Behind China's surge in patents

FORTUNE -- China has won a few high-profile crowns lately: In January, the East Asian giant surpassed Germany as the world's largest exporter. Then in August, it trumped Japan to become the world's second largest economy.

And by next year, China is expected to surpass both Japan and the United States in patent filings, according to a Thomson Reuters report released this month.

Since patents often measure a country's inventive streak, it's reasonable to think that China is in line next year to become the world's top innovator. But the country, which is known for being lax on piracy and for its relatively uneven enforcement of intellectual property laws, has some ways to go before it catches up to the kind of innovation found in Japan and the U.S.

There's little doubt that China has made incredible advances since its first patent law went into effect in 1985 -- the country has been reforming its court system and administrative offices to better enforce laws. China's government has also encouraged innovation through subsidies and other incentives. More students are engineer graduates, and the country is known for some of the world's most innovative companies including Lenovo.

While patent applications across the world grew at their lowest rate in 2008 since the dot-com crisis in the early 2000s, growth of applications in China grew by 18.2%, according to the World International Property Organization. In fact, the country kept the worldwide total from spiraling to zero growth in 2008 as applications in Japan and Korea dropped, 1.3% and 1.1%, respectively. The U.S. saw zero growth.

In 2009, patent filings at most offices dropped again except in China, where they grew by 8.5%, even as public companies on average reduced R&D spending, according to WIPO. Spending at General Motors fell by 24.5%; Toyota (TM) by 19.8%; Caterpillar (CAT, Fortune 500) by 17.8% and Unilever (UL) by 3.9%, WIPO notes in a report released last month. Even information technology companies reduced spending, with the exception of a few, such as Apple (AAPL, Fortune 500) and Microsoft (MSFT, Fortune 500).

In many ways, the global recession gave China an unexpected edge over other economies leading innovation.

Growing pains

But the relevance of China's rise to the top isn't straightforward. It signals huge progress, and yet reminds the world that the country still has a host of issues to work out before its level of innovation reaches that of the United States, Europe or Japan. Just because the country may lead in patent volume doesn't necessarily mean it has yet become the world's top innovator.

For instance, look at China's quality of patents. Though experts say it's improving, Reuters notes that about half of all Chinese patents filed in 2009 were utility models -- a more affordable and less rigorous form of patent that provides a shorter term of protection of only 10 years versus 20 years for invention patents. What's more, despite the challenging economy in 2008, utility model applications surged with China leading the helm with a 24.4% increase in utility model patents, according to WIPO.

"If you're talking about Chinese companies using patents to exclude Americans or to gain a competitive advantage in the U.S. marketplace, the utility patents are meaningless," says Bruce Lehman, president of the International Intellectual Property Institute, a Washington DC-based think tank that promotes the idea that intellectual property can help drive economic growth, especially in developing countries.

Lehman adds that while the surge in utility model applications is a sign of progress given the Chinese economy's size and history, they are not recognized in the U.S. and most parts of the world.

And while China's intellectual property laws are strong, enforcement is still inconsistent. Even though the country has reformed its court system to better handle disputes, inefficiencies remain. Song Jung, attorney with McKenna Long & Aldridge, recalls his experience four years ago winning an intellectual property infringement case against a Chinese company. He says that while China's system has generally improved, one of the drawbacks is that compensation and royalties for intellectual property is very low compared with the U.S. This potentially creates a situation where companies that have grievances might not have an incentive to resolve intellectual property issues through the courts. Jung says it's not that compensation should be outrageously high either, as that could spark a frenzy of lawsuits and scare off companies from innovating.

"You have to strike a balance," he says.

Indeed, China is on its way to becoming the world's top innovator. It's not there yet, however.