For decades, the relationship between China and the U.S. has been like a big brother and a little brother. You teach the little guy how to play basketball, how to talk to girls, and the ways of capitalism (I don't have a brother, but I assume this is one of the lessons). Eventually he starts beating you on the basketball court and making his own path in the world as you look on proudly.
But our relationship with China comes with a contentious back-story that hasn't improved as the country has gotten more powerful. Theft, fraud, and manipulation are rampant. You probably remember hearing about replica Nike (NYSE: NKE) products making their way out of Chinese factories that would be shut down in the U.S., and that's just scratching the surface of the problem. Consumer-goods like shoes were good enough for China in the '90s, but today its sights are set much higher.
Normal rules need not apply
As part of the World Trade Organization, or WTO, China is supposed to be an open trading partner. Free trade breaks down the barriers of protectionism that plagued the world for centuries. The WTO says it stands for non-discrimination, as well as open, predictable, transparent, competitive, and environmentally friendly trade.
What happened to that philosophy in the rare-earth market, where China supplies 95% of the material? China has put limitations on exports for a key raw material for hybrid cars, wind turbines, and other high-tech gadgets. This has been a boon for Molycorp (NYSE: MCP), which will be one of the first miners outside China to begin production, but it flies in the face of free trade. Recently the country has begun being even more restrictive, consolidating power and working on a new pricing mechanism. That doesn't sound like free trade to me.
Companies such as Toyota (NYSE: TM) have been forced to look into alternatives to rare-earth magnets, increasing business risk that shouldn't be a problem in a world where free trade rules are followed. The U.S., E.U., and Japan are challenging China's practices with the WTO, but so far there's been little to no progress.
Protection of none
One of the foundational building blocks of developed countries is the protection of intellectual property. Whether it's an idea, a catch phrase, a piece of art, or this article I'm writing, intellectual property is protected. China has blatantly disregarded IP protection, to the detriment of U.S. companies, and I'm wondering why we put up with it so willingly.
If you haven't heard the story about American Superconductor (Nasdaq: AMSC), it's a cautionary tale we should all know. The company sold equipment, designs, and software to Chinese wind turbine manufacturers, basically providing the technical expertise that made their businesses possible. The largest of these was Sinovel, one of the world's largest wind turbine manufacturers.
At the foundation of American Superconductor's business and licensing agreements was code that was the brains of the wind turbine. It was a tenuous competitive advantage, but this type of IP would be protected in the developed world. In China, the story is different.
According to American Superconductor, a disgruntled employee sold this valuable code to Sinovel, which then backed out on its licensing and supply agreements. Since selling these trade secrets is illegal, the ex-employee is sitting in an Austrian prison at this very moment.
But what about Sinovel? It's no worse for wear, legally speaking. American Superconductor has brought four lawsuits against the company for the theft of intellectual property, and one of the suits has already been thrown out of court. If the others are similarly tossed, you'll have your final answer as to what China thinks of IP.
Our currency is worth whatever we want
Free trade should involve another free-market mechanism, floating currencies. But China has decided to peg its currency to ours, making goods cheaper to produce in China. President Obama has complained about the action, and Candidate Romney has talked tough about the manipulation, but little has been done to stop this manipulation of China's currency.
Why do we put up with it? Because China buys our debt and is a major trading partner, a relationship we don't want to mess with.
Outright fraud
One of the biggest controversies last year was the fallout from reverse-merger IPOs and Chinese fraud. How are we supposed to invest in China when we can't believe its companies' financials?
A surprisingly large number of companies that were found to have misled investors, yet we simply gobbled these garbage stocks up -- for a while. We have such an appetite for exposure to China's growing economy that we're willing to overlook normal IPO due diligence and invest in complicated corporate structures that would take a law degree to understand. Why we still put up with this is beyond me.
Foolish bottom line
I've outlined just a few examples of how China greets U.S. companies and investors with a smile and then stabs them in the back. If you have others, feel free to share them in the comments section below.
These are major problems in China and with investing in China, but I don't see the situation changing any time soon. Companies thirst for the potential growth China provides and are willing to overlook the risks associated with investing there. A few weeks ago, I highlighted how even all-powerful Apple (Nasdaq: AAPL) may be teaching a new generation of companies how to make its products, just as we taught China how to make PCs and automobiles. That decision could have China taking over increasingly important markets in the future.
For stock ideas that have some protection from Chinese imitators, check out our report highlighting companies set to dominate the world. The report is free.
