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DOES ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS MATTER

IN CHINA? EVIDENCE FROM FINANCING AND INVESTMENT CHOICES

IN THE HIGH-TECH INDUSTRY

James S. Ang, Yingmei Cheng, and Chaopeng Wu*

Abstract—Using a unique and rich database of high-technology ﬁrms in

China, we show that effective enforcement of intellectual property rights

at the provincial level is critical in encouraging ﬁnancing and investing in

R&D. Better enforcement of intellectual property (IP) rights positively

affects ﬁrms’ ability to acquire new external debt and allows ﬁrms to

invest in more R&D, generate more innovation patents, and produce more

sales from new products. Our results suggest that facilitating ﬁnancing

and investing in R&D are the channels through which better IP rights

enforcement can affect economic growth.

I. Introduction

LLEN, Qian, and Qian (2005) raise the puzzle that

‘‘China’’s legal and ﬁnancial systems as well as institu-

tions are all underdeveloped, but its economy has been

growing at a very fast rate.’’ More speciﬁcally, it is a chal-

lenge to explain the high growth in R&D expenditures in

China, which ranked ﬁrst among forty OECD countries and

selected nonmember economies from 2002 to 2010, in spite

of its generally perceived weak protection of intellectual

property (IP) rights (Israel, 2006; Stratford, 2006; Interna-

tional Intellectual Property Association, 2007).

The China

phenomenon has become such an anomaly, as some cross-

country studies are able to obtain the expected positive rela-

tion between IP protection and economic growth only when

China was excluded (Gould & Gruben, 1996; Schneider

2005). Does this lead to the inference that China is some-

how different and IP protection does not matter there? That

is the question we address in this paper.

Effective protection of intellectual property rights depends

on both the existence of IP laws and the enforcement of the

laws.

Although much has been written about the IP rules and

laws (Gould & Gruben, 1996; Moser, 2005), there is little

empirical evidence on the importance of their enforcement.

One reason is that studies of IP protection are generally per-

formed at the country level.

Country-level analysis does not

allow researchers to separate the confounding effect of the

existence of IP laws and the effectiveness of their enforce-

ment. Rather than dealing with cross-country variations in IP

laws, we focus on a single country, China. We analyze the

impact of local enforcement of IP laws on the ﬁnancing of and

investing in R&D by ﬁrms in provinces throughout China.

To our knowledge, our paper is the ﬁrst to investigate the

relationship between province-level enforcement of IP

rights and ﬁrm-level ﬁnancing of and investing in R&D.

We do not treat China as a single homogeneous entity.

Rather, we recognize that even though the applicable IP

laws and international treaties are the same for all provinces

in China, there exist signiﬁcant differences in the local enfor-

cement of the IP laws. Our approach of analyzing provincial

variations parallels that of Guiso, Sapienza, and Zingales

(2004), who study the differences in regional social capital

in Italy, and Benfratello, Schiantarelli, and Sembenelli

(2008), who investigate the effect of local banking develop-

ment on ﬁrms’ innovative activities in Italy.

We propose that better enforcement of IP rights mitigates

the problems associated with R&D: risks of expropriation by

competitors and information asymmetry. This leads to the

empirically testable hypotheses that better enforcement of IP

rights helps to generate more funds available to ﬁnance R&D,

more investment in R&D, and more output from R&D.

To test our hypotheses, we use several unique data sets

that have not been examined in previous empirical studies.

The database compiled by the Ministry of Science and

Technology of China (MOST) provides ﬁrm-level ﬁnancial

and R&D-related information for a large number of Chinese

high-tech companies. We chose to focus on these ﬁrms, all

of them unlisted, for the following reasons. First, the suc-

cess of high-tech ﬁrms critically depends on the output from

R&D and the legal protection of their exclusive rights. Sec-

Received for publication August 24, 2009. Revision accepted for publi-

cation November 19, 2012.

* Ang and Cheng: Florida State University; Wu: Xiamen University.

