Photos: China Photos/Getty Images

When Zhang, a graduate student at Beijing University, decided to upgrade his computer to the Chinese version of Microsoft Windows XP, he knew exactly what to do. A quick search on Google turned up a couple of open-access FTP servers right in Beijing, one in China's top science school, Tsinghua University, and the other in the Chinese Academy of Sciences. Fifteen minutes later, his new operating system was locked and loaded, with a copy of Macromedia's Flash MX thrown in for good measure. Total transaction cost: $0.

The Internet has become the most common vehicle for software piracy in China, but Zhang—who asked not to be identified by his full name—had other options, too. Any number of friends working in state-run organizations and private firms would have gladly lent him a licensed version long enough to burn a copy. Or he could have taken his computer to one of Beijing's dozens of electronics bazaars for a low-cost upgrade. Failing that, itinerant peddlers on Zhongguan Cun Road, in the heart of the capital's "Silicon Alley," sell pilfered copies of Windows XP—and a dozen other popular software titles—for about 2 percent of the sticker price of a couple of thousand yuan (US $240).

Does Zhang feel just a wee bit guilty about ripping off Mr. Gates and Co.? "Microsoft's prices are totally inappropriate for the Chinese market," he says. A legal copy of Windows would cost him nearly as much as a semester's tuition. "Besides, intellectual property is not necessarily a commonly shared value." Whether statements of conviction or convenience, these are widely expressed views in China.

If all this sounds familiar, it is: the modus operandi and moxie of high-tech pirates are the same the world over. What makes China stand out is the rate of piracy: fully 92 percent of software loaded onto PCs in China in 2003 was illegally obtained, according to the Business Software Alliance, an industry lobbying group in Washington, D.C. That means the actual size of China's burgeoning software sector is many times larger than the $20 billion in registered sales in 2003 cited in a study by China's Ministry of Information Industry. Piracy rates in the United States (22 percent) and western Europe (36 percent) might be higher than most people realize, but when it comes to software thievery, China is clearly in a class of its own.

It's not just software, of course. In virtually every manufacturing sector—pharmaceuticals, fashion, tobacco, consumer electronics, car parts, even baby food—counterfeiting and copying in the Middle Kingdom are rampant. And despite an ongoing national campaign to stamp them out, they're on the rise, according to many foreign and Chinese businesspeople forced to cope with the consequences. "I wish I could say that it's getting better, but it's not," moans an entertainment industry executive based in Asia. "A pirated DVD"—average price 80 cents—"is literally easier to buy than a bowl of rice," he says, pointing out that the Motion Picture Association of America estimates that only 5 percent of the hundreds of millions of DVDs sold in China each year are legitimate. Mark Cohen, the first-ever intellectual property attache to the U.S. embassy in Beijing, calculated that Zhang Yimou's 2002 kung fu hit, Hero (Ying xiong), grossed 30 times as much in the United States as did all U.S. films distributed in China the same year.

There are whole economies that thrive on piracy —Local governments will do what they have to do to develop

The brazenness can be breathtaking. GM Daewoo Auto and Technology Co., of Inchon, South Korea, sued Chery Automobile Co., of Anhui province, earlier this year for producing what it claims is a headlights-to-tailpipe knockoff of its Chevrolet Spark. Chery's plans to export its QQ minicompact—"QQ for Qopy Qat," quips one Shanghai-based expat—are presumably on hold pending the outcome of the case. Last year, a team prospecting locations for a new KFC restaurant arrived in a northeastern Chinese city only to discover a KFC already in place. At first they assumed the home office had made a mistake, but upon closer inspection they realized that the restaurant was a fake from top to bottom, including uniforms, logos, the crispy-spicy chicken, and even the likeness of the Colonel himself.

So why is the theft of IP in China such a problem? For one thing, argues Li Mingde, vice director of the Chinese Academy of Social Sciences's Institute of Law, in Beijing, the modern IP system "is rooted neither in China's traditional economic and social structures nor in its ideology." The old Chinese saying, "To steal a book is an elegant offense"—a paean to learning and literature—reflects a deep-seated disregard for IP, Li notes. It may take awhile for China to come around, he adds, noting that other once-flagrant offenders, notably Taiwan, needed decades to curb piracy and counterfeiting.

