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The following article by Shaun Rein of the China Market Research Group originally appeared in BusinessWeek:

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Intellectual property rights is a hot topic for President Bush. Recovering the money lost by large multinationals such as Nike (NYSE:NKE) and Microsoft (NASDAQ:MSFT) in China would go a long way toward reducing the trade surplus with the U.S., which hit a whopping $85 billion in May.

Some of the numbers are startling. The Business Software Alliance estimates that in 2005, 86% of all software used in China was pirated, accounting for a $3.9 billion sales loss. Meanwhile an estimated $60 billion a year's worth of counterfeit goods are exported out of China, ultimately ending up for sale on U.S. street corners.

With counterfeiting a huge concern, companies must look at new ways to address the problem and protect intellectual property rights. With signs that China's consumers and its government are taking intellectual property issues more seriously, companies with a smart approach to China can prosper.

A Matter of Economics

First, multinationals should try to stop the piracy by taking a business approach rather than a legal or moral one. They must become less moralistic about intellectual property theft by the Chinese. While they do have the legal high ground, their current posturing does little to stop the pirates or generate revenue from legitimate sales.

The problem is more a matter of economics than of a morally corrupt Chinese populace. As the disposable incomes of Chinese consumers continue to grow, brand loyalty gains currency, and domestic Chinese companies begin to lose revenue to pirates, intellectual property problems will be solved in much the same way as they were in Taiwan and Korea. Smart multinationals will make sure they are in a strong position to reap the benefits in China.

One positive sign is that Chinese are in many ways no different from other consumers. Millions are entering the ranks of the middle class, and they want to look the part of the urban aristocrat. If they cannot afford genuine items they turn to touts on the street hawking fake Louis Vuitton, Tiffany (NYSE:TIF), Montblanc [CFR.VX], Rolex, and Polo (NYSE:RL) items. But as Chinese consumers become increasingly sophisticated, the situation is changing. Now consumers can value the difference between a real Giorgio Armani tie and a fake one.

Counting On Cachet

My firm, The China Market Research Group [CMR], conducted one-on-one interviews with consumers in Shanghai, Guangzhou, and Beijing. We found that consumers prefer to buy genuine articles if they can afford to pay for them. The majority of aspiring respondents said that they are buying some real products and then completing an ensemble with fakes.

Many young women making $400 a month said that they are willing to save three months of salary to buy a thousand-dollar Gucci (GUC) handbag or shoes from Bally. One 23-year-old female respondent said, "Right now I can't afford to buy a lot of real Prada or Coach (NYSE:COH), so I buy the fake items. I hope that in the future I will be able to afford the real thing, but right now I want to look the part."

A 27-year-old woman working at a multinational admitted that she did buy fakes but said, "If you wear a lot of fake clothing or have a lot of counterfeit bags, your friends will know, so you are not fooling anybody. It is better to have the real thing." As long as companies make an effort to develop the cachet of their brands, they do not need to worry about pirates making copies of their products.

All the signs say the situation will continue to improve as spending power rises.

Per capita income has more than doubled in the last decade, from $633 in 1996 to $1,537 last year, and shows few signs of slowing. There are now around 250,000 millionaires in China and the number is growing every day.

Can't Trust Mom and Pop Stores

Creating a more attractive retail experience will also help bolster demand for legitimate products. Best Buy's (NYSE:BBY) opening in Shanghai helps illustrate another developing trend in China. Consumers increasingly want to make big-ticket purchases in a pleasant environment that is supported by knowledgeable sales staff and good return policies. Best Buy has found success in Shanghai quickly because consumers trust that Best Buy will not sell them counterfeit or gray-market items.

As one male customer interviewed by my firm put it, "I want to buy a computer or mobile phone from Best Buy because I trust that the product is real. If I am going to spend so much money on an item, I want to make sure that it is not a knock-off like those bought in a mom and pop shop."

Many Chinese have had to put up with buying Dell (NASDAQ:DELL) and Hewlett Packard (NYSE:HPQ) computers and other expensive items from shady shops that offer little or no support and products of dubious origin. Very often one might buy a shell of a Nokia (NYSE:NOK) or Motorola (MOT) phone and find that the vendor has swapped the battery or charger for an inferior knock-off. One of the best ways to make Chinese consumers feel comfortable parting with money for large purchases is to offer them a retail environment that demonstrates that it only sells genuine products, has a comfortable shopping environment, and delivers top-notch customer service.