We appreciate the comments and suggestions from the editor (Philippe

Aghion), two anonymous referees, seminar participants at the 2009 WFA

Meeting, the 2009 Annual Darden International Finance Conference, the

2009 FMA Asian Conference, the 2009 FMA European Conference, the

2009 CICF, the 2011 ASSA Annual Meeting, National University of Sin-

gapore, Florida State University, and Shanghai University of Finance and

Economics. C.W. gratefully acknowledges ﬁnancial support from the

National Natural Science Foundation of China (grants 71002042,

71272082, 71172053, 71232005), Social Science Foundation of Fujian

(grant 2012B025), NSF of Fujian (grant 2010J05152), and New Century

Talent Supporting Project of Education Ministry (NECT-12-0320).

A supplemental appendix is available online at http://www.mitpress

journals.org/doi/suppl/10.1162/REST_a_00372.

We obtained this information from the OECD website, http://stats.oecd

.org/Index.aspx, and R&D Magazine, http://www.rdmag.com/.

La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) state that ‘‘a

strong system of legal enforcement could substitute for weak rules’’ (p.

1140). The cross-country studies of La Porta, Lopez-de-Silanes, and Shleifer

(2006) and Jackson and Roe (2009) have documented the role of private and

public enforcement of securities laws.

Comparisons are made on national intellectual property laws, but not

the quality of their enforcement. Existing empirical evidence suggests a

positive effect of the extent of IP laws on GDP growth (Gould & Gruben,

1996), direction of technical change (Moser, 2005), and foreign direct

investment (Javorcik, 2004; Du, Lu, & Tao, 2008). The impact of intellec-

tual property protection on the number of innovations and R&D invest-

ment is also widely studied (Nordhaus, 1969; Sakakibara & Branstetter,

2001). However, most of the studies are at the country level.

The Ofﬁce of the U.S. Trade Representatives in its June 2006 review

of intellectual property rights protection in China switched its emphasis

from country-based assessment of China to developments at the provin-

cial level in China (Federal Register 43,969, June 16, 2006; also see Yu,

2007).

The Review of Economics and Statistics, May 2014, 96(2): 332–348

2014 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology

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ond, listed ﬁrms in China are not required to disclose

detailed information on their R&D activities, while our

database of unlisted ﬁrms provides rich detail, from R&D

expenditures to R&D personnel composition. Third, since

unlisted ﬁrms are unable to raise funds from the stock mar-

ket, the ﬁnancing of their R&D activities is of particular

interest.

The enforcement of intellectual property rights is many

faceted. We introduce two measures of IP rights enforce-

ment. The ﬁrst is the fraction of intellectual property infrin-

gement cases won by the plaintiffs in each province (here-

after labeled as IPP1). It directly measures the probability

of winning by the plaintiffs in IP infringement cases, and

thus it is a good proxy for the enforcement of IP rights in

the provincial courts. The court is an integral part of the IP

rights enforcement, where it can order the defendant to

cease infringement, compensate the plaintiff, or destroy the

conﬁscated products. We collect the outcomes of IP infringe-

ment cases brought before the courts with the IP owners as

the plaintiffs. We compute IPP1 as the percentage of these

cases ruled in favor of the plaintiffs. We expect that better

enforcement of intellectual property rights raises the odds

that the IP owners will win their cases in courts.

Chinese authorities often announce policy directives

through the Communist Party’s ofﬁcial newspaper. The sec-

ond measure of IP rights enforcement, labeled IPP2, is the

number of articles advocating IP protection published in the

ofﬁcial newspaper of the provincial Communist Party,

which represents the highest level of the provincial admin-

istration. Articles published in this paper serve to convey

policy guidelines to all levels of local government, since

these local ofﬁcials are invariably members of the Commu-

nist Party. A greater number of articles related to IP protec-

tion transmits a stronger commitment to IP enforcement by

the top provincial ofﬁcials. Whereas IPP1 reﬂects the enfor-

cement effectiveness of courts, IPP2 monitors the attitude

of the top provincial ofﬁcials toward IP enforcement.

