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For years, China's Kingsoft Corp. struggled to make money selling consumer software. Although its products were popular, the company couldn't get people to pay for them -- because of rampant piracy. Then last year, the company, based in the southern city of Zhuhai, shifted its focus to the Internet.

In September, Kingsoft launched Sword Online, a rollicking game that lets players create their own characters, strike cyberalliances, and fight virtual attackers. The new business is taking off: In just six months, more than 1.7 million people have signed up, paying either $4.20 a month or $1.20 for 25 hours. Kingsoft expects the game's success to help it double revenues this year, to about $20 million, expand into other Asian markets, and become a world-class innovator in online gaming. "We want to be the pioneers," says Oliver Wang, Kingsoft's chief technology officer. "Let other people copy us."

Such dreams may seem outsize, but Chinese dot-commers have good reason to think big. China's Internet is booming. More than 22 million newbies piled on to the Web last year, bringing the total number of Chinese online to 80 million. That makes China second only to the U.S. in Internet subscribers -- and the Middle Kingdom won't remain No. 2 for long. By 2006, it is expected to overtake the U.S., with 153 million Chinese online, estimates investment bank Piper Jaffray & Co. The surge is being driven by several factors, including a strong economy that's letting people buy PCs and the opportunity the Net provides to skirt China's tight government censorship. "The Internet is growing like crazy here," says Craig Watts, managing director of Norson Telecom Consulting in Beijing.

The expanding audience has set off a building spurt in recent months reminiscent of Silicon Valley in the late 1990s. Local businesses such as Kingsoft are moving onto the Net, staking a claim to the rich opportunities ahead. Foreign Web companies, including Yahoo! Inc. (YHOO) and eBay Inc. (EBAY), are making acquisitions to expand their operations in the country. And entrepreneurs from around the world are opening shop on China's Net. They range from Peggy Yu, a 38-year-old MBA from New York University who runs what she hopes will be the Amazon.com Inc. of China, to Li Ka-shing, the Hong Kong billionaire whose Internet portal, Tom Online Inc., expects to raise as much as $200 million in an initial public offering scheduled for this month.

Investors are just as gung ho about the market. Sina Corp., the largest Net portal in China, has seen its shares surge eightfold over the past year, to $45. After the strong IPO of travel site Ctrip.com in December, numerous companies, like Tom Online, are lining up to sell stock to a hungry public. One of the hottest prospects? Shanda Networking Development Co., a Shanghai online gambling outfit that is expected to raise as much as $200 million in an IPO scheduled for later this year. Even venture capitalists are getting bolder. In February, business-to-business auction site Alibaba.com landed $82 million from Fidelity Investments, Softbank, and other venture players -- the largest VC investment in a Chinese dot-com ever.

No question, China's Internet companies have lots of growing up to do. Add up the market caps of all the publicly traded players, and the total comes to less than $10 billion. That's one-quarter of an eBay, one-third of a Yahoo. In most markets, the Chinese dot-coms are well behind rivals in the U. S., Japan, and Korea. And just like in the U. S., the boom will probably lead to excess, with some poorly conceived businesses imploding.

CALLING THE TUNE. Still, look at what's happening from Zhuhai to Shanghai to Beijing, and you realize that the implications could be profound. So far, the Internet has been dominated by a single country -- the U.S. Now, China has the potential to become the second major power of the Digital Age. By 2006, it is expected to have more people on the Net, more broadband subscribers, and more mobile-phone customers than any nation on earth. "To have 300 million people in China use the Internet is a tiny issue," says Jack Ma, Alibaba's founder and CEO.

You won't need to speak Mandarin to surf the Web. But important innovations will emerge from the country, especially in markets like Net services for mobile phones and online gaming. Foreign companies that want to be dominant Net players -- think eBay and Amazon -- will need to have a presence in this market. And high-tech multinationals will have to consider China not just when they're selling products but when they're designing them, too. Last fall, Nortel Networks Ltd. (NT) decided to invest $200 million in a research and development facility in Beijing to develop networking and wireless gear.

