their complaints public. Tougher action is therefore warranted.

Trump’s Flawed China Strategy

From the beginning, the Trump team’s efforts to solve American firms’ problems in China conflated the real problem of forced technology transfer with the nonproblem of a large bilateral trade deficit for the U.S. with China. The U.S. has run large bilateral deficits with some trading partners and large surpluses with others for decades – just as other economies do. Large bilateral imbalances are a natural occurrence in a global economy, not a problem that requires a solution.

Apparently seeking to solve the real problem and the nonproblem at the same time, the administration first threatened and then imposed broad-based tariffs on a wide range of Chinese goods. Yet, as Mary Lovely (Peterson Institute) and Yang Liang (San Diego State)have shown, these tariffs have hit multinational supply chains serving U.S. firms far harder than the Chinese entities that potentially benefit from forced technology transfer. Indiscriminate tariffs have also invited Chinese retaliation, with tariffs aimed at, among others, soybean farmers who are concentrated in states that Mr. Trump carried in 2016.

 
If Chinese government intervention succeeds in tilting the playing field in favor of less innovative Chinese firms, and thereby limits the resources flowing to the world’s most innovative firms, then, in the long run, innovation will slow and consumers around the world will suffer.
 

The lever grasped by the Trump administration has generated so much collateral damage within the U.S. economy that even business leaders convinced of the danger of forced technology transfer have (rationally) concluded that the “cure” chosen by the administration is worse than the disease. This generates intense pressure to abandon the tariffs, even if the technology misappropriation problem remains unresolved. The administration’s flawed fixation with the bilateral deficit has also invited Chinese offers of one-time state-driven purchases of American commodities as a face-saving way for the president to declare victory and eliminate the tariffs, leaving the Chinese free to coerce foreign technology transfers.

The second major flaw in Trump’s strategy has been its unilateral nature. The influence of America alone is not nearly enough to credibly deter the Chinese actions that the U.S. seeks to restrain. Only a multilateral approach has any chance of lasting success. Yet at a time when the U.S. should be organizing Europe and East Asia into a grand coalition to combat Chinese misappropriation of technology, the White House has chosen to outrage our closest allies with unjustifiable tariffs on steel and aluminum imports. And it looks set to do even more damage with tariffs on autos.

A Better Way

The forced technology transfer strategies described above are often effective because the foreign companies that are targeted are too scared to speak up. The likelihood that they will be punished and ostracized by the Chinese government is extremely high – much higher than the likelihood that complaints to their home country governments would settle complaints in their favor. Without hard data on which Chinese government officials and SOE executives are applying pressure on U.S. multinationals, it has been difficult for the U.S. or any other country to use targeted sanctions or the threat of targeted sanctions to deter forced technology transfer.

New legislative authority could help. As part of an omnibus defense spending authorization bill passed with bipartisan support in 2018, Congress expanded federal scrutiny over incoming foreign investment (through the Foreign Investment Risk Review Modernization Act) and strengthened the federal government’s controls over technology exports (through the Export Control Reform Act). Both pieces of legislation have been extensively reviewed by the Peterson Institute’s Martin Chorzempa, who notes that the latter statute empowers the Department of Commerce to lead an interagency group that will define “emerging and foundational” technologies “essential” to national security.

 
One hopes that the existence of a well-targeted, credible sanction could significantly deter bad behavior so that the sanctions would rarely be applied.
 

That interagency process is still ongoing. Business leaders are concerned that the defense and intelligence agencies will push for a list of “essential” technologies that is unduly expansive, covering both military and civilian applications. Once the technologies are enumerated, Commerce would be empowered to license covered technology exports and transfers to countries under any U.S. export embargo, including China. And it could potentially extend this control far beyond the current country list. In the licensing process, Commerce is able to call upon the resources of the intelligence community in vetting the identity and aims of the foreign counterparty seeking access to U.S. technology. And it has the legal authority to subpoena documents and compel oral testimony from the U.S. firms trying to export the technology.

In the best of all possible worlds, one can imagine how these new authorities could disrupt the dynamic that has facilitated forced technology transfer in the past. A U.S. company, under Chinese government or SOE pressure to transfer, say, an advanced machine-learning technology on the Commerce Department’s list to an indigenous Chinese enterprise, would have to get permission from the federal government. As the reviewing committee analyzed the proposed terms and content of the transfer and how they do or do not differ from the firm’s technology transfer practices in other countries, Washington would have a good shot at identifying cases of coercion.

At this point, the government could use its subpoena power to force U.S. firms to divulge any threats and inducements laid out by Chinese customers. Even U.S. firms reluctant to tell the truth would now have little choice: threats quietly whispered in Beijing cafes would now be divulged in full to U.S. government officials, under penalty of law. And once the federal government had strong reason to suspect forced transfer, it could use its export control powers to delay or suspend the transfer.

