China's Pirates

It's not just little guys--state-owned factories add to the plague of fakes

In a cavernous building the size of several football fields, thousands of vendors are peddling everything from clothes to razors and detergent. This is the massive wholesale market in Yiwu, a dusty city five hours by train from Shanghai. Each day, some 200,000 distributors buy up to 2,000 tons of goods, making Yiwu one of China's largest wholesale centers.

Yiwu has another, more dubious distinction: It is China's Counterfeit Central, where unscrupulous distributors load up on a cornucopia of fake brand-name goods. On a recent humid afternoon, a cautious stall owner looks both ways before pulling out a pack of fake Gillette razor blades. Her wholesale price: just 65 cents for 10 boxes, each with five blades. In Beijing, a real 10-pack retails for $9.60. She is being extra wary because, a couple of weeks ago, Gillette agents and local officials swooped into the market to seize 48,000 knockoff Parker pens and 4 million Gillette blades.

Not that the raid has seriously damaged business. Over in Yiwu's crowded Qiaoshi cosmetics market, a fortysomething vendor offers the sniff test for fake Rejoice shampoo and Safeguard soap, both brands of Procter & Gamble Co. "This one smells much sweeter, so we can sell it for more," she says, holding out a bottle of Rejoice. The shampoo ranges in price from more than $3 for the real thing down to $1 for the cheapest and least fragrant phony. The fake Safeguard goes for 20 cents, half the price of an authentic bar. "Of course, the fakes sell much better," she says. "They're so much cheaper."

Wait a minute. Wasn't China supposed to be getting serious about stamping out piracy? Five years ago, following a diplomatic fight that brought Washington and Beijing to the brink of a trade war, the mainland made sweeping promises to protect intellectual-property rights. Since then, authorities have launched numerous raids on illicit producers of software and music CDs. And many of the culprits have been convicted in Chinese courts.

But even as China gears up to enter the World Trade Organization, it is becoming increasingly clear that not only is the piracy problem still bad for software and entertainment companies, it also has spread like wildfire through many other industries. In the past, these companies preferred not to discuss the problem, lest they spook consumers. Now, some of the biggest commercial names on the planet--among them Philip Morris, Anheuser-Busch, Prada, Robert Bosch, and Nike--are publicly lobbying Beijing to halt a scourge they say is costing them billions of dollars in sales each year and putting in jeopardy their brands and reputations. Already in China there is a consumer backlash. People who buy a pack of cigarettes that gives them a headache are immediately aware that they've been had--and will be less likely to buy that brand again unless they can be sure it's the real thing. Same goes for the guy who unwittingly buys a bogus Yamaha motorbike and then finds the warranty is useless once the machine breaks down. "Counterfeiting does impact our sales," says Tina S. Berry, a spokeswoman for Kimberly-Clark Corp., whose Kotex feminine care products have been pirated. "But our major concern is that the consumer will be dissatisfied because of inferior quality."

SEA CHANGE. Many foreign manufacturers in China conservatively estimate that 30% of their products in the mainland are fakes--everything from Tide detergent and Budweiser beer to Marlboro cigarettes. In China's glutted motorcycle industry, the problem has grown so egregious that Yamaha estimates that five out of every six bikes bearing its brand name there are bogus. In the first four months of this year, Gillette has seized more fake products than it did in the past two years combined, say company officials. "We are spending millions of dollars to combat counterfeiting," says Joseph M. Johnson, president for China operations at Bestfoods Asia Ltd., which thinks one-quarter of its Skippy Peanut Butter sold in China is pirated. "Unfortunately, the problem is getting much worse."

As profits continue to elude them and carefully planned China strategies come unraveled, some multinationals are reassessing new investments. One U.S. consumer-goods outfit has laid off 35 of 800 employees in its China operations, in large part because of the challenge from counterfeiters. "Counterfeiting is an issue that continually comes up as we think about new investment plans," says William Dobson, P&G's vice-president for public affairs in Asia.

Such sentiment is a sea change from just a few years ago, when Big Business was falling over itself to break into the fabled China market. Multinationals have long known that counterfeiting was a problem and that divulging trade secrets to joint-venture partners was risky. In fact, some companies figured they had truly arrived as a brand in China once pirates started knocking off their products. But no one predicted the pirates would come so far so fast.