But foreign multinationals and governments—with the United States first in line—have grown impatient with China's pleas for time and insist on using the yardstick of China's own laws and multilateral obligations to measure progress. "The regulations are in place for copyright, trademarks, patents—the laws themselves are good," comments Jeanette K. Chan, head of China practices at Paul, Weiss, Rifkind, Wharton & Garrison LLP, in Hong Kong. "The problem is implementation. The laws are only effective if regulatory authorities and courts apply the law," she says.

There are signs of change. Within the last year, China has taken steps to stiffen penalties for piracy, streamline procedures, and educate the public. Last December, the Supreme People's Court significantly lowered the monetary threshold for criminal prosecution, which means that even small-scale pirates now face possible jail time. "This is quite significant," says Lester Ross, a partner in the Beijing office of Wilmer Cutler Pickering Hale and Dorr LLP. "The court has identified this as an important issue and signaled lower courts to be more aggressive." Already there have been a string of high-profile software cases: Microsoft, Adobe, and Autodesk, a design software company in San Rafael, Calif., have racked up courtroom victories in the last 18 months that set important precedents, including jail time for two purveyors of Windows and court-calculated damages imposed on Autodesk end-users.

Despite such gains, many China watchers suspect that the poor enforcement of piracy is in fact deliberate. Most foreign businesspeople are reluctant to say so openly, but many agree with Ted C. Fishman's assertion in his new book China, Inc. that "China's failure to police industry and to protect IP act, in effect, like one of the greatest industrial subsidies in the world." By not compelling Chinese companies to pay the same licensing fees that their foreign competitors pay, the government gives them an obvious leg up. Even if piracy wanes, foreign companies will still have to cope with the type of China-first procurement guidelines that prompted the Beijing city government to rescind a $3.5 million order last November for Microsoft software. "It is irresponsible for some local departments to purchase foreign-made software on a large scale instead of Chinese-developed software," opined Li Wuqiang, a senior official at the Ministry of Science and Technology.

Often it's hard to draw the line between protectionism and out-and-out corruption. In February, the Business Software Alliance asked the copyright administration in Jiangsu province for permission to raid two targets in Wuxi city, recalls Clement Ngai, legal counsel for Autodesk in Asia. "But when we arrived for the surprise audit, the local copyright administration officials—asked by the provincial authority to assist in the raid—said, 'We need to serve notice on the companies first,'" defeating the whole purpose of the raid, Ngai says. Ross, the Beijing-based attorney, isn't surprised. "There are whole economies that thrive on piracy—local governments will do what they have to do to develop," he notes.

When a state-owned enterprise is itself the pirate, the problem is nearly impossible to root out. Last year, Sony Corp., Tokyo, launched an investigation into the source of fake PlayStation 2 game consoles, only to discover that some 50 000 sets a day were being assembled inside a prison in Shenzhen. Most of Autodesk's clients are government-run institutes, and some of them are major offenders, running hundreds of unlicensed copies of proprietary software. But Autodesk has never sued a state-owned enterprise. "We know what the result would be," Ngai says, without elaborating.

Piracy isn't just a problem for foreign firms. It's also hamstringing domestic software developers, a fact that the Chinese government is waking up to. A 2004 Ministry of Information Industry report notes with alarm that piracy has created a severe "imbalance in the overall structure of the Chinese software industry." Nine out of 10 domestic companies surveyed had oriented their businesses toward customized software, system integration, and technical services to avoid the headaches of piracy. "The awareness that they have to develop their own technology, trademarks, and copyright has increased enormously," Ross says, echoing a widely held view. "Chinese companies will drive change more than foreign pressure."

Lun Yu—probably the most battle-hardened IP lawyer in China, with more than 100 court cases under his belt—would certainly agree. Lun is chief legal counsel for Founder Technology Group Corp., in Shanghai, China's largest software company and a direct competitor of San Jose, Calif.-based Adobe Systems Inc. He is sympathetic to foreign companies but points out that the stakes are even higher for firms like his.

"For Microsoft or Adobe, the Chinese market is only a small part of their global market share," he says. "But the Chinese market is often 100 percent of a Chinese company's business. If 90 percent of the market is occupied by pirated goods, the result will destroy the local industry."