While sheer size is the obvious reason for China's growing Net influence, the policies of the Chinese government are just as important. Under President Hu Jintao, the Beijing government is carefully nurturing local companies to help them compete in the global marketplace. Not content with low-end manufacturing, Beijing is determined to turn China into a high-tech force that can rival the U.S., Japan, and others in innovation. Already, the government has used the billions it spends on networking gear to help China's Huawei Technologies Co. and ZTE Corp. become world-class rivals to Cisco Systems Inc. (CSCO) and Nortel. Huawei's exports doubled last year, to more than $1 billion, out of $3.8 billion in total sales.

That may be a sign of what's to come. Beijing is trying to set the standards for several key Web technologies that may let the country's manufacturers become big players around the world. Take Wi-Fi, the wildly popular wireless technology. In December, Beijing mandated that a new Chinese encryption standard for Wi-Fi be used in all gear sold in the country after June 1. The move is necessary, officials say, to make Wi-Fi more secure. To comply with the rule, foreign companies have to share their product designs with one of the two dozen Chinese companies Beijing has designated as licensees of the standard. These companies integrate the standard into the designs and then help produce the equipment.

Howls of protest have come from American high-tech companies. Dennis Eaton, chairman of the Wi-Fi Alliance, says many of the trade group's members, which include Intel, Cisco, and Broadcom, are worried that they could lose their tech edge by disclosing chip designs and other intellectual property to potential Chinese rivals. He says some may even stop shipping Wi-Fi products to China this June. U.S. industry representatives in Washington and Beijing vow to fight the policy, which they say violates World Trade Organization rules (see the letter Bush Administration officials wrote to Beijing protesting Wi-Fi encryption standards). "It's a very ominous move for the Chinese government to take," says Anne Stevenson-Yang, managing director in Beijing of the U.S. Information Technology Office, a lobbying group for U.S. high-tech companies.

Even if the U.S. companies ultimately win in a WTO court, a legal battle still may be a losing proposition. A company such as Intel or Broadcom would have to forgo sales to China for years to prove its point. That's why Beijing's policies will probably help several Chinese tech companies follow in the footsteps of Huawei, becoming powerful enough to compete globally. Among those with the most potential are networking-gear maker Harbour Networks Co. and chipmaker Semiconductor Manufacturing International Corp.

HOT MESSAGES. Focusing on the trade dispute, however, risks missing an important development in China's tech industry. Just as Beijing is trying to tip the scales for domestic manufacturers, local Net companies are coming up with promising innovations on their own. In part, that's because of the special characteristics of the Chinese market. Like the U.S., portals were the first Net companies to emerge in China. But the country's top three -- Sina (SINA), Sohu (SOHU), and NetEase (NTES) -- soon found that, unlike their U.S. brethren, they couldn't rely on ad sales, since online advertising was scarce.

Instead, the companies in 2002 struck gold with paid messaging services. These are tailor-made for China, which has 286 million mobile-phone users, nearly double the number in the U.S. Through revenue-sharing deals with China's two state-owned cellular operators, the portals charge to send news updates, games, and online dating information to mobile phones. The services have evolved far beyond simple text messages. Sohu even sends out color greeting cards with voice messages from basketball star Yao Ming. Multimedia services are expected to help push the market from $200 million in 2001 to $3 billion this year, estimates Lehman Brothers Inc. (LEH).

Upstarts are experimenting with a wide range of paid content. One runaway success has been virtual games, played either online or on mobile phones. In many cases, thousands of people compete against one another at the same time, taking on game identities and amassing special powers over weeks or months. China's online game market is expected to grow fivefold by 2007, to $809 million, says IDC. Late last year, Mtone Wireless Corp. scored a hit with a mobile-phone game based on Cell Phone, a blockbuster Chinese movie about miscommunication and infidelity. In just three months, 500,000 people have signed up for the game. "The mobile Internet has really saved China's Internet industry," says Victor Wang, Mtone's CEO.