Microsoft Woos the Authorities

Pirated software and DVDs from China receive a lot of media attention. It's a huge problem on Web sites such as eBay (NASDAQ:EBAY). Different companies trying to protect their products have taken very different approaches in handling the theft and distribution of their property.

Microsoft (MSFT), a company that has faced years of intellectual property violations in China, has done an admirable job of moving beyond a moralistic defense of its rights. Instead, Microsoft has focused on a business approach to propagating legitimate Windows and Office software and worked to engage the support of the Chinese government.

In 2005 Microsoft reached an agreement with Lenovo (OTCPK:LNVGY) so that Lenovo would begin pre-installing genuine copies of Windows on new computers. Other makers, including China's No. 2 computer vendor, Founder, have followed suit, and Microsoft has made recent deals to develop support for other applications including Microsoft Office and Windows Live.

Time Warner's Disk Problem

Windows is still one of the most popular pirated products to buy, but slow progress is underway. Microsoft just announced that its revenues will increase 20% in China due to help from the government in stopping the piracy problem, in large part by ordering government ministries not to run pirated software. The Chinese authorities are also chipping in. More aggressive initiatives to combat the problem of software piracy have led to a waning demand for counterfeit products. Software piracy has dropped 10% over the last three years.

Other companies still have to find better ways to wean Chinese consumers away from the pirates when product prices are cheap and there is no recognizable value-added, as there is with luxury products, for buying a genuine article. Time Warner (NYSE:TWX) has suffered losses in China because so many vendors are selling copied DVDs for less than a dollar a disk. In response, Time Warner has tried to lower costs of legitimate DVDs, but the 300% differential is still too much for a product that consumers see as disposable.

To compete head to head with pirates, DVD prices must come down still further or Time Warner has to create a value proposition, such as utilizing the Web to interact with consumers: for example, by setting up online contests open only to those who buy legitimate copies of Time Warner's movies. Consumers will pay for a product if they see they are getting more from buying it.

Chinese Consumers Want Safety Too

Multinationals in China also must realize that Chinese consumers will pay for healthy, safe products just as Americans do. During the last few weeks, China has been lambasted in the global press because of unsafe food and drug products that have made it onto store shelves in the U.S., Panama, and other countries. The most recent international problem involved a U.S. recall of China-produced pet food laced with a fake protein additive and toothpaste suspected to contain diethylene glycol.

China has also had to deal with domestic concerns over product safety with recent instances of fake baby formula, vitamins, antibiotics, and even blood protein pumped out of unlicensed factories reaching store shelves and hospitals.

And while Americans have rightly become increasingly worried about the safety of products produced in China, Chinese consumers are just as worried. They do not want to feed their babies contaminated baby food or deadly drugs any more than Americans do. One 38-year-old woman we interviewed imports her baby formula from Japan because she trusts that the product will be real. Another female shopper said she only shops at international stores such as Wal-Mart (NYSE:WMT) and Carrefour (OTCPK:CRERF) because she can trust that the products are of high quality.
Now Mainland Firms Are Suing

Sales of Pfizer's Viagra (NYSE:PFE) in Hong Kong boomed after the authorities eased travel restrictions for mainlanders entering Hong Kong. Chinese consumers know that many of the products for sale on mainland store shelves are suspect and often they will go out of their way to find a product they can trust. Multinationals should leverage this fear of consuming pirated, low-quality health products by fostering consumer trust. Chinese consumers get a tangible benefit from buying real drugs, safe toothpaste, and healthy baby formula, and they will pay for that benefit.

What is promising is that more Chinese firms are taking pirates to court and winning. China is trying to make the shift to an innovation-based economy, so expect more pressure coming from Chinese companies that want to develop products and services in a fair environment.

Once the pirates hurt enough domestic Chinese business interests, you will see Chinese companies lobbying for better protection. And once they do, it is certain that the government will pay attention and protect its wards. That, combined with an increasingly sophisticated Chinese consumer, will cause piracy to continue to drop in China. The piracy problem in countries like Korea and Taiwan was huge and it was fixed in much the same way. The stakes are bigger in China, so multinationals must be more proactive in their approach to expansion in China.