China's Internet is
expanding,
but is hampered
by more red tape
than foreign investors
would like

Penetrating China's Internet-related markets requires patience and a set of focused approaches. If a firm approaches the market with the view that long-term involvement is crucial, then investment in China is a strategic move. In contrast to the current uncertain legal environment surrounding Internet-service and -content provision, high-end software and hardware products, made especially for customized servers and equipment used in large systems, are legal and in demand. Such products will need intensive after-sales service and technology support from a foreign representative office or foreign-owned enterprise for the foreseeable future.

China's Internet infrastructure

The global Internet-related markets depend upon an infrastructure of national domain registrars and network organizations. China has a single registrar for ".cn" domains, the China Internet Network Information Center (CNNIC). Six network organizations, regulated by Ministry of Information Industry (MII) officials, operate international telecommunication circuits and network facilities: China Public Computer Network (CHINANET), China Golden Bridge Network (CHINAGBN), Unicom's UNINET, China Netcom (CNCNET), Chinese Science and Technology Network (CSTNET), and China Education Network (CERNET) (see p.21 and Table 1). These networks form China's Internet backbone, and connections to this backbone can make up 80 percent of the costs of Internet businesses.

China's Internet backbone infrastructure runs at increasingly high speeds. According to

CNNIC, China had a combined international bandwidth of 351Mbps (million bits per second) by December 1999. This is a healthy increase from the 143Mbps of January 1999, but is dwarfed by the 622Mbps speeds of OC-12/STM-4 bandwidth of the US Internet backbone.

Each network organization is constructing new infrastructure that will further improve access speeds. Speed of access is a nationwide problem in part because most ISPs use modems with only 56Kbps (thousand bits per second), even though their direct digital ne tworks connect with network organizations at speeds ranging from 256Kbps to 4Mbps. But bandwidth is still a problem, with the key networks between big cities generally only supporting 64Kbps-8Mbps, and only parts of these networks reaching 155Mbps.

Government limits service offerings...

MII-issued permits enable CHINANET, CHINAGBN, UNINET, and CNCNET to support business operations on the Internet. These four network operators are thus defined as national business networks providing commercial connections to the Internet. MII has also approved them for trial use of Internet Protocol (IP) telephony. The government has banned foreign investment in these four companies, and forced Unicom and its subsidiary UNINET in particular to unwind its numerous arrangements with foreign investors under the so-called "Chinese-Chinese-Foreign" (CCF) model (see The CBR, May-June 1999, p.16). Unicom recently took steps to improve damaged relations with 23 foreign investors, but the CCF controversy was a sobering lesson for telcom-related businesses.

China officially does not allow cable companies to offer telephony, but some experiments with Internet services are under way. Though the State Council, through the State Leading Group on Informatization chaired by Vice Premier Wu Bangguo, seeks to ban cable networks fr om offering telecom services, including Internet access, local pilot projects continue. Qingdao, Shandong Province, and Guangzhou and Shenzhen in Guangdong Province, have launched cable television networks offering experimental broadband Internet access. As cable modems and other means of high-speed access become available, competition on both price and quality are likely to intensify.

...and tries to regulate, strictly

The constant changes among Internet businesses, such as new approvals by provincial authorities and numerous experiments with new technologies, have prompted MII and other authorities to revise regulations for both ISPs (in which foreign investment is limited) and Internet content providers (ICPs), in which regulations are unclear. Between October 1999 and January 2000, the State Leading Group on Informatization issued directives, and MII considered regulations, to organize the Internet industry and address broad issues about content, operations, and encryption (see p.61).

The effects of these and other regulations have varied. Chinese officials state that one of MII's main tasks is to support and develop information sources, and to provide information on the highest quality ISPs and ICPs. MII regulation to date is also based on earlier regulations for the Internet and value-added telecommunications services. Despite efforts by some government officials to protect national and economic security through the exclusion of all foreign participants, the future Int ernet legal framework will likely evolve under the umbrella of World Trade Organization (WTO) rules. This does not mean that foreign companies will see a total opening of China's Internet market after the country becomes a WTO member. Rather, Chinese officials will likely seek a smooth and orderly progression based on licenses and strong legal and regulatory oversight.

MII licenses are currently required for production and sale of all types of telecom-related equipment including wired, wireless, hardware, and software products. MII has authorized telecommunications administrations to issue network-access licenses and identification marks, which are placed on the licensed products. The sale, use, or advertisement of unlicensed telecom products in China is prohibited. Violators are warned and then fined for continued non-compliance.