One concern about the causal effect of IP rights enforce-

ment on ﬁnancing of and investing in R&D is that some

unobserved provincial factors may contribute to both IP

rights enforcement and ﬁnancing of and investing in R&D,

thus producing a potentially spurious relationship between

IP enforcement and ﬁnancing of and investing in R&D in

the OLS regressions. Another concern is the possibility of

reverse causality: a greater level of ﬁnancing and invest-

ment may increase the demand of IP protection. We use

instrumental variable regressions to address the endogeneity

problem. To choose the right instruments, we go back to

premodern Chinese history and make use of the inﬂuence

of Western ideology on the enforcement of IP rights. We

use two instruments: Christian colleges (the number of col-

leges established by Christian missionaries in the provinces

by 1920) and British settlement, a dummy variable that is 1

when a province had a concession or leased territory estab-

lished by Great Britain during the late Qing dynasty. They

are expected to be positively and signiﬁcantly related to the

two measures of IP rights enforcement, yet they are not likely

to directly affect the ﬁnancing and investment of ﬁrms in the

twenty-ﬁrst century. The results from the partial F-tests ver-

ify that the two instruments are indeed strong instruments.

In addition to the IV regressions, we also employ dynamic

panel GMM estimators developed by Holtz-Eakin, Newey,

and Rosen (1988), Arellano and Bond (1991), Arellano and

Bover (1995), and Blundell and Bond (1998). The panel

GMM approach can address the potential endogeneity of all

the regressors, and it also incorporates ﬁrm-ﬁxed effects to

account for time-invariant unobservable heterogeneity.

We show that high-tech ﬁrms in provinces with better

enforcement of IP rights enjoy greater access to external

debt, invest more of their funding in R&D, generate more

patents, and have greater new product sales. Our results

demonstrate that protection of IP rights matters even in

China. Better IP rights enforcement helps to facilitate ﬁnan-

cing of and investing in R&D, and therefore serves as a

channel to stimulate economic growth.

The rest of our paper proceeds as follows. Section II pre-

sents the testable empirical hypotheses. Section III describes

the database of high-tech companies, measures of province-

level IP rights enforcement, and other control variables. Sec-

tion IV reports the empirical results of the effect of IP rights

enforcement on external ﬁnancing, R&D input, and R&D

output. Section V concludes.

II. Intellectual Property Rights Enforcement

and R&D Investment

In this section, we describe IP rights enforcement in

China and discuss the risks of expropriation by competitors

and the problem of information asymmetry. These issues

can lead to undersupply of funding and underinvestment in

R&D. Finally, we develop hypotheses of how better IP

rights enforcement may mitigate these problems.

A. IP Rights Enforcement in China

China is often perceived as having a poor record in the

protection of IP rights (see Wang, 2004; Maskus, Dough-

erty, & Mertha, 2005). However, an examination of China’s

IP laws (see online appendix A) and the international trea-

ties it has acceded to (see online appendix B) put China on

par with more developed economies.

There are two expla-

nations for the discrepancy between written laws and the

common perception.

The ﬁrst is that most of the IP laws in China came into

existence in relatively recently. It may take time for these

laws to work and set precedents in a legal system with little

or no experience in IP cases. Nevertheless, there is some

tangible evidence of improvement in IP enforcement. Fig-

Of particular importance is membership in the three major agreements

identiﬁed by Park and Ginarte (1997): the Paris Convention, the Patent

Cooperation Treaty (PCT), and the International Convention for the Pro-

tection of New Varieties of Plants (UPOV).

333DOES ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS MATTER IN CHINA?

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ure 1 plots the amount of licensing fees paid by residents in

China and other major economies to nonresidents from

2001 to 2010, as reported by the World Bank. Payments by

China tied with Germany, ranked fourth, behind the United

States, Japan, and Singapore in 2010. The compounded

annual growth rate of these payments by China over the

same period is 24%. The numbers suggest a signiﬁcant

increase in IP rights protection in China since its admission

to the WTO. The evidence may blunt the criticisms of poor

intellectual property protection in China cited earlier, as

many of these studies are based on older data or surveys.

The second is that effective protection of IP rights depends

on both the existence of IP laws and the enforcement of these

laws. Although the applicable IP laws and international trea-

ties are the same within China, there are signiﬁcant differ-

ences in the local enforcement of the IP laws, as we ﬁnd in

our study. One has to consider local differences in enforce-

ment to assess the effectiveness of IP protection.

These two factors suggest that it is worthwhile to investi-

gate local differences in the IP enforcement in the more

recent period in order to understand the issue of intellectual

property protection in China. We focus on how better prov-

ince-level enforcement of IP rights helps to resolve the prob-

lems associated with investing in R&D by high-tech ﬁrms.

