China’s Systemic Counterfeiting and IP Theft Undermine U.S. Economic and National Security

THAAD Launcher

On May 21, 2012, the Senate Committee on Armed Services released a disturbing report on the extent to which counterfeit electronic parts had infiltrated the U.S. defense supply chain. The report, which looked at just one part of the defense supply chain from 2009 to 2010, documented 1,800 cases of suspected counterfeit electronic parts being deployed on a wide range of weapons systems, including anti-submarine aircraft and helicopters, cargo planes, and missile defense systems such as the Terminal High-Altitude Missile Defense (THAAD) system. Regarding THAAD—a short- to intermediate-range missile defense system designed to shoot down ballistic missiles (think SCUDs in the Gulf War)—the investigation found that the mission computers that controlled the missiles contained suspected counterfeit memory devices, which if they failed while deployed would have comprised the entire missile defense system, placing the lives of U.S. service members (or even U.S. or foreign citizens) at risk.

The Senate’s report found that the overwhelming majority—at least 70 percent—of the suspected counterfeit parts originated in China. This conclusion was not surprising. While the Senate’s report was limited to assessing counterfeit electronic parts in the defense supply chain, a broader report by the U.S. International Trade Commission (ITC) on Chinese Intellectual Property Infringement found that 80 percent of trademark- or copyright-infringing goods imports to the United States come from China (and an additional 10 percent come from Hong Kong). A separate ITC report on the Effects of China’s Intellectual Property Infringement and Indigenous Innovation Policies on the U.S. Economy found that China’s rampant intellectual property theft cost the U.S. economy $48 billion and 1 million jobs—in the year 2009 alone. Indeed, such counterfeiting and IP theft are an endemic element of the Chinese production system. The Senate report notes that the Shantou district of Shenzhen is widely acknowledged as “the counterfeiting district,” where some “counterfeiting factories” employ from 10,000 to 15,000 people. In many cases, such factories affix false or faked labels or counterfeit part numbers onto products. For instance, the technique known as “black-topping” involves sanding down parts number or identification marks on recycled products, recoating, and stamping a false part number or brand label on the product.

Such counterfeiting is widespread—and widely accepted—in China. For example, as ITIF notes in its report Enough is Enough: Confronting Chinese Economic Mercantilism, in an article in the Journal of Science and Technology Policy in China, edited by the Chinese Academy of Sciences, Sheng Zhu and Yongjiang Shi write about how the cell phone industry “cluster” in Shenzhen called Shanzhai is “turning to the Shanzhai ethos, starting with producing counterfeited mobile phones to rebel against the expensive world-leading brands….The Shanzhai idea of rebellion has evolved into a desire to take on global corporations by producing copies of the world leading brands.” The view is that this kind of rebellion is almost “Robin Hood-like” as it provides cell phones for the masses at the expense of the greedy, rich Apples, Nokias, and LGs of the world. As the authors note, China’s central government “tend[s] to tacit consent the phenomenon.”

While it’s bad enough when China’s counterfeit products hurt the U.S. economy and cost American jobs, it’s worse when they have the potential to comprise mission-critical defense systems. While it would be impossible to entirely prevent counterfeit parts from entering the U.S. defense supply chain, both government and industry (here, defense contractors primarily) must work in partnership to significantly curtail the penetration. Four broad steps must be taken:

1) Pressure China (and other complicit countries) to crack down on counterfeiting;

2) Improve the inspection regime to better identify counterfeit parts at the border and prevent them from entering the country;

3) Improve procurement and testing practices to ensure that counterfeit electronic parts that have entered the country don’t enter weapons systems;

4) Manufacture more defense-critical systems in the United States.

Regarding the first, recent U.S. government reports—such as the U.S. Trade Representative’s Special 301 Report and the aforementioned ITC report—have done an excellent job of shining light on the counterfeiting problem. The Obama Administration and the trade policy community must continue to bring increased pressure on the Chinese government to crack down on illegal counterfeiting and, if necessary, be prepared to bring more trade infringement cases before the World Trade Organization or even to single out China specifically by placing more rigorous and stringent inspection and importation requirements on products coming into the United States from the country.

At the border, for many years, when U.S. customs officials suspected a product was counterfeit, they were able to share photos of the product or the product’s serial number with U.S. companies. In the case of semiconductor chips, the practice enabled U.S. companies to often instantaneously determine if a chip was counterfeit. However, in 2008, customs changed this practice and started “readacting” the parts number of the suspected counterfeit parts (for fear of divulging trade secrets). While an amendment in the 2011 Defense Authorization Act clarified that customs could share both photos and parts numbers with U.S. companies to better identify counterfeited parts entering the country, the Customs Department has failed to embrace the rule change and return to readily sharing information that could better help industry partner with government in identifying counterfeited parts. But put simply, the United States needs better policies and more resources to stop counterfeits at the border.

The Senate report recommends a range of smart policies to keep counterfeit parts that have found their way into the country from finding their way into weapons systems, all of which should be enacted. These include: wherever possible, acquiring parts directly from manufacturers or their authorized distributors; strengthening inspection and test protocols; making defense contractors bear replacement costs if they use counterfeit parts; and improving reporting systems to track counterfeit parts.

Finally, the report underscores the point that the erosion of the U.S. manufacturing base has eroded the U.S. defense industrial base. As ITIF notes in The Case for a National Manufacturing Strategy, domestic sourcing is endangered in an increasing number of defense technologies, including propellant chemicals, space-qualified electronics, power sources for space and military applications (especially batteries and photovoltaics), specialty metals, hard disk drives, and flat panel displays (LCDs). And as the Defense Production Act Title III notes, there is “at present no domestic production capability for extremely long life Li-ion cells.” Manufacturing is vital to U.S. national security, and if the United States wants to reduce its exposure to potentially counterfeited foreign goods, it needs to start manufacturing defense-critical products in the United States.

In summary, the Senate report at once shines light on the extent of Chinese counterfeiting, the erosion of the U.S. defense industrial base, and vulnerabilities in the U.S. defense supply chain. It’s an important report, whose recommendations should be implemented with alacrity by the public and private sectors.

 

Image is a work of a U.S. Army soldier or employee, taken or made during the course of the person’s official duties. As a work of the U.S. federal government, the image is in the public domain.

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About the author

Stephen Ezell is a Senior Analyst with the Information Technology and Innovation Foundation (ITIF), with a focus on innovation policy, international information technology competitiveness, trade, and manufacturing and services issues. He is the co-author with Dr. Atkinson of "Innovation Economics: The Race for Global Advantage" (Yale, 2012). Mr. Ezell comes to ITIF from Peer Insight, an innovation research and consulting firm he co-founded in 2003 to study the practice of innovation in service industries. At Peer Insight, Mr. Ezell co-founded the Global Service Innovation Consortium, published multiple research papers on service innovation, and researched national service innovation policies being implemented by governments worldwide.