How Chinese Companies Fight Domestic Piracy

This week, Hillary Clinton and Timothy Geithner are leading a team of almost 200 wonks to China for the Second Strategic and Economic Dialogue, where they will try to push Beijing on issues ranging from the North Korean torpedo crisis to indigenous innovation laws. An evergreen on this wish list is China's persistent lack of copyright protection, especially in information technology: almost 10 years after entering the WTO, Chinese companies and underground organizations still pirate goods at an alarming scale, with expert hackers who can reverse-engineer most products. The practice is thought to cost U.S. companies $25 billion per year "We have a particular problem in China in our business, which is that piracy is sky high," Microsoft CEO Steve Ballmer said recently.

But Western companies are wrong to imagine that their code writers, authors, and designers are the only victims. Chinese content providers are also being robbed by pirates. But unlike their Western counterparts, they've invented creative strategies to circumvent the culture of theft. Instead of rending their garments and gnashing their teeth, they've accepted the reality that people will copy when they can and worked to prevent it. It's a lesson Microsoft could stand to learn.

Videogame makers have been particularly vulnerable to piracy. In fact, games for Wii, Playstation, or Xbox—which dominate the U.S. market—never really caught on in China because users copied and sold the software at a fraction of its market cost. To avoid such a problem, many Chinese companies designed games that only work when users connect to a centralized server, à la World of Warcraft. "When you're the gatekeeper and control the server, it's not impossible, but much more difficult for your content to be stolen," says Bill Bishop, a Beijing-based tech entrepreneur and blogger who estimates that this approach has reduced the amount of pirating from a whopping 95 percent to 10 percent. (Unsurprisingly, makers of pirated software are coy about releasing data.)

With this strategy, most gamers play for free, but accessories that enhance the experience are available only online from the manufacturer, and only for a price. Tencent Holdings, China's largest online-gaming operator (it has a market capitalization bigger than eBay and Yahoo) has been particularly successful in getting its gamers to pay for items like better swords and horses for online role-playing games. The research firm Niko Partners has estimated that the online Chinese gaming market will grow to $4.5 billion in 2010 from $3.57 billion in 2009 and have a compounded annual growth rate of more than 20 percent over the next five years. The big Chinese gaming companies, "from a digital media perspective, have pretty much figured it out," says Bishop.

If you can't build a digital fortress to protect your property, building a real one may be the next best thing. Foxconn, the world's largest contract maker of electronics, employs 800,000 people in mainland China. Foxconn doesn't produce under its own brand name; instead it hires out its manufacturing capabilities to Apple, Intel, Dell, and HP, among others. (This year, for instance, it will produce an estimated 24 million 4G iPhones for Apple.) But with so many high-tech products made in China, Foxconn must guard against prototype theft, which in China could provide a payout exponentially higher than a worker's monthly $130 salary. For that reason, Foxconn has "a compound of secrecy run like a military operation," says Stan Abrams, a Beijing-based legal scholar who specializes in intellectual property. "They have so many facilities inside, people coming and going are monitored very strictly." Last year a worker killed himself after being questioned and allegedly beaten on the suspicion that he stole an iPhone prototype; this year, 10 workers have fallen from buildings for reasons unknown. Foxconn's international image may have suffered as a result of the unexplained deaths, but overall, the company's elaborate security measures offer its clients reassurance that Foxconn values intellectual property and will go to great lengths to protect it.

As for the local companies that pirate the technology, they tend to succeed when producing something beneficial to China, or when they have a protector—that is to say, when regulators are willing to overlook their transgressions. "China derives great economic benefit from keeping the cost of operating software [like Windows] low and putting it in the hands of people who normally could not afford it," says Paul Midler, author of the business book Poorly Made in China. Successful piracy is a major reason why Microsoft's revenue per personal computer purchase is 15 times greater in the United States than in China. With numbers like that, there's a clear value to selling products that are less easy to steal.