Certainly, China is playing catch-up in many Net markets. E-commerce, for example, has been slow to develop in China because so few people have credit cards and the postal service isn't reliable. But NYU MBA Yu is starting to make progress with Dangdang.com, a distinctly Chinese version of Amazon. Dangdang began letting would-be buyers pay with money orders and even old-fashioned cash on delivery. To get packages to customers, Dangdang hired a fleet of delivery boys who zip around China's biggest cities on bicycles. Yu says more than 2 million customers have bought books, CDs, and DVDs from Dangdang, with an average order of about $10. "We have figured out the basics," she says.

FACTORY FLOOR. So have business-to-business Net companies. At Alibaba, CEO Ma had to win over manufacturers worried about fraud when doing business with strangers over the Net. To help customers get up the Internet learning curve, Alibaba sends representatives to the factory floors of each new manufacturer to explain how the site works. Ma says more than 1 million companies have signed up to be listed on Alibaba's import-export site, each paying $5,000 a year. What attracted the record-breaking VC investment is Alibaba's potential: Companies from around the world can request bids from Chinese manufacturers for thousands of products from cookware to washing machines. Purchasers don't need a representative in China to buy directly from the manufacturers that often have the lowest costs in the world.

The fast-growing domestic market is giving Chinese equipment makers an edge. While the China market is open to foreigners and North American companies such as Lucent Technologies Inc. (LU) and Nortel are winning contracts, local players such as Huawei and ZTE often enjoy better connections to government officials as well as lower manufacturing and R&D costs. And those companies are starting to expand beyond China. Huawei is better known, but rival ZTE is looking abroad too. Ling Dongsheng, general manager for Internet protocol equipment at ZTE, says the company wants to sell its networking gear in Eastern Europe, the Middle East, and Latin America.

As Huawei and ZTE expand overseas, top U.S. high-tech companies are crying foul. They fear Beijing is becoming involved in setting technology standards specifically to give homegrown companies an edge in the global market. The U.S. companies worry that the Wi-Fi mandate is only the start of a more widespread Chinese effort to use its market clout to create local standards for key technologies -- including radio frequency ID (RFID), digital music, and IPV6, a technology for the next-generation Internet. In February, Beijing created a group to establish a Chinese standard for RFID.

SHARE A SECRET? Most worrisome is the prospect of having to share technology secrets with Chinese companies that could become competitors. That would be reminiscent of a national policy that was common during the 1990s that used to require multinationals interested in partnering with local companies to transfer technology to them, instead of simply licensing it to them. In early March, U.S. Secretary of State Colin Powell and other Bush Administration officials sent a letter to China protesting the Wi-Fi policy.

Chinese officials say they don't understand what all the fuss is about. They argue that the new standard will make people feel more confident of the safety of Wi-Fi, which has been notoriously insecure. That will encourage people to adopt the technology and "will have a positive impact on wireless development in China," says Huang Chengqing, vice-secretary general of the Internet Society of China, a Beijing industry group associated with the government. American critics contend that China could find itself without any new Wi-Fi products after the June deadline. Wang Lijian, head of the IT research center at China Electronics Standardization Institute, the group authorized by the Ministry of Information Industry to develop industrial standards, says there's plenty of time for Chinese companies to come up with new products that comply with the standard. "June 1 is the hard-and-fast deadline," he says.

There's little doubt that as tens of thousands of Chinese go online for the first time every day, the country is changing. It's becoming a more attractive place for foreign companies to invest -- and it's starting to show signs of indigenous innovation. "In the old days, China was not on the radar screen for leading-edge technology," says Robert Mao, president and chief executive for Nortel's Greater China operations. Now, "China is part of the leading edge."

Kingsoft's Wang is certain that's the case. He's already eyeing the next generation of technologies on deck in China, including video phones and mobile-phone games that blend movies, voice, and data. He has the technology, and he has the audience. It's little wonder he's dreaming big. By Bruce Einhorn in Zhuhai


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