B. Risks of Expropriation by Competitors and Information

Asymmetry

The competitiveness of high-tech enterprises is largely

determined by their intellectual properties, such as patents,

trade secrets, specialized manufacturing technologies, and

processes. However, as Nelson (1959) and Arrow (1962)

suggested, it is difﬁcult for companies to internalize all

positive externalities and prevent free riding on their intel-

lectual properties. Innovative ideas are often imitated and

expropriated by competitors. The risks of expropriation by

competitors have led to the result that private returns to

R&D investments are lower than their social returns, as

documented by Griliches (1992) and Hall (1996). For these

reasons, ﬁrms can be reluctant to ﬁnance and invest in

R&D when the expected loss from the expropriation is

high, which in turn reduces a country’s economic growth.

Information asymmetry can also reduce the amount of

ﬁnancing of and investment in R&D. In the context of our

analysis, the problem of information asymmetry refers to

the fact that ﬁrms are unwilling to disclose conﬁdential

information to potential lenders and investors because these

fund providers may expropriate the knowledge (Anton &

Yao, 2002). Ueda (2004) analyzes a situation in which a

venture capitalist can pose a threat by stealing ideas and

projects from entrepreneurs and suggests that stronger pro-

tection of IP rights can mitigate the problem and encourage

entrepreneurs to seek ﬁnancing from venture capitalists.

C. The Effect of IP Rights Enforcement on External

Financing

More effective IP enforcement raises the costs of imita-

tion and infringement. Those who infringe on others’ intel-

lectual property face a higher probability of legal sanctions

in provinces with better enforcement of IP rights. Consis-

tent with the model in Ueda (2004), better protection of IP

rights punishes lenders and investors who steal innovation

secrets. Thus, ﬁrms in provinces with better IP protection

are expected to have more conﬁdence in disclosing conﬁ-

dential information to potential external fund providers and

to receive more funds. If better IP rights enforcement helps

high-tech ﬁrms reduce the risks of expropriation by compet-

itors and resolves the problem of information asymmetry

with external fund suppliers, high-tech ﬁrms are predicted

to receive more outside debt ﬁnancing in provinces with

better IP rights enforcement (hypothesis 1).

On the one hand, having greater access to external capital

alleviates the need to ask for more funds from the existing

FIGURE 1.—THE AMOUNT OF LICENSING FEES PAID BY RESIDENTS IN CHINA AND OTHER MAJOR ECONOMIES TO NONRESIDENTS, 2001–2010

The ﬁgure plots the royalty and license fees paid by residents in China and other major economies to nonresidents for the authorized use of intangible, nonproduced, nonﬁnancial assets and proprietary rights (such

as patents, copyrights, trademarks, industrial processes, and franchises) and for the use, through licensing agreements, of produced originals of prototypes (such as ﬁlms and manuscripts). Data are in U.S. billion dol-

lars. The data are obtained from the World Bank.

334 THE REVIEW OF ECONOMICS AND STATISTICS

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shareholders, the source of equity for privately held compa-

nies. On the other hand, existing shareholders may want to

increase investment when IP protection is better. Given the

two opposite effects, the impact of IP rights enforcement on

external equity ﬁnancing is ambiguous in theory. We empiri-

cally test the following hypothesis: better IP rights enforce-

ment reduces the amount of new external equity (corollary 1).

D. IP Rights Enforcement, R&D Input, and R&D Output

Better IP rights enforcement raises the expected payoff

from investing in R&D. Thus, we hypothesize that high-

tech ﬁrms in provinces with better IP rights enforcement

invest more funds in R&D (hypothesis 2). Firms in prov-

inces with better IP rights enforcement receive greater pro-

tection from patent infringement and thus are more likely to

generate patents and apply to register their patents. We

therefore expect that better IP rights enforcement increases

the number of patents generated by ﬁrms (hypothesis 3A).

Poor IP rights enforcement makes it possible to ﬂood the

market with infringing products, which results in a loss of

sales to the owners of the intellectual property. As a conse-

quence, we hypothesize that better IP rights enforcement

increases ﬁrms’ sales from new products (hypothesis 3B).

