China Restricting Entry by U.S. Firms

Doing business in China will keep getting harder for foreign companies. Beijing is leveraging its huge government purchasing power to encourage homegrown firms to develop import substitutes, with the aim of creating national champions to compete against multinationals both in China and worldwide.

“Japanese, European and American companies … used to think that China welcomes foreign technology, welcomes our presence to help develop,” says Frank Vargo, vice president for international economic affairs at the National Association of Manufacturers. “Increasingly, they don’t feel that way anymore. They feel they are being discriminated against, being shut out of certain market segments.”

A growing number of procurement rules from central government ministries insist that foreign firms hand over sensitive technology to Chinese partners or government regulators. Those that comply run the risk of having their intellectual property compromised and used to compete against them. Companies that refuse risk the loss not only of sales to Beijing but also to state owned enterprises, which still make up one-third of the economy, as well as to provincial and local governments.

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One rule that has serious potential to disrupt U.S. business in China is Beijing’s National Indigenous Innovation Product Accreditation Work for 2010. The regulation restricts government procurement in six key areas of high technology: computing and application hardware, software, telecommunications equipment, modern office equipment, renewable energy technology and energy saving products. That list is certain to expand to cover other industries.

As originally framed in November, the rule mandated that foreign manufacturers seeking to do business in China would have to transfer their patents and trademarks to Chinese firms. Beijing softened the language in response to vigorous protests by the U.S., Japan and the European Union. But even before the rule is implemented, it is having a chilling effect. According to an April 2010 survey conducted by the American Chamber of Commerce in China, 28% of U.S. companies said the rule has already cost them business. More than 40% said they expect to suffer, a number that jumped to 57% for companies in the six targeted high-tech sectors.

A related rule, announced in December, encourages Chinese firms to develop import substitutes for heavy equipment, the demand for which has escalated along with China’s growing infrastructure needs. As a prime example, Beijing singles out Caterpillar’s diesel engines for high efficiency electric drills.

Adding to the problem is that China insists firms meet its unique technical standards, distinct from internationally recognized ones, before they can sell certain products to government agencies. One recent variation of this affects encryption technology used in telecommunications and information technology. It will require makers of network routers, firewall software and smart cards to hand over source codes, encryption algorithms and design specifications to the government controlled testing labs that dole out certification. This transfer of intellectual property poses a high theft risk.

Washington’s options are limited because China has yet to sign the World Trade Organization’s (WTO) Government Procurement Agreement. It pledged to do so when it joined the WTO but did not even begin talks on the subject until December 2007. The two-plus years of negotiations since have been disappointing, with Beijing unwilling to provide the same level of access as do current parties to the pact.

Unless China does sign, the only tool the U.S. has at its disposal is diplomacy. It will continue to argue that Beijing’s policies will discourage the sharing of valuable research, stifling Chinese innovation rather than stimulating it. So far, though, that approach isn’t working. Beijing still resents Washington’s decision to block its participation in U.S. government procurement of iron and steel products under the Buy American rules of last year’s stimulus.

The bottom line is that U.S. companies will damp down hopes for the potential of the Chinese market. They won’t pull out precipitously or entirely. The sheer size of the market makes it impossible to ignore. U.S. direct investment rose to $45 billion in 2008, the last year for which figures are available. And income of U.S. affiliates in China hit $6.9 billion in 2009, a hundredfold increase from 15 years earlier. China still falls short of other leading U.S. investment destinations -- the Netherlands, Ireland, Switzerland, the U.K. and Canada. But the potential for growth in China is unmatched, and rivals Brazil, India and Russia offer even less hospitable business climates.

Still, look for U.S. firms to grow more wary of new investments in China. Much as they may regret the lost business, they know they’ll regret it even more if the trade secrets they share today create unbeatable competitors tomorrow.