China's Cutthroat Internet Competition. Foreigners Need Not Apply?

About a year ago, veteran China journalist Chris Myrick wrote a very thoughtful and well-researched article on China internet competition for knowledge@Wharton. The article is entitled "Land-grab Mentality: The Cutthroat Competition on China’s Internet" and it discusses the increasingly hostile and legalistic competition between China's leading internet companies. I was quoted in that article and a friend of mine just wrote me today to say that he had seen it.

His email caused me to read the article again and doing so caused me to have the following initial thoughts:

• It is, not surprisingly, an excellent article. I say, not surprisingly, because I have known Chris Myrick since his days as AFX's Beijing Bureau Chief and I think very highly of him.
• The article, written in December of last year, already seems woefully out of date, for reasons I will explain at the end of this post.  

The article begins by describing the mano-a-mano competition that is China's Internet:

The gloves are off. Tensions over recent weeks between China's major Internet players have been rising precariously. As interactive entertainment provider Shanda accused search engine giant Baidu of copyright infringement, Tencent's instant-messaging provider QQ and anti-virus company Qihoo 360 blocked each other's online products and services amid allegations of users’ privacy being violated. But as attention grabbing as these run-ins might be because of the sheer size of the firms involved, they are pedestrian in a sector in which intellectual property (IP) and copyright infringements and other underhandedness are commonplace.

Myrick then analogizes China's internet of today with California's Gold Rush in the 1800s with "Internet entrepreneurs ... [as] the modern-day prospectors staking claims in a vast and wild frontier, where sheriffs are few and far between.“ Mark Natkin of Marbridge Consulting provides a good explanation as to why this is the case:

China is an extremely rapidly developing economy that has undergone tremendous change in the past 20 years, you could almost say that there hasn’t been time to establish universally accepted ethics or business practices," says Mark Natkin, managing director of Marbridge Consulting in Beijing. "There is a certain Gold Rush or ‘land grab’ mentality in China.”

The mentality, he argues, is partly driven by an uncertain regulatory environment. Online video, blogging or social media businesses can change overnight from being unregulated opportunities to services subjected to rigid regulation. “Some people have seen rule changes where there may have been an opportunity yesterday, but it is gone today because the government changed a regulation overnight," he says. "This fosters a very short-term outlook to making profits, and because it’s short term, people are looking for short cuts.”

Natkin is right and what he says extends beyond the Internet. In fact, his description of what is happening in China jibes with what I wrote in an article many years ago for why short term thinking so often predominates in emerging market countries:

For example, many emerging market countries have a history where "bad business" meant "thinking long-term." A year or two after the fall of Soviet communism, I was involved in a matter where an investor put $250,000 into a Russian joint venture. The business very quickly was making good money and all indicators pointed towards steadily increasing profitability. But, quite quickly, the Russian company stole the $250,000. Was it so irrational for the company owner to think so short term in a country where the government and tax systems had such a history of unpredictability?

Way back in 2006, in a post entitled, "Is There A Chinese Mindset, And So What If There Is?" I too analogized China capitalism with the Wild West (and I certainly was NOT the first to do so), when I compared what I was seeing in China to what I was seeing on the TV Western, Deadwood:

I think the duration of a country's capitalist system, its economy, and its legal system greatly influence business behavior. I think American business behavior is based at least as much on the belief that a breach of contract will lead to an expensive and detrimental lawsuit as on our mindset. I am in the middle of renting all episodes of the HBO series, Deadwood. I defy anyone to watch that show and still claim America's business morality is inherent in our culture, rather than something that has evolved over time, mostly for business, rather than moral reasons. 

China is new to capitalism. China is learning how to conduct business according to international best practices. Some there have already learned and more will learn. I do not believe there is anything immutable in the "Chinese mindset" that should make me believe otherwise. 

The number of Internet users in China has already overtaken that of the U.S. and revenue from Internet businesses in China is exploding. With growing take-home pay and a steadily increasing Internet user base, China is a gold mine where businesses aggressively fight to gain turf and defend it.

The article quotes Tim Smith, an IP lawyer with Rouse as saying that “[w]hat principally motivates companies in China is a ‘land grab.’ It’s a brutal commercial environment and they will do whatever they need to gain commercial territory. He goes on to say that "[t]hey [Chinese Internet companies] will seek to -- as any company would if faced with the same situation -- filibuster, slow down, defend as vigorously as they can any proceedings that suggest that their business model is infringing on anybody [else’s] rights.”

The article goes on to note how badly foreign companies have fared when trying to break into China's Internet market:

For foreign companies trying to break into China's market, this creates rough and unforgiving terrain. Big Western names such as eBay, Amazon and Yahoo have failed. Others -- including Google and MSN -- struggle against local competitors and YouTube, Twitter and Facebook are among those that have been shut out by domestic restrictions and China’s "Great Firewall." While some may have grievances about the operating environment, they also might be partly to blame for their struggles if they're inflexible and incapable of adapting their business to China.

Despite all this, "there is no shortage of investors willing to join the Gold Rush....[t]he potential rewards are just too high. They can’t bear not to participate:”

William Bao Bean, managing director of SingTel Innov8, a Singapore Telecommunications-backed venture capital fund, notes that investors see China as a big pool of profitability, even though innovation may be lacking. “China is the place where the services are being created, perhaps not the high-level tech, but the services,” says Bean. “Talking about regulation and lack of enforcement probably made sense five years ago … but these days the real focus is on where the value is. For us, we’re looking for game-changing technologies out of the U.S., and we are looking for money-making services out of China.”

The article then talks about the role of China's lack of IP enforcement and there is general agreement that companies really have no choice but to persevere despite that: 

A major complaint – and perhaps excuse – among Western firms is the country’s weak or underdeveloped regulatory system, particularly in areas such as IP and copyright protection. Analysys’s Yu notes that while China’s Internet sector lacks solid regulations, "enforcement is a bigger issue…. In some cases, everyone knows something is in violation of a law, but from a legal point of view, it is very hard to prove an infringement or copying of an innovation … and to do so, may take months or years.”

While that may be true, Dan Harris, founding partner of Harris & Moure, a boutique law firm specializing in U.S. investments in China, says the entire system needs to be put into context. “Americans are always complaining about the lack of enforcement in China," he says. "But what they really mean by that is, 'The government is not doing enough to stop someone from manufacturing fake Adidas.' Well, in the U.S. the government is not that active either.”

Other experts agree. Harris says the Chinese legal system – while generally good at dealing with complaints in a fair manner -- is not as effective at penalizing bad behavior. “The reality is that Chinese courts do not have the same power to enforce judgments as courts in the U.S. do. In the U.S., if you get a judgment for US$5,000 against a U.S. company and they don’t pay, you can bring in the sheriff and start seizing furniture and bank accounts,” says Harris. “You can do that in China too, but it’s a lot more difficult and the court just isn’t as strong a body.”

In spite of imperfections, Smith notes that the legal system is increasingly used for conflict resolution in China and proving capable of handling an increased caseload. “There were 30,000 intellectual property claims filed last year in China. It’s the most litigious IP jurisdiction in the world … but the system is quick. You expect to get a decision in the first instance within six months and on appeal within a year,” he says.

All of the above is true, but it now seems almost quaint because when it comes to China's Internet, the big issue is no longer IP, it is whether foreign companies will be allowed to compete at all. Right now the answer to that is pretty much no. Moving on...

What do you think?