By Paul DeGroot [bio]
Posted: Apr. 17, 2006

The following is the full text of an article published by Directions on Microsoft, an independent research firm focused exclusively on Microsoft strategy & technology. More samples of our content, as well as a list of upcoming articles and reports are also available.

New agreements between Microsoft and Chinese computer manufacturers, a government requirement that Chinese computer manufacturers preinstall legal OSs, and high-level meetings between Microsoft and the Chinese government point to a shift in China's attitude toward software piracy. The changes, prompted both by pressure from the West and by concerns that the country's 90% piracy rate will cripple the domestic Chinese software industry, could provide some significant benefits for Microsoft, although the company is unlikely to enjoy in China the dominance that it has elsewhere, as China continues to encourage use of open-source software.

Political Pressure for Legality

Widespread piracy and counterfeiting, of not only software, but of movies, music, and consumer goods such as watches and handbags, has been a major irritant between China and other nations, and the country agreed to crack down on piracy as a condition for entering the World Trade Organization (WTO) in 2001.

However, software piracy remains a serious problem. According to the Business Software Association (BSA), which publishes an annual report on world software piracy, China had the world's third-worst piracy rate in 2004, at 90%, compared with a U.S. piracy rate of 21%, the lowest in the world.

Even with new programs such as Genuine Windows, Microsoft's Windows desktop OS is the world's most pirated software, and the company faces a delicate balancing problem in China. On the one hand, it wants a large presence in one of the world's most energetic markets, but most Chinese are unwilling to pay for legal Microsoft software. Pirated versions, though they generate no revenue for the company, have given Microsoft a presence and have limited the growth of alternatives such as Linux.

Chinese officials have begun to recognize, however, that continued software piracy will pose a serious problem for the country in the future. Foreign software vendors earn most of their revenue from markets outside China, where piracy is much lower, and they can sustain some losses to piracy in China. But any China software vendor will be crippled from the start by casual attitudes toward piracy in its local market. Thus, if China is to develop a software industry of its own, as the government clearly desires, it must create a viable market for commercial software vendors, both foreign and domestic.

New Rules for China

The Chinese government began to tackle many of these issues in March and April of 2006, in preparation for an April visit to the United States by Chinese President Hu Jintao. One of Hu's first stops will be at Microsoft headquarters in Redmond, WA, where he will meet Bill Gates and other senior Microsoft officials. Among the signs that China wanted to remove some potential stumbling blocks before that visit were the following:

No bare desktop PCs. At the end of Mar. 2006, the Chinese government issued new regulations prohibiting the shipment of new computers without legal OSs. In the past, many desktop computers in China were shipped bare—without a preinstalled OS—with the expectation that purchaser would obtain an inexpensive pirated version of Windows and install it on the computer.

Legal software for state enterprises. The March regulations also included a requirement that large enterprises in China (including state-owned, joint venture, and foreign-funded enterprises), use legal software on all computers.

Agreements with manufacturers. As of mid-Apr. 2006, all four of China's major domestic computer manufacturers (Founder, Lenovo, TCL, and Tongfang) had signed agreements with Microsoft to promote the use of genuine Microsoft software on their computers. The agreements are not royalty agreements and only commit the companies to work together to collaborate on marketing, sales, and training programs, but combined with the government regulations they could help Microsoft sell more legal software in China. One Chinese manufacturer, Lenovo, has an OEM agreement with Microsoft for some of its operations as a result of its acquisition of IBM's personal computer and notebook businesses. Dell and Hewlett-Packard (HP), which together account for about 12% of the Chinese market, also have such agreements with Microsoft.

Obstacles Remain

The new regulations and agreements are victories for Microsoft and for other companies concerned about a lack of enforcement against piracy and counterfeiting in China, but they don't guarantee that Microsoft will enjoy the dominance that it enjoys in most of the rest of the world.

For one thing, the Chinese government only requires that PC manufacturers preinstall legal software—not Microsoft software—on PCs that they ship. Many Chinese will likely purchase new PCs with the lowest-cost preinstalled OS—such as one of the free distributions of Linux—and do what they have always done with a new PC: format the hard drive and install a pirated copy of Windows on it.

Microsoft can increase its odds of a legal sale by producing Chinese versions of its lowest-cost version of Windows, Windows XP Starter Edition, which is specifically aimed at price-sensitive emerging markets. The company has generally required evidence that a country is taking steps to limit piracy and counterfeiting before it makes Starter Edition available in a market. However, Starter Edition alone would not provide a major boost for Microsoft. It has restricted functionality, which renders it unsuitable for business use and limits its popularity among consumers. Starter Edition has had only a lukewarm response in countries where it has been offered.

Where possible, Microsoft will want to shift Chinese purchasers toward full-featured versions of Windows, such as Windows XP Home and Professional. In spite of the widespread piracy, rising incomes in China will make it easier for Chinese consumers to afford full versions of Windows. The average selling price of a desktop computer in China's domestic market in the last quarter of 2005 was nearly US$700, a price point at which most PCs sold elsewhere in the world include a Windows OS.

A Boost for Linux?

The changes could, however, prove just as beneficial for Microsoft competitors, particularly Linux, on which the Chinese government looks favorably.

The government has announced an initiative to require all government agencies to use only "locally produced software" in the future, with a goal of 100% compliance by 2010. This policy could encourage a movement in China away from Microsoft products, few of which would be considered to be locally produced.

Linux enjoys official government support in China, not only because it is inexpensive but because China can freely use Linux source to develop China-specific versions of the software. Red Flag Linux was created by the Institute of Software at the Chinese Academy of Sciences and is widely used in government departments and agencies, a very significant market for software in China.

Because free versions of Linux qualify as "legal" software, they are likely to be a popular choice for OS installation on new computers, particularly low-priced models. Many of these installations may be replaced by pirated versions of Microsoft, which is not a happy solution for Microsoft; but neither will the company benefit if Chinese consumers don't use pirated Windows. They may continue to use the Linux software that came with their computer and that offers not only an OS and Web browser but also a broad range of other free application software, such as Chinese versions of the open-source OpenOffice.org productivity suite, often shipped with Linux distributions.

Government mandates for wider use of Linux could also help the Linux community solve one of its major problems, a lack of hardware drivers. As Chinese computer makers (including Western companies such as Dell and Hewlett-Packard) and motherboard and device manufacturers try to tap the Chinese market, they may need to ensure that their hardware will work with the Linux OS that ships on many PCs in the Chinese market.

Resources

Background on the challenges Microsoft faces in emerging markets is available in "Emerging Markets Present New Challenges" on page 29 of the Mar. 2006 Update.

Microsoft's Genuine Windows program, designed to reduce piracy, is described in "Genuine Windows Pilot Expanding" on page 11 of the Dec. 2004 Update.

Windows Starter Edition is described in "Windows Starter Edition Launched in Asia" on page 5 of the Sept. 2004 Update.