III. Measures of IP Rights Enforcement, Provincial

Characteristics, and Database Description

In this section, we describe the two measures of province-

level IP rights enforcement. In addition, we specify the con-

trol variables (the provincial and ﬁrm characteristics, used in

the analysis), describe the data sources, and present a preli-

minary description of the high-tech ﬁrms in our sample.

A. Measures of Province-Level IP Rights Enforcement

National laws and regulations apply to all provinces in

China, although local enforcement can vary a great deal.

There are 27 provinces and 4 special districts (Beijing, Tian-

jin, Shanghai, and Chongqing) in China. However, 3 rela-

tively underdeveloped western provinces (Ningxia, Qinghai,

and Tibet) do not have National Innovative and High Tech-

nology Industrial Development Zones, so these provinces do

not have high-tech companies in our sample. Thus, the total

number of provinces or districts in our analysis is 28.

We measure provincial enforcement of IP rights in two

ways. The ﬁrst is the fraction of IP infringement cases won

by the plaintiffs (the IP owners) in the provincial courts. It

directly measures the probability of IP owners’ winning and

thus is a good proxy for the enforcement of IP rights. We

label it IPP1. The second is the local authorities’ willing-

ness to enforce IP rules, measured as the number of articles

advocating IP protection each year that appear in the ofﬁ-

cial newspaper published by the provincial Communist

Party. We label this variable, which gauges provincial ofﬁ-

cials’ attitude toward IP enforcement, IPP2.

To construct IPP1, we download and read the written

judgment of 7,668 IP infringement cases ﬁled in 28 prov-

inces from 2001 to 2005 from the China Judicial Case Data-

base, with the IP owners as the plaintiffs. We consider only

IP infringement because we believe that the court judg-

ments in IP infringement cases are the most relevant to our

study. The cases include patent right infringements, infrin-

gements of other companies’ technologies, commercial

secret infringements, new plant infringements, and inte-

grated circuit design infringements. We classify a case as

won by the plaintiff if the court ordered the defendant to

cease infringement, compensate the plaintiff for its eco-

nomic loss due to the infringement, destroy the infringing

products and equipments involved, or pay the legal cost of

the lawsuit. The case is classiﬁed as won by the defendant

if the court dismissed the plaintiff’s lawsuit.

Two possible scenarios may create bias in using the frac-

tion of cases won by the plaintiffs as the measure of IP

enforcement. One concern is that plaintiffs may initiate

lawsuits with no merit. Given that there are substantial

monetary costs in going to court in China, it is highly un-

likely that plaintiffs will initiate nuisance lawsuits with no

merit and thus no or a low chance of winning.

Another

deterrent for a ﬁrm to bring up a nuisance lawsuit is the

adverse impact on its reputation, or loss of face. Given the

large number of lawsuits, even if there were a handful of

nuisance ones, it is reasonable to assume that they will not

affect the measure in any meaningful way. In addition,

there is no evidence to lead us to believe that the incidence

of no-merit lawsuits should be systematically different

across the provinces. The other concern is that better IP

enforcement may lead to fewer lawsuits, which is not cap-

tured by the fraction of lawsuits won by plaintiffs. How-

ever, the expectation of better enforcement in the courts

means higher expected returns for the intellectual property

owners to pursue the violators in courts. Indeed we ﬁnd that

provinces with a higher winning percentage for the IP own-

ers actually have a greater number of IP lawsuits.

The main purpose of the provincial Communist Party’s

ofﬁcial newspaper, published by each province circulated

daily, is to promote provincial policies and affect public

opinion. Provincial government organizations at all levels

are required to subscribe to this newspaper. Its readers

include people in all ﬁelds, in addition to government per-

sonnel. Because the Communist Party is the only political

party in China, its attitude toward IP enforcement is critical

in the protection of IP rights. A stronger advocacy of IP

rights by the party’s ofﬁcial newspaper in a province is

expected to lead to better IP enforcement. We use the full-

text database of China’s major newspapers to search for

relevant articles in the party newspaper with the following

Legal expenses for lawsuits between businesses are substantial in

China. Losers of lawsuits pay between 3% and 10% of the disputed

amount for legal fees, plus 0.2% to 2.5% for brief fees. Winners pay even

more: 10% to 20% of the disputed amount for legal fees.

335DOES ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS MATTER IN CHINA?

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