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from Forbes on Monday, February 03, 2003

Sell one operating system to every citizen in China and you could make some real money. But in China software is pirated, not sold legitimately. What's a producer of intellectual property to do? The future of business in China--and why it is both tantalizing and troublesome--is on display in Beijing at the bustling Hailong market, an elbow-your-way-in set of hundreds of stalls peddling computers and software. Just a ten-minute drive from the offices of Microsoft China, the market sells everything from ready-to-go laptops to motherboards, monitors and "mice" for the boldest shoppers bent on building a PC on the cheap.

At one busy table a Chinese-language version of Windows XP, Microsoft's latest operating system, comes in a shrink-wrapped box with the familiar logo. The price--$245--amounts to four months' salary for an average Chinese worker. Too steep? No problem. At a nearby stand a woman reaches under the counter to a tall stack of CDs on which XP has been illegally copied. Gentle bargaining brings the bootleg price down to $5.50.

That is the paradox of China for Microsoft (nasdaq: MSFT - news - people ). Like many U.S. companies, Microsoft is mesmerized by the dream of capturing its share of business here--if only it could overcome some rather monumental barriers. Piracy is rampant: More than 90% of the application software used here comes from illegal copies. It has been only 13 years since the nation adopted its first copyright law, and it later tightened the rules only reluctantly, mostly to win support for its admission to the World Trade Organization. Comfortably in WTO now and enjoying a $30.4 billion trade surplus with the U.S., China scarcely bothers to enforce the laws.

Microsoft has tried the belligerent route, suing Chinese companies to stop piracy much as Cisco Systems (nasdaq: CSCO - news - people ) recently did. But those moves have largely backfired, making Microsoft seem a foreign bully. Whenever the Chinese government has been threatened, it has thrown more of its weight behind Linux, the freebie operating system that poses a looming global threat to Windows.

The piracy dilemma confronts any company doing business in China with a brand or idea to protect. (See box, p. 82.) For Microsoft, accustomed to a gross profit margin of 85% on its most popular wares, the experience in China has been an unending torment. Bill Gates might be retired before his company sees anything but red ink in Red China. Microsoft acknowledges that it has run losses in China for ten years, is likely to do so for at least five more, and could wait another decade or two for profits.

The problem: Although Microsoft's software is by far the most popular, with 60% of China's computers running on Microsoft operating systems, few consumers or businesses shell out for the real thing. Microsoft's China revenue was only $85 million last year, estimates International Data Corp. Microsoft should have taken in nearly $400 million, had it been paid only for its share of software in brand-new computers.

And yet at a time when the rest of the world economy languishes, glutted with high-tech gear and reeling from the worst tech slump ever, China looms with untold riches. Its economy grows at a torrid 8% a year, more than twice the rate in the U.S. The untapped potential is huge. This nation of 1.3 billion people and millions of abacuses uses only 36 million personal computers. Its PC market, the fastest growing on the planet, is expected to surpass Japan's to become the world's second largest this year, and to double in three years. A PC costs $870, more than a year's pay for an average worker, but customers found the money to buy 7.6 million last year.

The whole high-tech category, like so many business sectors in China, is a blank slate now, awaiting a latter-day information revolution driven by its latter-day industrial revolution. The dream is that sales of computer systems and software will follow the rocket trajectory of the mobile phone. Five years ago 24 million Chinese had cell phones; today the total is 200 million--and counting.

Microsoft thinks its China profits are worth the wait. "This is a very long term opportunity of substantial magnitude and strategic importance," says Craig Mundie, a Microsoft senior vice president and chief China strategist. "Are we happy if we only make this money over 10 or 20 years? Ultimately, yes."

Alexander Huang, the Taiwan-born president of Microsoft's China unit, sips a cup of Microsoft's Beijing office blend--chrysanthemum and jasmine tea, not the Starbucks coffee that fuels home base in Redmond, Wash.--and puts it more succinctly: "The future is very bright."

The present, however, is a black hole, and Microsoft is embarking on a renewed assault on the China market. In stark contrast to the combative style that is the company's trademark, this is a march of good public deeds, academic support, even generosity. Microsoft will pour $750 million into the land of fake software in the next three years. The money, to be funneled through China's powerful state planning department, is over and above the $1 billion the company spends annually to do business and research there.

It amounts to one of the most expensive kowtows a foreigner has ever offered China. Microsoft is helping build a software industry from scratch, forming joint ventures with indigenous firms, promoting basic research at Chinese universities, and training students and entrepreneurs in its own state-of-the-art development methods. It is all the more surprising given Microsoft's bungling attempts to set up in China early on. "There was a degree of naiveté in how we entered the country," concedes Mundie. "We did it like we did any other country." But China is not like anyplace else.

The first foray came in 1989, when Microsoft opened a branch in Taiwan--the thorn in China's paw. It entered the mainland market by opening a Beijing sales office in 1992 and translating its software into Mainland Chinese characters. Then a Taiwanese programmer embedded pro-Taiwan messages in Microsoft code, infuriating China's government. In 1997 it opened a tech support office in Shanghai to serve corporate customers across Asia and take some nocturnal inquiries from the U.S. In 1998 Microsoft opened its Asian research office in Beijing, hoping to tap into China's growing pool of smart software engineers.

But Microsoft had a lot of swagger, and swagger does not work in China. John Chen, the Hong Kong-born chairman of rival Sybase, says Microsoft's attitude was: "We're Americans; we know everything. Why don't you just pay for everything, and we'll be cool."

By the late 1990s Microsoft began suing Chinese computer makers that loaded pirated Microsoft operating systems or other software on the computers that were hurtling out of their factories, and it sued Chinese companies found using ill-gotten software. This produced mixed legal results in a country where the rule of law is not a given. The lawsuits succeeded mostly in winning Microsoft a reputation for bullying tiny Chinese firms.

The confrontational strategy was all wrong. "You can't just walk in there and say, 'Hey, I'm Microsoft and here's how it's going to be played,'" says Denis Simon, a longtime China hand who is dean of the Lally School of Management & Technology at Troy, N.Y.'s Rensselaer Polytechnic Institute. "China doesn't covet Microsoft the way other countries do."

By instinct any Chinese government official would be wary of turning over his country's information technology sector to foreigners. The suspicion is all the greater when the foreigners in question run a firm that has been attacked by its own government as being an illegal monopoly.

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