How to Tell if Your Fraud Systems Are Outdated

Flu-Fighting in the Hutong
1626 hrs.

Interfax is apparently reporting that the People’s Bank of China is going to limit all Internet-based payment transactions to US$124, or RMB¥1,000.

On the one hand, that amounts to a public admission that China’s electronic payment fraud control systems are inadequate. On the other hand, it’s a clear move by the central bank to put a cap on fraud until they can figure out something better.

Given the trends I’ve seen in e-commerce in China, this is only going to adversely affect a very tiny percentage of transactions, as most sales online at this point are fairly small.

For larger stuff, I suspect we’re going to have to go back to my personal favorite payment system, commercial COD via the Express Mail service – a safer bet for all concerned given the fact that China’s system needs considerable time and investment to catch up to the speed of electronic transactions.

Good on the PBOC for stepping in. Now, lets get to work on better systems, eh, boys?

IPR Goes to the WTO: Big, Fat, Hairy Deal

In the Hutong
Enjoying the Magnificent Fall Weather
1447 hrs.

As I sat in Starbucks in FullLink Plaza last Thursday talking to global strategist and educational publisher Hanya Kim about tech and agriculture, who should run by looking slightly harried but Jonathan Landreth, The Hollywood Reporter’s Beijing bureau chief. Gentleman that Jonathan is, he apologized for not stopping to chat, but he was heading next door (the Ministry of Foreign Affairs) to hear the party-line response to the WTO complaint about China’s lax IPR enforcement.

Jonathan wrote a good article that subtly made the point that putting China on 90 days notice to provide a full report on its IPR record was a tad impractical. Here in the Hutong, however, the whole thing looks irrelevant. And here’s why:

The Playground Dynamics of IPR Enforcement

The biggest problem with the international neé American neé Hollywood approach to the IPR problem in China is that it is fundamentally selfish. Essentially, Hollywood shows up and says “you guys better stop letting your people make money stealing our stuff, or we’re going to tell mom on you.”

Beijing’s policy-makers understand that the constituency that keeps them in power is NOT Hollywood, but the local party and industry. Keeping people working, even if they’re manufacturing, transporting, distributing, or retailing pirated DVDs, is far more critical than the happiness of the film, television, and music moguls of the world. So they make polite noises, a couple of politically convenient and highly-publicized busts, and that’s it.

So Hollywood runs and tells mommy (the US Government), who then uses the exact same tactics that Hollywood used, petulantly demanding that Beijing play by the rules or it will run and tell the WTO, fully expecting (apparently) that Beijing will be more afraid now that the challenge is coming from the government instead of the industry.

Same response from aforementioned Chinese bureaucracy.

So now, its off to the WTO, and invariably three months from now we will face the specter of the WTO showing up with some tough questions. And once again, China’s policy makers must ask the question for which they have yet to get a satisfactory answer: “if we go and shut down all of the pirates, what’s in it for us?”

Let’s assume this goes to its ultimate, logical conclusion, which would be to impose some form of WTO-based trade sanctions on China. What sorts of terms and conditions could the WTO impose on China? Could the WTO reasonably demand that China end piracy?

They might. More likely they will demand some lesser level of compliance, including a demonstration of stepped-up enforcement against the most serious violators, because a fair argument can be maid that China needs more time and resources to expand its enforcement infrastructure. If this is the case, there will still be a lot of piracy for a very long time.

No Silver Bullets

Even if the WTO goes all the the way and brings down the hammer on China, the awful truth is that piracy won’t go away – it will just go underground. As long as the financial rewards of piracy remain large, pirated and counterfeit goods will simply go the way of moonshine, marijuana, and grey-market cigarettes: deep underground, where its hard to chase.

The other reason the IPR problem is naturally resistant to a single, comprehensive solution is that it is not a simple issue. On the legal and regulatory side alone, China’s IPR problem is partly a matter of an adequate body of laws (now largely but not completely solved,) investigative and policing resources, judicial procedure (in terms of evidence and sentencing guidelines), and of China’s complex brand of federalism that puts provincial and local authorities at odds with – and often in the way of – enforcement driven from the central authorities.

And there’s even more to it than that.

It’s About the Money

People forget that there is a huge commercial component to the IPR problem.

They forget because industry is really uncomfortable saying things like “people love our products but they don’t like paying so much for them.”

They forget because it is incredibly embarrassing for the executives of fast-moving consumer goods companies to admit that the biggest source of counterfeit goods is coming from within their own supply chains – and sometimes their own organizations.

