Jason Lee / Courtesy Reuters Lei Jun, CEO of China's mobile company Xiaomi, does his best Steve Jobs at a launch ceremony for Xiaomi Phone 2, August, 2012.

Fake It Till You Make It

The Good News About China’s Knockoff Economy

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No one knows for sure why some societies are more innovative than others. The United States is a highly inventive society, the source of a host of technologies -- the airplane, the atomic bomb, the Internet -- that have transformed the world. Modern China, by contrast, is frequently criticized for its widespread copying of foreign inventions and creative works. Once the home of gunpowder, printing, and other transformational inventions, China is today better known for its knockoffs of almost every imaginable product: cars, clothes, computers, fast food, movies, pharmaceuticals, even entire European villages. The United States gave the world the iPhone; China gave it the HiPhone -- a cheap facsimile of a groundbreaking American gadget.

Some see deep cultural roots to the pervasiveness of copying in China. But a more common view is that China fails to innovate because it lacks strong and stable protections for intellectual property. Many lawyers and economists believe that intellectual property rights are critical because they ensure that the economic rewards of innovation go to the innovator. Without such protections, the thinking goes, copycats will undercut and outrun originators. This, in turn, will dry up investment in innovation. The basic logic is straightforward: sustained innovation requires stringent intellectual property laws, and countries that tolerate too much copying will suffer. And since in a globalized economy, copying that occurs abroad can be just as harmful as copying at home, this logic also undergirds an array of international intellectual property treaties that nearly all major states have adopted, including the World Trade Organization’s Agreement on Trade-Related Aspects of Intellectual Property Rights, established in 1994, and the many even stricter bilateral accords that states have entered into since then.

As a member of the WTO, China is supposed to follow these rules. But its compliance is far from perfect, to Washington’s perpetual annoyance. Briefing reporters at the White House in February, U.S. Undersecretary of State Robert Hormats called the extensive theft of intellectual property by Chinese firms and individuals “a serious and highly troubling issue.” Although estimates of the cost of Chinese piracy to the U.S. economy vary widely and are sensitive to assumptions, the U.S. International Trade Commission has estimated that in 2011 alone, the figure was nearly $50 billion.

For U.S. policymakers and American executives, the scale and scope of copying in China are bad enough; worse yet is the fact that it is encouraged by an official Chinese policy of “indigenous innovation.” According to a planning document issued by the Chinese government in 2006, indigenous innovation includes “enhancing original innovation through co-innovation and re-innovation based on the assimilation of imported technologies.” Washington justifiably views this as an official green light for piracy. The U.S. government considers it vital to rein in Chinese copying, and it has exhorted China to change its ways -- and sued it before the WTO.

But American anxiety and anger over Chinese piracy are misplaced. Copying is not the plague that American business leaders and politicians often make it out to be. In fact, far from always being an enemy of innovation, copying is often a critical part of creativity. Although copying has a destructive side, it also has a productive side. Nearly all creations rest on prior work, and the ability to freely copy and refine existing designs fuels fields as varied as fashion, finance, and software. Copying can also foster stronger competition, grow markets, and build brands.

For Chinese firms and individuals, copying has irresistible benefits that go beyond simply undercutting Western competitors. Many Chinese have gained valuable design and manufacturing skills by copying goods originally produced elsewhere. The results of this imitation are affordable products and services that have allowed millions of Chinese to enjoy the trappings of a consumer society. And the wealth created by piracy has aided the growth of an emerging Chinese middle class, which represents a massive potential pool of new customers for Western firms that sell the genuine article.

For these reasons, any sensible policy toward China’s knockoff economy must begin with an appreciation that copying and creating are linked and that copying can be a force for good as well as ill. Given that Chinese copying has benefits as well as costs, and considering China’s historical resistance to Western pressure, the fact is that trying to push China to change its policies and behavior on intellectual property law is not worth the political and diplomatic capital the United States is spending on it.

THE REAL FAKE

To understand how imitation and innovation coexist in today’s China, one need only look to Xiaomi, one of China’s fastest-growing technology companies. Less than four years old, Xiaomi has sold nearly seven million smartphones and raked in more than ten billion yuan ($1.6 billion) -- impressive numbers for a company that sold its first smartphone in August 2011. Xiaomi’s phones look familiar because many of the company’s designs closely imitate Apple’s iPhone. And design is not the only cue that Xiaomi takes from Apple. At a recent product launch, Lei Jun, the head of Xiaomi, stood alone onstage in a black shirt, jeans, and black Converse sneakers -- déjà vu for anyone who ever saw the late Steve Jobs, the founder and former ceo of Apple, introduce new products at a Macworld convention. Lei’s message was clear: Xiaomi’s phones are just as cool as Apple’s. Chinese consumers have taken the bait, happily embracing Xiaomi’s products without any illusions about their provenance: as a Shanghai university student recently told The New York Times, “Xiaomi is the real fake.”

