How To Develop High-tech Industry In A Country With Poor Intellectual Property Protection

China's intellectual property protection is considered very weak in comparison to other countries (Israel, 2006; Stratford, 2006; International Intellectual Property Association, 2007). The "Intellectual Property Rights Risk Index" reported by Hong Kong Political and Economic Risk Consultancy shows that China's intellectual property protection is weaker than most of Asian countries. The "Rule of Law Index" released by World Bank also suggests that China ranks 95th in 195 countries, and its score is lower than global average level. Theoretically, China is not an ideal location for R&D investment. However, we are surprised to find that the growth of China's R&D expenditure ranks first among 40 OECD (Organization for Economic Co-operation and Development) countries and selected non-member economies from 2002 to 2006. And the amount of R&D expenditure of China ranks third in OECD countries, only lower than US and Japan. Additionly, in the UNCTAD (United Nations Conference on Trade and Development) survey to multinational companies, China is selected as the most attractive prospective R&D locations in the world. How could China develop its high tech industry in an environment generally perceived as poor protection of intellectual property (IP) rights? Is China somehow different and intellectual property protection does not matter there? Are there any other alternate mechanisms to support the R&D activities of Chinese high-tech firms? These are the questions I addresses in my thesis.First, we examine whether intellectual property protection does not matter for Chinese high-tech firms. Based on following two findings, our answer to this question is intellectual property protection does matter.1. We find that the enforcement of IP rights positively affects firms' ability to acquire new external debt (including formal and informal financing) and external equity. The firms in provinces with better enforcement of IP rights invest more funding in R&D, generate more patents, and produce more sales from new products.2. As is known, financing of and investing in R&D is prone to risks of appropriation by competitors, information asymmetry, and agency problems. Our evidences show that the enforcement of IP rights affects financing of and investing in R&D by solving these three problems.Second, although our evidences support that enforcement of IP rights matters even in China. It still difficult to explain why foreign investors regard China as the most attractive prospective R&D locations, since they could choose to locate in other countries which could provide better IP protection. Therefore, we conjecture that there exist alternative mechanisms to attract foreign investment in high tech industries. Our evidences show that social capital is the right mechanism. La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997) define social capital as "a propensity of people in a society to cooperate to produce socially efficient outcomes and to avoid inefficient non-cooperative traps such as that in the prisoner's dilemma." Knack and Keefer (1997) also emphasize that trust, cooperative norms, and associations within groups all fall within the elastic definitions of social capital. These views of social capital share an important implication, namely, that high levels of social capital generate higher levels of trust toward others. LLSV (1997) find that China has one of the highest levels of social trust among a group of 40 developed and developing countries. Allen, Qian, and Qian (2005) interpret high social trust in China as being influenced by Confucian beliefs, consistent with the idea that the social capital in China has a long history and is time persistent. When they asked the surveyed firms what type of losses concern them the most if the firm were to fail, every firm's founders/executives (100%) said "loss of reputation and trust among local friends and business partners" is a major concern, while only 60% of them said economic losses are of major concern. This suggests the importance of trustworthiness in Chinese business circle. We thus conjecture that high level of social capital enhances local people's trustworthiness, and thus reduces the risk that intellectual properties are misappropriated by local partners, employees and competitors. This leads us to hypothesize that social capital is one of the alternative mechanisms in attracting FDI in high tech firms. To test above hypotheses, we investigate the relationship between provincial-level social capital and the investment decisions of foreign high tech firms. Our empirical results show that: 1. The provinces in China characterized by high levels of social capital attract more foreign investment. We also find that the likelihood of foreign investors establishing joint ventures with local partners increases with the level of social capital prevailing in that area. Foreign high tech firms conduct more R&D investment and hire more R&D personnel in high-social-capital provinces.2. Moreover, foreign-owned firms located in high-social-capital areas keep improving their intensity of R&D investments over time. By contrast, in low-social-capital areas, foreign high tech firms do not improve and actually diminish their R&D intensity over time. It suggests that foreign investors acquire knowledge of local social capital from learning from their own experience.To understand the mechanisms through which social capital affect foreign high tech firm's investment in China, we also investigate how the social capital in the country of origin (the home country) of a foreign company affects its investment decisions in China, and we also examine the cultural difference between the home country and the host country bias the foreign company's weighing of the regional social capital difference in the host country. We find that:1. The social capital in the country of origin (the home country) of a foreign company also affects its R&D investment decisions in China.2. Cultural difference between the home country and the host country magnifies the foreign company's weighing of the regional social capital difference in the host country.3. Foreign companies from higher uncertainty avoidance home country prefer to invest in regions with higher social capital in the host country.4. Kinship decreases the need to deal with strangers, and thus reduces the reliance on the provincial social capital.5. The history of wars discourages cooperation between foreign investors and local partners. Based on the reported coefficient, each additional war between the two countries decreases the possibility of establishing a joint venture with the local partners by 3.2%, and reduces their R&D intensity by 0.6%.These findings contribute to the growing literature on cultural biases and economics outcome. This thesis consists of six chapters.Chapter 1 raises the questions we address in this thesis. And we also introduce the research background, basic idea and main contributions.Chapter 2 is literature review and theoretical analysis. Based on prior literatures, we analyze the impaction of IP rights enforcement and social capital on a series of investment decisions of domestic and foreign high tech firms.Chapter 3 describes the institutional background. We introduce China's current main law, administrative regulations, and department rules regarding IP