The federal government could also use other existing legal tools to sanction the individual Chinese government officials and SOE executives involved in pressuring a U.S. firm to transfer technology, and it could impose additional sanctions on the specific Chinese commercial entities that were or would be the beneficiaries of the forced transfers.

The International Emergency Economic Powers Act of 1977, or IEEPA, provides sweeping legal authority for the U.S. president to order sanctions of firms, individuals and countries. The IEEPA was the legal basis for the U.S. sanctions recently imposed on the China-based telecom company ZTE, which quickly brought this major multinational to its knees. That episode drives home the degree to which the U.S. government can put the screws on individual foreign companies when it chooses to.

Targeted sanctions could also involve travel bans in the West and foreign asset freezes for key Chinese individuals and their families, as well as financial and trade penalties on the firms and products benefiting from forced technology transfer. America’s allies possess similar statutes and could participate in enforcing multilateral sanctions against entities that forced the transfer of U.S. technology.

The United States, of course, could reciprocate.

 
Marginon/Alamy
 

These sanctions would not come without economic costs to the United States and its allies. However, the focus of these sanctions on specific Chinese enterprises currently pressuring Western firms to transfer technology or already benefiting from such transfers would ensure that maximum pressure would be applied with minimum risk of collateral damage. The targeted nature of the sanctions on China would invite similarly limited countersanctions (if any) from the Chinese, further minimizing the fallout from this dispute. One hopes that the existence of a well-targeted, credible sanction could significantly deter bad behavior so that the sanctions would rarely be applied.

Walking The (Fine) Line

To be credible and effective, the campaign described above would have to be multilateral, with extensive sharing of sensitive information regarding potential forced technology transfer practices across agencies and governments. There are few technical domains where American firms possess a monopoly, and if government bureaucrats inhibit the business of U.S. firms but there is no parallel oversight of European, Japanese, Israeli and Korean firms, all the intervention would accomplish is the decimation of U.S. firms’ market share in the world’s fastest-growing large economy.

The campaign would also need to find the sweet spot between constructing a list of “emerging and essential” technologies that is too expansive and one that is too narrow. Already, corporate America is worried that the technology list and the new authorities would inhibit their ability to conduct business anywhere outside the U.S. – and especially in China. Given the incompetence and inclination to overreach on the part of some of Mr. Trump’s key appointees, these concerns seem well-founded.

 
By attacking the issue with unilateral tariffs on a wide range of products, the administration is shooting itself in the foot.
 

Finally, the new powers extended to the Commerce Department would have to be exercised judiciously, even if the list of technologies is carefully chosen. Most exports of advanced technology to China enhance America’s prosperity and pose little or no threat to national security. Government bureaucrats would have to resist the temptation to interfere in the activities of rational profit-seeking enterprises except where such interference is truly warranted. One can easily imagine administrative abuse or incompetence turning the new authorities created by Congress into an expensive and enduring burden for U.S. companies.

On the other hand, without appropriately targeted and better-informed government intervention, there is no reason to believe that China’s behavior will change. At the moment, Beijing believes technology transfers can be forced with little fear of discovery, much less sanction. History bears out this confidence. China’s behavior will change only when it faces the credible threat of discovery and meaningful sanction. For these reasons, an excessively narrow technology list is also problematic because it would reduce the impact of the most effective tool the U.S. government has ever had to combat this problem.

Precisely because there is such a compelling need to get these critical balances right, there is considerable merit in the recent bipartisan proposal introduced by Senators Marco Rubio, Republican of Florida, and Mark Warner, Democrat of Virginia, to create a White House Office for Critical Technologies and Security. The office they envision could bring in high-level talent from research universities and leading tech companies to help refine both the list of emerging technologies and the means to protect them from misappropriation. The parentage of this bill shows that taking a tougher line against China is one of the few domains in which Republicans and Democrats can find common ground. Washington should take advantage of the current consensus to take forceful, but intelligently targeted, action.

At the core of the White House’s dispute with China lies a real problem that merits decisive action. But by attacking the issue with unilateral tariffs on a wide range of products, the administration is shooting itself in the foot, undermining the support of multinational corporations and U.S. trading partners that the more targeted approach outlined here would require. While the use of the newly created policy tools proposed here – and the more aggressive use of existing ones – would not be without costs, such costs would be limited by design.

A muscular response to coerced technology transfer could work. It would be a sad irony if the dead-on-arrival tactics now being used to bludgeon China pushed a sophisticated, coordinated approach out of reach.

main topic: Trade
related topics: China, Technology