A confluence of factors is behind China's piracy rise. The spread of advanced production technology--be it affordable color-copying machines, entire production lines supplied by veteran pirates from Taiwan, or knowhow stolen from multinationals that have been required by Beijing to transfer technology to local partners--has given pirates the ability to make near perfect replicas of everything from Power Ranger action figures to the packaging of Microsoft Corp. software. Increasingly loose global supply chains have also contributed: Traders use Internet chat rooms and unauthorized dealership networks to move product around the planet---and mix fakes in with legitimate products sold on the secondary gray market.

Beijing also may have unwittingly boosted the counterfeiting industry with its attempts to rein in rampant smuggling of foreign goods into the mainland's protected markets. When Beijing began executing smugglers, those who didn't get caught decided to switch to the fakes racket, where the rewards are just as big but penalties are far lighter. Combine all this with China's weak rule of law, which makes it difficult for Beijing to enforce policies in recalcitrant local jurisdictions even when it wants to, and the result is counterfeiter nirvana.

Tens of thousands of counterfeiters are at work in China today. They range from low-tech factories mixing shampoo and soap in back rooms to big state enterprises that have discovered the profits to be made selling knockoffs of soft drinks and beer. Higher up the technological ladder are factories that produce everything from car batteries to motorcycles. At the top end of sophistication are mobile CD factories with optical disk-mastering machines costing $1.2 million.

NIGHTMARE. From factories in southern Guangdong or Fujian provinces, fakes may be trucked from village to village, or to central distribution centers such as Yiwu. Or they may be sneaked over China's porous borders into Russia, Pakistan, Vietnam, and Burma. Or they may be loaded into oceangoing cargo ships bound for the Port of Los Angeles, the shipments organized and financed by Asian crime syndicates.

For now, pirates are acting with relative impunity. While Beijing is making concrete efforts to bring them to heel, authorities have a hard time getting local police and courts to cooperate--especially if a powerful state-owned enterprise is involved. "The government is aware of the consequences of the problem," says a Chinese foreign-investment official. "It has a serious impact on the investment environment."

China's entry into the WTO may help somewhat. The trade body may eventually prescribe stricter standards than those mandated by previous bilateral agreements hammered out with Washington as a result of trade disputes in the mid-1990s. But given China's lackluster rule of law, enforcing new rules will be tough.

So, considering the money to be made from piracy, it's bound to grow further. Take car parts. Bangkok-based market researcher Automotive Resources estimates that profit margins on fake Chinese-made shock absorbers can reach 80%, vs. 15% for the real thing. In high-volume businesses like oil filters for a Mercedes, counterfeiters undercut legitimate products by as much as 80% less than the $24 for an authentic filter.

What has really made counterfeiting a nightmare for foreign investors in China is the leaps that pirates have made in copying packaging. Until recently, manufacturers didn't worry too much about copies because the work was so amateurish. Even now, a consumer can tell a fake Nike or Adidas sports shoe by its sloppy workmanship. But over the past year, experts say, pirates have moved to a whole new level of sophistication in copying bottles and boxes.

YO, HO, HO, AND A BOTTLE OF BUD. Anheuser-Busch Co. first discovered the problem several years ago when it found some Chinese retailers were stocking Budweiser beer in 640 ml bottles even before its sales representatives had visited. "If you open the bottle and drink the beer, it's easy to tell the difference," says Stephen J. Burrows, CEO of Anheuser-Busch International. "But just looking at the labels, it's extremely difficult to tell the legitimate from the counterfeit." To confound the pirates, the company is now using bottles embedded with special images that appear only when they are chilled, making them hard to copy.

But veterans of China's piracy wars know they cannot underestimate the enemy. Microsoft found this out when it started including holograms on its software boxes, and then inside the user manuals. Pirates soon learned the trick. They have gotten so good that they are making knockoff CDs of Microsoft's Windows NT operating system in packaging that is almost indistinguishable from the original. Indeed, whereas fake software for years has sold for a couple of dollars in arcades or street markets, pirates are now able to sell through established retailers--and are fetching up to 95% of the full price of a Windows NT disk, which sells for $240 in China. "We have no idea who is manufacturing this stuff," says Hong Kong-based Microsoft attorney Tom Robertson. "But this is a concerted criminal enterprise backed by serious businessmen."