rights, as well as international conventions on IP rights China has acceded to. We also discuss the cross-province variation of IP rights enforcement, and the social capital across the provinces in China and arround the world.Chapter 4 investigates the impaction of enforcement of IP rights on external financing, R&D input and output. We also examine the three mechanisms through which enforcement of IP rights affects financing of and investing in R&D.Chapter 5 explores whether social capital matter in foreign companies' choice of location, ownership type, and investment in R&D. We also discuss how the social capital of their home country affects the foreign firms' investment choices in a host country. In addition, we examine whether country-level cultural differences bias the weights given to the host country's regional social capital in foreign direct investment decisions.Chapter 6 concludes and gives policy suggestions.My thesis addresses a topic of general interest and contributes to several streams of literature.1. How to develop high tech industry in a country with poor intellectual property protection? This is an issue of common concern among all countries. The sharp contrast between weak intellectual property protection and rapid growth of high tech industries make China a unique candidate for an investigation of this topic. In addition, a unique firm-level database compiled by the Ministry of Science and Technology of China (MOST) also facilitate our study. The importance of the topic to China is clear -China's emphasize to make substantial progress in scientific breakthrough needs to go hand in hand with adequate and efficient allocation of funds through both public and private sources. The results of our study could not only provide several policy implications to improve the way China could meet the technology challenge in the next few years, but also share with other countries China's successful experience.2. My thesis contributes to the literature on law and finance. There are still some confusing questions in this research field. For example, La Porta, Lopez-de-Silanes, Shleifer, Vishny (1997) argue that countries with poorer investor protections have smaller and narrower capital market. Demirguc-Kunt and Maksimovic (1998) show that in countries whose legal systems score high on an efficiency index, a greater proportion of firms use long-term external financing. However, these studies do not tell us what kinds of economic mechanisms through which law affect financial development and corporate finance. To address this problem, we choose a specific law - intellectual property legal protection, and a special industry - high-tech industry which is intimately bound up with this law. We examine and find that intellectual property legal protection affect firms' financing and investment by reduce the problem of positive externalities, asymmetric information and agency conflict.3. We investigate the impact of local level enforcement of IP rights on the financing of and investing in R&D in China. Effective protection of intellectual property rights depends both on the existence of intellectual property protection laws and the enforcement of the laws. Although much has been written about the IP rules and laws (e.g., Gould and Gruben, 1996; Moser, 2005), there is little empirical evidence of the importance of enforcement. One reason is that studies of intellectual property protection are generally performed at country level. Country level analysis does not allow researchers to separate the confounding effects of the existence of the IP laws and the effectiveness of the enforcement. We deal with cross country variations in IP laws by focusing on a single country, China. We do not treat China as a single homogeneous entity. Rather we recognize that even though the applicable intellectual property laws and international treaties are the same within China, there exist significant differences in the local enforcement of the intellectual property protection (IPP) laws. Our approach of studying provincial variations is similar to that of Guiso, Sapienza and Zingales (2004) who study the difference in regional social capital in Italy, and Benfratello, Schiantarelli, and Sembenelli (2006) who investigate the effect of local banking development on firms' innovative activities in Italy. We analyze the impact of the local enforcement of IPP laws on financing of and investing in R&D by firms in various provinces throughout China. To our knowledge, our paper is the first to investigate the relationship between provincial-level enforcement of IP rights and firm-level financing of and investing in R&D.4. In prior literatures, measures of IPP enforcement at country level are of two types: perception of IPP enforcement from a survey (see the studies cited in Lanjouw and Lerner, 1997), or existence of mechanism for enforcement. The latter is exemplified by the index constructed by Park and Ginarte (1997) where a country's enforcement score is the sum of the availability of (1) preliminary injunction, (2) contributory infringement pleadings, and (3) burden of proof reversals. My thesis adds to these studies by constructing several ways of measuring enforcement of intellectual property rights. These measures great facilitate the research on economic outcomes of IPP enforcement.5. My thesis is related to the empirical literature on social capital and economic activities. Previous studies show that social capital has a positive effect on GDP growth (LLSV, 1997; Knack and Keefer, 1997, Temple and Johnson, 1998; Zak and Knack, 2001), financial development (Guiso, Sapienza and Zingales, 2004a), stock market participation (Guiso, Sapienza and Zingales, 2008c), bilateral trade and foreign direct investment (Guiso, Sapienza and Zingales, 2008a), and venture capital investment (Bottazzi, Da Rin, and Hellmann, 2007). Our paper complements these studies by focusing on how social capital facilitates foreign direct investment in innovative activities, through which social capital could affect economic growth. Complementing the macro-based approach in prior literature, our micro-based approach provides details on the effect of social capital on foreign companies' investment decisions in choosing location, ownership structure, and magnitude of R&D investment.6. My thesis also contributes to the growing literature on cultural biases and economics outcome (see Guiso, Sapienza and Zingales (2006) for a recent survey). We show that the social capital in the home country and cultural backgrounds of foreign investors cause them to bias their weighing of local social capital in the host country.7. My thesis adds to the ongoing debate about China's economic development and institutional defects. Allen, Qian and Qian (2005) propose that alternative governance mechanisms, such as those based on reputation and relationships, may support the rapid economic growth in China. Fan, Morck, Xu, and Yeung (2007) also try to explain why China attracts massive FDI despite global media spotlighting its institutional shortcomings. This paper adds to these studies by showing that social capital is one mechanism to support the high growth of the China economy; in particular, high social capital facilitates foreign investment in the innovative activities of high tech industry. Our results are in the same spirit as Allen, Qian and Qian (2005) on the roles of alternate governance mechanisms.