Xiaomi’s success, however, also hinges on the company being quite unlike Apple. For one, Xiaomi’s phones typically cost about half that of its rival’s. Even more important, Xiaomi has a very different attitude toward innovation. Apple is known for its closed approach to product development. The company believes that it knows what its customers want before they do, so Apple’s design process is essentially dictatorial. Xiaomi’s design process, by contrast, is quite democratic. Every Friday, Xiaomi releases a new round of software updates for its mobile operating system, which is based on Google’s open-source Android software. Within hours, thousands of users flock to Xiaomi’s online forums to suggest new features, functions, and designs and to identify and resolve software bugs. Xiaomi has relied on user input to determine how much memory to install on its phones, how important the phone’s thickness is to users, and whether its phones should allow users to take photos without pushing a button. Lei might dress like Jobs, but he runs his company very differently.

Xiaomi is hardly China’s only imitator-innovator. Weibo, the country’s most popular social networking service, boasts hundreds of millions of users. It began in 2009 as an undisguised Twitter clone. Since then, it has added a clutch of features that distinguish it from Twitter, including a more interactive system for commenting. Such improvements make Weibo arguably more functional, and more fun, than the service it copied.

Another Chinese value-adding knockoff is Youku, which is just one of a number of Chinese copies of YouTube. (Youku translates as “excellent” or “cool.”) Unlike YouTube, Youku allows users to upload videos of any length without copyright verification. That means that Youku hosts hundreds of thousands of hours of unauthorized programming. But the service has also partnered with more than 1,500 professional content providers to deliver authorized videos, and the Chinese service is much further along than its U.S. rival in delivering original content. Indeed, Youku has emerged as a serious competitor to traditional broadcast TV in China -- a feat that YouTube must envy.

COPY THAT

Just as the conventional wisdom holds, incorrectly, that innovation and imitation are inherently at odds, so, too, does it falsely maintain that the United States should take a very tough line when it comes to halting intellectual property theft in China. In fact, Washington’s heavy-handed approach to Beijing’s copycat culture is too blunt and reflects a simplistic view of innovation. It is also unlikely to succeed, since it will be difficult for the United States to overcome the strong incentives for Chinese firms and individuals to rely on copying.

Chinese manufacturers gain market share in China and elsewhere by offering inexpensive copies of Western products. Along the way, they also learn by doing, gaining the skills to improve their production processes and eventually innovate on their own. The freedom to copy also has an important social dimension in China. A critical byproduct of the country’s amazing growth has been skyrocketing economic inequality. A recent study by the Southwestern University of Finance and Economics, in Chengdu, found that China is now one of the most unequal societies on earth. China has a Gini coefficient of 0.61; the Gini coefficient is a measure of economic inequality, with zero indicating the least possible inequality and one indicating the most. That score puts China on par with Botswana and Haiti when it comes to inequality. This is a recipe for substantial social discontent, especially because China’s have-nots are increasingly exposed to all the benefits that contemporary consumer society can offer.

This helps explain the uniquely Chinese phenomenon of shanzhai. Literally translated, shanzhai means “mountain stronghold” or “bandit stronghold.” In contemporary usage, however, it refers to low-cost knockoffs, such as buildings (including those of the ersatz central European villages that have cropped up in Chinese suburbs), stores (such as the fake Apple store in Kunming that sold real but refurbished Apple products), and even events (such as the imitation Olympic torch relay that rural villagers in China organized when the official relay passed over their regions). But like so much else in China, the meaning of shanzhai is undergoing a drastic change. As The Wall Street Journal recently noted, “Once a term used to suggest something cheap or inferior, shanzhai now suggests to many a certain Chinese cleverness and ingenuity.” Indeed, Beijing seems to believe that shanzhai is something to cultivate. In 2009, an official from China’s National Copyright Administration declared that “shanzhai shows the cultural creativity of the common people.” He added, “It fits a market need and people like it.” There is a certain convenience to this realization, of course: Chinese authorities hope that the relative freedom to copy might help ease or at least mask the yawning economic divide in China.

But the fact that copying is tolerated, and arguably even encouraged, by China is not necessarily a catastrophe for Western businesses. China’s huge population is still poor, and few can afford Western products. Copies of Western products, as a result, do not necessarily represent lost sales. Instead, they often serve as effective advertisements for the originals: gateway products that, in the long run, might spur demand for the real thing as China’s burgeoning middle class grows. For example, several sandwich shops in China have copied the look and food of the American fast-food chain Subway. Subway’s executives, wisely, are not overreacting. Alexander Moody-Stuart, the managing director of the chain, recently told The Wall Street Journal that for a Western brand like Subway, which is trying to build awareness for a type of food that Chinese don’t usually eat, “mimicking isn’t exactly a bad thing.” In a huge but largely untapped market such as China, exposure, and the prospect of growth tomorrow, can trump greater market share today. And although shanzhai products are celebrated, those Chinese who can buy the original products generally do.