Such attention to detail costs money--and that's where foreign experts enter the picture. Taiwanese counterfeiters, for example, are major players in the lucrative market for fake mobile-phone accessories. Ringleaders in Taipei send scouts to the mainland, where they find factories best suited to making everything from the blister packaging to molded plastic battery casings. Because many Taiwan pirates also supply the gray market, the fake accessories often are sold with real phones in the thousands of unlicensed shops across China. As many as half the batteries inside the five top-selling foreign handsets are fake, says one Western industry expert.

Taiwanese pirates began migrating to the mainland en masse after Taipei cracked down on the trade in the early 1990s. Pinkerton agent William Thompson recalls several cases when equipment from Taiwan plants copying Western jeans showed up in factories in Guangdong. "They box it up and move the whole factory over," he says.

One reason Chinese pirates now have global reach is through tie-ups with organized crime. In recent years, experts say that Asian gangs such as Wah Ching of Los Angeles and United Bamboo of Taiwan entered the counterfeiting business after they were squeezed out of narcotics by Latin syndicates. But the trade isn't as organized as the Italian Mafia. Richard C. LaMagna, senior manager for worldwide investigations at Microsoft, describes the typical overseas Chinese counterfeiting ring as an ad hoc partnership. "It is a group of entrepreneurs with finance, manufacturing talent, connections, and access to distribution who come together for moneymaking enterprises," says LaMagna, a former agent with the Federal Bureau of Investigation and the Drug Enforcement Agency.

More often than not, however, the biggest players in China are not syndicates at all. They are state-owned factories that started out as legitimate businesses--or they may even be current joint-venture partners with multinationals. But as economic pressures at home grew and sales of their own brands fell, the temptation to use their excess production capacity to copy foreign brands became irresistible.

That's what happened to Yamaha. In the mid-1990s, the Japanese company invested $93 million in three motorbike and engine joint ventures. Like most foreign investors, Yamaha acceded to Beijing's demand that it bring in new technology and license it to domestic suppliers. Within four months of launching a new model, says Masayuki Hosokawa, chief representative of Yamaha's Beijing office, "copies of our machines came onto the market."

The suspicion: The Chinese suppliers sold Yamaha's technology to mainland motorcycle manufacturers. Hosokawa estimates that 88 local bike makers are copying Yamaha's popular 125cc scooter and selling it for some $1,450, vs. the $2,300 the real ones fetch. Some 45 more pirates are copying its 150cc motorcycle and selling it for $1,200, about half the regular price. Why? The local market is glutted with low-quality models Chinese consumers don't want. So factories are making knockoff Yamahas instead.

U.S. SHELVES. These bikes are not only showing up in licensed Yamaha distributorships in China. An estimated 110,000 Yamaha copies were exported to the U.S., Europe, and South America in 1998, says Hosokawa--and the number may have doubled last year. Yamaha is not alone. This year, Gillette seized containers with more than 1 million fake Duracell batteries bound for Spain and Malaysia.

Most fakes go to emerging markets, where consumers are less likely to notice the difference and customs officials tend to look the other way. Pakistani, Korean, and Russian distributors are a common sight in Yiwu markets, and many counterfeits are produced expressly for these countries. Pirated Gillette razors, for example, are made in China, but their packaging is in Russian.

Yet the bogus goods also are starting to seep into the U.S., where customs officers examine perhaps 2% of everything that enters the country. There have been a few big busts involving millions of dollars' worth of fake software CDs in Los Angeles, the main entry point for Asian pirated goods. But such bonanzas are rare. Counterfeiters are now sending smaller shipments that attract less notice.

The Internet has helped counterfeiters, too. No longer must pirates, distributors, and buyers meet face to face. A distributor in Singapore, say, can post an ad for 20 copies of authentic Windows 97 on a technology chat room or online auction site, claiming the stock was obtained from a company that went out of business. Once an order is placed, the goods are shipped by Federal Express or DHL, while money is wired to third-party bank accounts. Microsoft has set up a special unit just to monitor Internet sites, which has led to some seizures in the U.S. But because pirates operate through various fronts and so many Web sites, says LaMagna, "detection is much harder, if not impossible."