They forget because it’s much easier for entertainment executives to blame piracy for a failure to build a market than it is to admit that one hasn’t pursued all of their commercial options, or thought creatively about taking market share and building revenue regardless of the legal environment.

They forget, indeed, because it is much easier to cast aspersions on China than on an industry that has yet to figure out one important fact: as soon as a failed IPR regime is demonstrably and severely hurting local interests, enforcement will get better fast.

These are issues that cannot be addressed directly by laws and enforcement, however stringent those systems. Anyone who doubts that need only look at the U.S. With arguably the worlds most robust IPR protection regime, software and music piracy is still huge in the U.S. The trade in counterfeit luxury goods is driven as much by American tourists as it is by local buyers. And the United States Bureau of Tobacco, Alcohol, and Firearms is discovering that its biggest challenge in overcoming smuggling of grey-market cigarettes is the internal systems of the tobacco companies themselves.

At the danger of oversimplifying, lets put it this way:

Chinese want DVDs of U.S. films. If they can’t go to HMV or a Virgin Megastore to buy legitimate goods, where are they going to go?

Dangerous Interlude: The Wal-Mart Factor

Here’s a tickler. A little out of left field, perhaps, but something to think about.

The WTO cracks down on China, placing putative tariffs on a wide range of exports. The company that suffers the most and the fastest is China’s largest customer, buying over $10 billion in a wide range of products from China and seeking a bigger role in China’s retail sector.

Wal-Mart.

Now here’s an interesting fact. The largest customer for some of the companies most aggrieved by China’s IPR regime (P&G, Unilever, Disney, Time-Warner, etc) is Wal-Mart.

Is it beyond conception that if this came down to details that Lee Scott, looking at his disappearing cost advantage and a Chinese government increasingly hostile to his expansion in the PRC, might pick up the phone and starting to apply some very angry pressure on these companies to back off?

Indeed.

But we digress.

Fixing the Problem

I am by no means advocating that anyone stop pushing the Chinese to continue to improve their enforcement of their IPR laws. But I think it’s time we all demonstrated how sincere we are about solving the problem by:

> Recognizing that there are no simple solutions to a complex, multifaceted problem.

> Taking a more sophisticated, multi-faceted approach to the legal and regulatory issue, and doing so in a concerted (rather than piecemeal) way.

> Working in concert with local IPR owners on helping them improve their own IPR protection, and making THEM, not the Seven Sisters of Hollywood, the true aggrieved parties in the process.

> Forgetting for a moment the lawyers and the politicians, and instead thinking creatively about the measures that can be taken at the enterprise level. There are already great examples of this (Time-Warner has, remarkably, a huge and growing legitimate home video business in China; some consumer goods companies are aggressively moving to shut down internal fraud). There need to be more.

> Addressing the commercial issues behind piracy: poor control over supply chains, bad pricing, bad or non-existent distribution systems, and

> Coming up with more creative ways to move into the market and to protect IPR as China develops, rather than standing on the sidelines fretting about poor legal controls.

I’m sure this will upset a lot of lawyers and career trade bureaucrats. But that’s okay – solving China’s IPR problem is about building businesses based on ideas, not about an annuity for the legal profession.

Carlyle Buys Xugong: Smart Move, or Longshot?

Hutongwise
1940 hours

Carlyle Group to Acquire 85% of Chinese Construction Firm by Laura Santini, The Wall Street Journal, October 25, 2005, Page C5

American private equity monster The Carlyle Group has tossed US$375 million into purchasing Chinese construction machinery manufacturer Xugong Group Construction Machinery. Leaving aside the potentially ugly issues surrounding The Carlyle Group and it’s alleged links to the pocketbooks of some very, very big people in the U.S. government, it’s quite possible that Carlyle has made a really smart move by making this investment.

It’s also possible they’ve stepped into some serious elephant spoor.

The calculus looks good. China is in a spasm of construction and there are local shortages of construction equipment. The world is looking for cheaper machinery, and it’s probably only a matter of time before Kubota, Caterpillar, Komatsu, and the whole lot turn into design and marketing houses, outsourcing all of their manufacturing to companies like Xugong.

But that could wind up as so much happy-talk. Consider:

• China’s construction boom is a fragile thing. It could end at any time, undercut by a capital shortage (real or created by the government), skyrocketing costs for materials, water and power supplies, or a simple government ban on new construction out of concern that the sector is leading the entire economy to overheat.