In 1999, the Chinese government approved more than 300 ISPs. Among them were 53 companies approved by MII for nationwide services, and more than 250 firms approved by provincial governments and post and telecommunications authorities (PTAs) for province-wide services. The MII Telecommunications Administration Bureau's Division of Market Management monitors recent industry developments for such Internet businesses and oversees the permit approval process.

China does not regulate ap proval of ICPs, which MII estimates at more than 600 nationwide, but this situation may change. Among other value-added telecom and information services, MII recognizes at least 2,744 companies that had operation permits as of the end of 1998. This figure includes 1,808 paging companies, some seeking to become ISPs or ICPs and using their subscriber base to develop related networking businesses. MII has drafted new regulations on both ISP and ICP management that are not yet published, and in January 2000, the State Leading Group on Informatization issued further directions to organizations charged with protecting state secrets.

This regulatory activity had become apparent, in Shanghai, by February 2000. On February 2, the Shanghai News reported that authorities had closed 127 illegal Internet cafes and seized their computers. The report emphasized that 777 legal cafes continued to operate. Other reports that work units would have to register Internet use appeared to focus only on the Huangpu District, where Shanghai's government offices are located.

China's new regulations are likely to require ISPs to obtain a permit to do business and may require ICPs with servers in mainland China to comply with procedures set by MII, local PTA, and police authorities. As The CBR goes to press, the jurisdictions and organization are still in flux.

In practice, regulating Internet businesses will be a daunting task. Government authorities can make access expensive and can ensure that content is channeled through selective prosecutions and the resulting self-censorship. But the control and monitoring of distributed IP networks will prove a challenge given the government's commitment to growth in the information industry.

Competitive strategies: US companies...

US dominance in Internet-related technology gives American firms an edge in China. Local companies operate established sales channels to import and distribute all leading US information technologies and products, with Hong Kong as a major transit port (see The CBR, January-February 2000, p. 64). Most major US technology firms--including Cisco Systems, Inc. (see p.28), Compaq Computer Corp., Dell Computer Corp., Hewlett-Packard Co., IBM Corp., Intel Corp., Microsoft Corp., Oracle Corp., and Sun Microsystems--have established subsidiaries in China.

Many have also formulated sophisticated strategies for working with universities to develop research and development facilities to customize products for the China market. These strategies include plans for long-term involvement in the development and contributions of Chinese engineers, as well as monitoring emerging technologies in China.

In Internet-related investments, American investors in leading Chinese ICP portals may be the most prominent new trend. Sohu.com attracted Intel, Dow Jones & Co., International Data Group (IDG) and the Massachusetts Institute of Technology (MIT), while China Infohighway has formed an alliance with Microsoft. Sina.com and China.com count Dell Computer and America Online, Inc. (AOL), respectively, among their backers. These investments and partnerships are only a few of the vast number of relationships between American-based firms and the Chinese entrepreneurs engaged in Inte rnet business.

...third-country products...

Taiwan companies, Japanese firms such as Matsushita Electric Works, Ltd., and Korean firms such as Lucky Goldstar (LG) are large investors in China. Of all the foreign challengers in mainland Internet markets, Taiwan companies have offered the most competitive products and services. They only compete in older technologies, however, which they are able to offer at lower prices.

...and foreign-PRC cooperation

Chinese firms are seeking to develop indigenous capacities and cooperate with others on products such as Internet television set-top boxes, which lack word-processing and spreadsheet software. Legend Computer Group, Hai'er Group Co., Beijing Stone Group Co., TCL Communication Equipment Share Co., Ltd., Beijing Yuxing Infotech Holdings, Ltd., and Shanghai Guangdian Electric (Group) Co. Ltd. are all producing Microsoft's set-top box, Venus. Leading Chinese firms aiming to become international brand names are seeking to learn about new standards and technology related to their strengths in consumer electronics and personal computers. In some of these markets, Chinese manufacturers have made substantial gains.

Domestic production: not yet high tech

Domestic production remains limited to the assembly of final products and the manufacture of products like PCs, monitors, computer accessories, modems, and some ISDN equipment. China still lacks the technology to manufacture high-tech hardware profitably. The Chinese government is using its influence to encourage foreign companies to localize production and introduce their newest technologies in Special Economic Zones, which offer tax and other investment incentives. As a result, and despite the risks, many US companies have set up wholly foreign-owned or joint-venture manufacturing and R&D facilities in China.

Because of China's high import duties and preferences for locally made products, once domestic production of a particular product begins, imports may be driven out of the market unless their quality is significantly superior. The still-undecided battle over set-top box dominance is a prime example. Microsoft's Windows CE-based Venus project has recently been challenged by the Chinese Nuwa brand and other Internet-access boxes.