This raises a disturbing question: What are the chances that fake car parts, toys, and drugs are being sold by U.S. and European retailers? Better than you may think, though reports of seized Chinese goods are scarce, thanks partly to manufacturers' reluctance to speak about the problem. "Producers of pharmaceuticals don't want to name their products because they don't want to scare the consumer away," says International AntiCounterfeiting Coalition President Timothy P. Trainer. "It's scary when you think what could wind up on our shelves." And carmakers don't want to raise public concerns over the safety of brake pads or turn signals.

As the ramifications of China's counterfeiting epidemic grow more stark, multinationals are getting more serious. The major point of attack is the Chinese factories that are turning out these goods. In December, seven battery makers, including Gillette, Energizer, and Panasonic, launched a series of raids on 21 factories in the southwestern city of Chaoyang. Working with more than 200 government agents in Guangdong, the team seized nearly 3 million counterfeit batteries destined for Russia. The raid also netted more than 150 pieces of manufacturing equipment, including an underground printing facility and two color presses worth more than $120,000 apiece.

PROTECTION. Companies also are trying to boost the government's ability to detect fakes. They have their work cut out for them. Local governments often are hesitant to crack down on pirates because they create jobs. A recent visit to a small village near Yiwu revealed how open the business remains--counterfeiting has taken over most of the economy. More than 100 small factories jammed into scores of five-story buildings were employing thousands of workers making fake Adidas and Nike gear for Russian, Syrian, and South African companies. When approached, managers weren't at all afraid of discussing their business.

While local authorities often can be cajoled into busting distributors of bogus goods, persuading them to shut down factories is difficult. Besides, many of the most flagrant brand violators are state enterprises, often run by the same local governments responsible for policing them. Indeed, police are more likely to protect the factory than allow it to be closed. When Kroll Associates raided a factory producing fake Japanese motorcycles in southern China, they were confronted by armed guards. The raiders had to bring in provincial-level authorities because local cops weren't cooperating. Distributors also hire protection. "A lot of these wholesale markets have thuggish security people," says Pinkerton's Thompson. "We've been confronted with scores--even hundreds--of extremely hostile people."

Undaunted, P&G, Gillette, and other companies are spending millions to open product-testing labs in several cities. They also are pressing Beijing to toughen laws and improve enforcement efforts. One major problem has been confusion over which agency is responsible for fighting trademark infringement. And trademark and product-quality laws are vague or rarely enforced. When seeking to raid a factory or wholesaler, foreign companies deal with local bureaus of the State Administration of Industry & Commerce. But turf battles sometimes erupt between local police and bureaucrats. What's more, penalties against counterfeiting are weak--and winning a criminal conviction of a culprit is difficult. Even though U.S. sunglasses maker Oakley Inc. has gotten Chinese authorities to close counterfeiters' factories and destroy their equipment, new ones pop up. "When you get one counterfeiter, you can be sure there is another waiting in the wings," says Oakley anti-piracy consultant Donna Sandidge.

The WTO may be able to help somewhat. Although its anti-piracy provisions are not sufficiently detailed, say legal experts, in theory at least, the trade organization requires members to actively deter counterfeiting. What must be clarified is what penalties foreign governments will be allowed to seek if the rules aren't followed. In time, the WTO's requirements that members ensure judicial proceedings are fair and open could be used to help aggrieved companies to win their cases in China.

There is only so much foreign pressure on Beijing can accomplish, however. The best hope is that aggrieved domestic industries will demand tougher action from Beijing. Rampant piracy already has thwarted development of China's software, book-publishing, and music industries. Beijing-based Li-Ning, China's best-known producer of sports clothing and shoes, figures some 20% to 30% of the shoes bearing its name in China are fakes. "Typically, U.S. government pressure starts the process, but what sustains it is the growth of indigenous providers," says U.S. Trade Representative Charlene Barshefsky.

The fact that many knock-off artists don't pay taxes is another incentive for Beijing to crack down. That's why Guangdong late last year raised fines and made it easier for companies to seize factory equipment of convicted culprits. The toll that copyright infringement takes on the local economy may be one reason why U.S. trade officials say they feel Chinese leaders seem much more willing to discuss solutions than they were during the diplomatic brawl over music and software piracy in the mid-1990s.

Still, the scale of the problem in places such as Yiwu demonstrates just how tough it will be to eradicate the epidemic. Even with more help from Beijing, foreign companies are likely to face this scourge for years to come. That reality shouldn't be forgotten by investors who are taking the WTO deal as their cue to rush into China.

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