• Exporting is not easy. Xugong does little of it now, and exporting tractors is not like exporting underwear. Dealer networks need to be established, dealers must be trained, repair facilities established, spare parts supply chains developed, owners manuals, repair manuals, parts lists translated into each required language. All while hoping that the world economy holds together, that export receivables don’t fly out of control, and that Komatsu or Cat doesn’t get a second wind and take away all of the profitable business, leaving Xugong with the low-margin stuff.

• Komatsu and Cat might outsource to Xugong et al. Or they might build their own, state-of-the-art factories in China. Either way, there is no telling when Xugong might pick up this windfall, if ever.

Interesting that Caterpillar and JP Morgan lost out the bidding war for Xugong against Carlyle. Cat has been dancing around with Xugong for years, and arguably knows where the value is in the organization, and their bid came up short. Carlyle has some capable investment bankers (they pulled the China Pacific Life deal – a smart investment – out of a tough stalemate), but common sense suggests the Boys from Peoria probably know their business better than the suits in Washington and Beijing.

There’s also a lot of private equity in China chasing very few deals. I would not be surprised if at some point in the future it came out that Carlyle, feeling the heat of JP Morgan in the deal, was a bit more aggressive than the fundamentals dictated. That would hardly be a first in China.

I may well be wrong, but I’d bet Carlyle left some money on the table. Either way, Xugong is going to take a lot of work – and the economic stars staying aligned – (or a pretty big sucker) to pay off for Carlyle.

The Real Implications of the Landwind SUV Safety Issue

In the Hutong
1951 Hours

The German Auto Club ADAC, on behalf of the European New Car Assessment Program, completed crash-tests on the Jiangling Landwind SUV and gave it the worst score ever achieved by an automobile in the program – a zero. China’s first high-profile SUV export has the distinction of being the first to achieve the score. You’ll hear a lot about that over the next few days, mostly auto observers talking about how China is not ready to go global. (For those of us who are aware that China’s annual highway deaths per registered vehicle exceeds that of the U.S. by over 2000%, such a conclusion would be no surprise.)

But the real implications are far different. It gives us a glimpse at some realities that China has been unwilling to face in its own globalization (sorry – “internationalization”) effort.

First, China is going to have to reconsider its “not invented here” approach to international standards, because there are some it is going to have to be prepared to accept. Auto safety standards, food safety standards, radiation standards, and the like are not negotiable.

Second, China’s industry is going to need help understanding those standards, keeping up with them as they change, and remaining competitive while doing so. Maybe the Chinese government can help, but I doubt they can be quick or nimble enough. This is going to be a powerful, compelling opportunity for some consultants someplace, because Chinese manufacturers are going to have to get up to speed fast, or they’ll have to settle for whatever third-world markets the Koreans and Japanese can’t serve.

Third, this is also going to bring about closer collaboration with global standards-setting bodies. Apart from information sharing, done well, such collaboration can become a point of competitive advantage. Foxconn, a computer and consumer electronics ODM in the Pearl River Delta, actually has an FCC lab set up in its factory in China that is capable of certifying products BEFORE they leave the factory. Look for more of that to happen in other industries, including the auto business.

Fourth, this is going to have broader implications for safety standards in China. For many big-ticket, relatively low-volume products (like cars), it is difficult to get economies of scale when you are building products to two sets of standards. Far easier, in such cases, to produce for a single set of standards, thus adopting the international one as the one you work by.

All of these are going to be good things, and in the long run will both redound to the benefit of Chinese industry, and place a higher value on collaboration with global partners.

For those who snicker at the expense of the Landwind, though, remember that some of the most substantial advances in SUV safety standards in the U.S. and Europe have come since the disastrous Suzuki Samurai crash tests in 1988. Improvements in rollover standards, roof safety, front-end safety, and side-safety have been continuous, and the standards have continued to rise. In essence, the Landwind may not be the total POS that the tests indicate – it may just be a car that is a decade or less out of date.

And that would be no surprise – most of Chinas businesses are still a bit behind in one way or another.

Watch this space.

Back in the Hutong, Pushing the Thief

Running out the Door
1000 hrs

Running out to a function for my son’s school – interestingly enough the only Jewish day school in Northern China – but wanted to check in.

After a desperately-needed one month hiatus and research trip in the U.S. and a brief run to Singapore, Silicon Hutong is back and getting ready to post.

In the meantime, a not-so-shameless plug for the Image Thief blog of my friend and former colleague Will Moss. Great stuff, Will. I think you missed your calling.