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by Justice Litle
For the big multinationals, investing in China is a schizophrenic enterprise. Dreams of huge profits are balanced against piracy nightmares, profit-crushing competition and razor-thin margins. This is exactly how China likes it. Foreign multinationals are prized for their technology and expertise: If they stay and succeed, Beijing leans on them to share the wealth with local partners. For those who leave with their tail between their legs, odds are good they were picked clean en route to the nearest exit. China has practically made an art form of bringing in outsiders to develop a market or industry, transferring said outsiders' knowledge and technology to local imitators and then brutalizing profit margins with local competition once the transfer is complete. Most companies are offered a Faustian bargain: To gain access to the kingdom, you must partner up...we share our markets, you share your expertise. The bit about intellectual asset stripping is conveniently left out of the deal.
The typical turn of events goes something like this: The starry-eyed multinational, thinking of limitless profits to be made in the world's fastest growing market, bears the brunt of the initial costs to set up shop. By the time the initial setup costs are recovered, the multinational discovers, with dismay, that copycats have crept in. The local partner, backed by Beijing, does not seem surprised; in a short while, profit margins have crumbled to dust. The multinational is then left with one of two less-than-pleasing prospects: soldier on near break even and hope that prospects eventually turn up, or pack the bags and go home...with strategic assets left behind.
The above may be a slight exaggeration, but not by much. Decent profit margins are hard to come by in China, and harder still to maintain for any significant period of time, due to the process just described. It has happened again and again, in everything from mobile handsets to microwaves to automobiles, as low-margin producers imitate, conquer and dominate. Optimists point out that Beijing is grudgingly moving toward general respect of intellectual property. Rampant piracy is recognized as a problem; China's judicial wheels are turning against industrial counterfeiters, albeit in slow motion. The simple reality is that a lax attitude toward piracy and intellectual asset stripping is currently in China's best interest (though it becomes steadily less so over time). Rather than reinvent the wheel, why not let a steady stream of naive wheel inventors who have already done the hard work come in and give away their secrets?
China will take a harder line on intellectual property rights when one of two things happens: Either multinationals will demand intellectual property enforcement and stop acting like sheep to be sheared, or China will build up enough proprietary knowledge and technical expertise of its own to warrant the standard legal protections.
On a more ominous note, China's hunger for knowledge extends to military technology. At the moment, Beijing's defense budget is less than 1/40th that of the United States ($20 billion versus more than $400 billion), but the gap will eventually close. Beijing will also have the advantage of leapfrogging the legacy systems and outdated programs that make up much of America's military infrastructure, moving straight to the latest technology even as the United States sees domestic spending pressures increase.
It is here, where the stakes are highest, that a distracted America is finally sitting up and taking notice. Europe, in a move led by France and endorsed by Britain, plans to lift the China arms embargo in place since 1989. From Europe's point of view, lifting the weapons ban is a natural and harmless move. Put in place as a result of the Tiananmen Square massacre, China is a new country with a new attitude. Europe and China both declare the move to be symbolic. China seeks acknowledgement as an upstanding member of the economic community, and claims to have no interest in the actual purchase of European weapons. As for Europe, it merely wants to smooth business relations with their second biggest trading partner and pave the way for future cooperation, by giving the Middle Kingdom a gesture of respect.
America, as usual, is stuck between a rock and a hard place. Protest seems pointless, but what other action can be taken? The true concerns of the United States are so grave they can hardly be voiced: potentially engaging China in a war over Taiwan in the South China Sea...and facing European military technology, bought for the express purpose of sinking American ships and killing American troops. How do you explain to your oldest allies that they are whistling past the graveyard when they breezily dismiss your concerns as paranoia? When the weapons ban is lifted - if America is unable to find some last-ditch effort to stop it - Europe will make all the right noises, all the right pronouncements. Promises will be made, peaceful intentions will be underlined, and all types of positive benefits will be sallied forth. The European Union says assuringly that a "code of conduct" will be put in place. For American hawks, the phrase might as well be "Peace in Our Time." Though the move may yet prove symbolic in the long run - China has multiple sources for military technology, at any rate - it is a harbinger of the dangerous game to come.
Who are the winners and losers in China's quest for knowledge and technology? Naive multinationals who do not understand the Chinese way are clear losers; Chinese firms that get a leg up on their foreign partners are clear winners. Avoid investments in companies that view China as a typical market with typical rules; instead, look to companies that understand exactly what they are getting into and have means to protect their intellectual assets. Also consider exchange-listed Chinese firms that are in a good position to upgrade themselves with the help of "borrowed" multinational expertise. Once intellectual property rights start taking hold in China, look for new opportunities in standards-dependent industries that were previously unfeasible in a lawless environment. Watch closely as China transitions from basketballs and sneakers to pharmaceuticals and computer chips.
On the military front, watch the drama unfold between Europe, America and China. If the ban is lifted, expect America to consider an across-the-board withdrawal of cooperation with Europe on sensitive technology projects. Will the transatlantic alliance be placed in doubt?
It's going to be an interesting century.
Justice Litle
for The Daily Reckoning
Editor's Note: Justice Litle is the editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between. Mr. Litle also acted as head trader for a private equity partnership, and has made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall, 2004). In addition, Justice Litle has been quoted in the Wall Street Journal and by multiple financial newswires, such as Dow Jones and Reuters.