No field illustrates the paradoxical nature of Chinese copying better than luxury goods. The country that once forced its citizenry into Mao jackets has become the largest luxury-goods market in the world, outstripping even the United States, according to a 2012 analysis by the consulting firm Bain & Company. This market is not limited to handbags or small accessories. In 2012, Beijing Review recently reported, Bentley Motors sold 8,510 vehicles worldwide, of which 2,253 were sold in China, making it the brand’s second-largest market. Even for Apple, the land of the HiPhone is lucrative: Apple’s business in China is worth nearly $25 billion annually, second only to its business in the United States. Moreover, China was the only place in the world where Apple’s sales grew in the first quarter of 2013.

In this way, China’s knockoff economy allows products to filter down to average Chinese people -- sometimes improving along the way -- and in the process helps China and Chinese firms develop and compete in the near term. In the longer term, open copying may build demand for Western innovations. As Microsoft’s co-founder Bill Gates -- not one known for his lenient views on intellectual property rights -- famously said of Chinese software copying, “As long as they’re going to steal it, we want them to steal ours. They’ll get sort of addicted, and then we’ll somehow figure out how to collect sometime in the next decade.”

ORIGINAL GANGSTERS

Perhaps the most important thing to recognize about China’s knockoff economy is that it is itself a knockoff. When the United States was just beginning its rise to wealth and power, it was every bit as much a pirate nation as China is today. In the eighteenth and nineteenth centuries, the United Kingdom was the primary target of thieving Americans, who focused their economic espionage on the British textile industry. American entrepreneurs sought to replicate secret British designs for looms and mills, and the U.S. government stood ready to help them.

As in contemporary China, imitative innovation was official policy: early U.S. law prohibited foreign inventors from obtaining patents in the United States on inventions they had already patented elsewhere, and significant barriers to foreign patents remained in place well into the late 1800s. U.S. copyright law was similar, explicitly denying any protection to foreign authors. That ban was not lifted until 1891, and even then, foreign authors were required to manufacture their books in the United States as a condition of U.S. copyright protection. That requirement did not disappear entirely from U.S. law until the 1980s. The most famous beneficiary of such laws was Benjamin Franklin, who republished the works of British authors without permission or payment. The British lambasted the Americans for their copying ways; Charles Dickens echoed the sentiments of other famous British writers when he bemoaned “the exquisite justice of never deriving sixpence from an enormous American sale of all my books.”

Yet Dickens’ own story shows how piracy can sometimes benefit creators. Widespread copying of his works led to a great deal of exposure, turning Dickens into a literary superstar in the United States. In 1867–68, Dickens made a grand speaking tour of the country, during which he netted more than 19,000 pounds, or nearly $1.75 million in today’s dollars. By the time Dickens died, two years later, more than 20 percent of his estate’s assets had come from this U.S. tour.

These parallels between the U.S. past and the Chinese present put in perspective Washington’s current paranoia over Beijing’s piracy. Just as copying allowed the economy of the United States to grow in the eighteenth and nineteenth centuries, today it allows China to do the same. And just as the British overstated the economic threat posed by American copying back then, so, too, is the Chinese threat overblown today.

This is not to minimize the importance of intellectual property rights. Indeed, they are essential in fields such as pharmaceuticals, where the costs of development are particularly high. But stronger rights do not always lead to better outcomes. Intellectual property rights can inhibit as well as incentivize innovation; they constrain competition even as they encourage creativity. Most important, since every innovation builds on what came before, protection that is too broad limits valuable sources of inspiration. To build a better mousetrap, one must be free to build on mousetraps that came before. Just as Apple took from Xerox the idea of combining a computer mouse with a screen featuring graphic icons (rather than just text on a screen) -- resulting in today’s desktop computer -- so, too, have millions of other innovators built on and improved the work of others.

China passed its first modern-era patent and trademark laws in the 1980s and its first copyright law in 1990. Intellectual property law remains a relatively new phenomenon in a society that is highly focused on expanding economic growth and maintaining social stability. Chinese attitudes and practices toward copying cannot be expected to change quickly. As China’s economy advances further, perhaps the balance of interests will shift, and the country might adopt a less permissive approach. In the meantime, it is critical to keep Chinese copying in perspective and recognize its upsides along with its costs. Above all, the United States should consider its own history as a pirate nation -- and relax.

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