US and China IP theft battle could hit Silicon Valley

On Monday, US President Donald Trump finally came good on one of his many pre-election promises. His executive memorandum will most probably lead to a year-long investigation into allegations of widespread Chinese theft of US intellectual property. While many Silicon Valley firms will be glad to see the White House finally take a determined line against the elephant in the room of Sino-US relations, just as many will be nervous of the potential outcome.

Be in no doubt: a possible trade war would be catastrophic, both for US firms operating in China and their global customers.

A multi-billion-dollar problem

The investigation will be carried out under Section 301 of the Trade Act of 1974, a controversial move which would allow the President to impose unilateral trade tariffs and/or sanctions and could itself contravene WTO rules.

“The theft of intellectual property by foreign countries costs our nation millions of jobs and billions and billions of dollars each and every year,” Trump said during the signing. “For too long, this wealth has been drained from our country while Washington has done nothing … But Washington will turn a blind eye no longer.”

For once, he has bipartisan support on this. Few doubt that China has been profiting from IP theft for decades. This IP has allowed Middle Kingdom companies to flourish, gaining near-parity with many of their US rivals and allowing them in some cases to make cheaper versions of products to sell either to US or domestic consumers. Either way, that has meant billions in losses for Silicon Valley and a widening trade deficit which last year hit a massive $310 billion. BSA stats claiming a 70% piracy rate in China make a mockery of Beijing’s claims to rigorously enforce IP protection.

China watcher Bill Bishop commented this week in his popular Sinocism newsletter: “there were plenty of people in the bureaucracy under the Obama administration who wanted to take a tougher a line against China but were in part held back by Obama, Susan Rice and John Kerry.” In the end, all that came in the past eight years was a much-heralded 2015 US-China cybersecurity agreement not to engage in “economic espionage”. While that has stopped straightforward IP theft, Chinese hackers are still hitting US firms, according to FireEye Chief Intelligence Strategist Christopher Porter.

“They continued to target US companies for purposes other than IP theft: the collection of sensitive information on private individuals, such as health records from hospitals and insurance companies; theft of advanced technology from defence contractors and dual-use technology suppliers; and targeting of companies that provide services to other companies, such as cloud hosting providers, law firms, and telecommunications companies,” he told me by email.

However, Trend Micro European cyber security solution architect, Simon Edwards, indicated that IP theft via cyber espionage is still a major issue.

“Each state actor tends to have its own raison d’être as to what they target in cyberspace; and more often than not with China it tends to be intellectual property that is stolen. The examples and cases of where Chinese operatives have stolen IP from Western companies and organisations is very well-documented, although final attribution is always tough,” he explained to me.

“There have been calls from all sorts of Western companies—not just American ones—for someone to put a stop to this. Clearly, being able to steal the plans to a new design is much cheaper than having to do that design work for yourselves.”

JV headaches

Yet China is accused not just of using arm’s length hackers to get what it wants. Foreign firms in many industries are forced to enter joint venture and tech transfer agreements with Chinese companies if they want to tap the massive domestic market.

“Joint ventures in China that involve technology transfer have the advantage of providing Chinese companies not only know-how but also ‘know-why’,” FireEye’s Porter told me.

“Many products that are made by American companies involve not only proprietary formulas and blueprints but trade secret methods, unique cultures, and informal rules that must be learned first-hand and cannot be simply stolen. Joint ventures give Chinese companies a chance to learn from these best practices and absorb them into their own parent companies.”

On top of this, a new Cybersecurity Law has mandated that foreign firms in China must hand over product source code to the authorities. It’s part of what the BSA has described as a “de facto trade barrier”: using security concerns to grab more IP and make life difficult for US players.

IT thinktank the ITIF sent out a strong statement supporting the trade investigation:

Simply put, China is an innovation mercantilist. It tries to gain advantage in strategically important industries by using dubious policies and practices such as coercing competitors into handing over proprietary technologies and intellectual property. For too long, China has systematically flouted the spirit, if not always the letter of its commitments under the World Trade Organisation and other agreements.

Over the years, the price US firms have to pay for access to a market of 1.4 billion people has grown increasingly high. The question is whether this new hard-line strategy from Trump will make things better or worse for tech firms with large China businesses.

China talks tough

China has sounded a typically tough line on Trump’s plans. A Commerce Ministry statement had the following:

If the US side ignores the facts, and disrespects multilateral trade principles in taking actions that harms both sides trade interests, China will absolutely not sit by and watch, will inevitably adopt all appropriate measures, and resolutely safeguard China’s lawful rights.

However, former US ambassador to China, Max Baucus, believes standing up to Beijing is ultimately the best approach.

“China is very clever; one step at a time they’ll tighten up their protectionism … We have to push back. We’ve not pushed back enough in my judgement,” he told Bloomberg. “I think to some degree since we’ve been a bit lenient China’s been a bit disrespectful of us on trade. The Chinese very much respect candour… if you stand up to them they’ll back off.”

On Trump’s side is the fact that Chinese companies clearly have the better end of the deal as it stands. They’re not pressured into handing over IP in return for US market access and some have even been able to build up Silicon Valley bases from which to cream off some of the brightest graduates in the country. Even Beijing-backed VC firms have been able to finance start-ups in the US to accelerate IP transfer.

On China’s side, however, is the fact that hacking is difficult to attribute with 100% certainty to Chinese companies or state operatives, allowing Beijing plausible deniability. What’s more, President Xi has huge leverage from the fact that so many US firms rely on China for a sizeable portion of their revenue. For Apple, it’s the biggest non-US market, with Greater China generating over $16 billion for it in the three months ending December 2016. That’s not to mention all the manufacturing facilities these firms have based in the Middle Kingdom, although this is also leverage for them as big employers.

Neither side wants a trade war.

Yet with China unlikely to give up on its plans to be self-reliant in key technologies as part of a major Communist Party “Made in China 2025” strategy, any deal could just drive IP theft deeper underground.

In the end, the best outcome for Silicon Valley could amount to little more than maintaining the status quo. This is not beyond the realms of possibility, as Trump has hinted he may be able to shift on trade in return for help on North Korea. This “carrot and stick diplomacy”, as Trend Micro’s Edwards brands it, could well be a way for both governments to get what they want whilst saving face. The loser, however, will continue to be US industry and its workers.