China's buyers

Network operators, which are subject to central planning and headquartered in Beijing, are the biggest buyers of Internet-related products. While central-government control over network planning remains, regional branches are making more a nd more of their own purchasing decisions. ISDN, DSL, cable modem, web-based e-mail, and IP telephony are also being purchased in the provinces, as well as at Beijing headquarters.

Government and state-owned enterprises are the next big buyers, as "Government Online" projects have led to new purchases. Central and provincial governments are mandating budgets for bringing the government agencies and key state-owned enterprises to the World Wide Web and e-mail.

Foreign access to China's Internet market

American information technology companies have witnessed a number of recent improvements in access to China's markets, attributable at least in part to their strengths in businesses related to the Internet. While the memory of past problems--including Unicom's CCF debacle--lingers, progress on investment, piracy, tariffs, and collective action is moving the industry forward. Nonetheless, US companies face a number of uncertainties in the following areas:

• Foreign investment Ambiguity over the legality of foreign investment in Internet businesses increases risks. The ban on foreign investment in ISPs has been explicit, while the practices toward ICPs are slightly more flexible. Exactly how WTO accession and forthcoming regulations will address, or even craft, exceptions for existing businesses, or new ventures in the three main cities, is still unclear. After China joins the WTO, its regulations will change, but broad questions remain about the timing and implementation of these changes.
• Tariffs In bilateral agreements on its WTO accession, China agreed to the Information Technology Agreement (ITA), which calls for the gradual elimination of tariffs on IT products in the first few years after accession. From operating systems to web browsers, and from servers to applications, tariffs will drop on software products. If China joins in 2000, most tariffs will be eliminated by 2003, though some will remain until 2005.
• Intellectual Property Rights Piracy is a fundamental issue for any US technology company hoping to enter, or already invested in, the Chinese market. Chinese consumers frequently consider purchasing legitimate software an unnecessary expense because cheap, pirated versions are widely available. Despite significant PRC government efforts to shut down manufacturers and retailers of pirated software, piracy continues to be a serious problem, and has yet to become a top priority among Chinese officials. As all sides acknowledge, the development of a safe and mature software market will be a long process.

One encouraging development is that Chinese software firms increasingly support anti-piracy efforts. Eighteen well-known companies, including Legend, Founder Group, and China National Computer Software Service and Technology Corp., support the China Software Alliance (CSA, or Zhongguo Ruanjian Lianmei), which seeks to address software piracy. CSA Secretary General Zou Bian reports that the organization's resources are limited , however, and until substantial resources are found for these efforts, both Chinese and foreign firms will suffer.

For an individual company interested in entering the Chinese market, popular products require protections. As a handful of US firms are well aware, user-friendly products proliferate quickly, whether or not the producer has a representative in China and whether or not the producer is being properly paid for its product. To protect their interests, some US information technology companies are building up, rather than reducing, their China presence. For example, even though a large percentage of the networking software currently in use in China is pirated, Novell (China's largest network software provider) continues to offer training courses for its Network Certified Administrator test. Using this creative approach, Novell has begun to establish itself as the industry standard for network software--and to build a market for its legal products.

The e-commerce grail

Though the CNNIC profile of Internet subscribers is one gauge of usage levels, and indicates limits on electronic commerce, China is already using the Internet for business. Because there are many more actual users than paid subscribers, accurate surveys remain difficult to come by. To date, many surveys--including CNNIC's--have re lied on voluntary responses from subscribers or are completed by marketing firms that ask few questions about the Internet.

Because of its prospects for rapid development, electronic commerce is perhaps the most attractive business for foreign information technology companies. Companies are confident that the millions of young, urban, debit-cardholding Chinese--which some estimate will reach 100 million within the next several years--will shop online. In April 2000, China will focus its government and business trade-show efforts on e-commerce, in the form of the Fourth Annual E-Commerce Summit in Beijing, organized by MII and the State Economic and Trade Commission. Together with IDG's Comdex 2000, the summit will bring added attention to the participating firms and their products. Despite these high profile events, unclear delineation of jurisdictions over encryption, standards, payment and delivery methods, and other sticky technical issues mean that the development of e-commerce will progress with difficulty in China.

Experiments and well-funded projects will nonetheless advance Internet business. Companies seeking business-to-business and electronic data interchange (EDI) applications, such as those used in Shanghai banking and ports projects, have made significant headway in creating testbed efforts for e-commerce applications. However, these projects illustrate that China must resolve the issues of jurisdiction for ISP and ICP regulation and for security-related matters of licensing and encryption technologies. For information technology businesses, China holds both promises and perils that will likely develop as fast as the Internet's influence spreads.