Issue: Microsoft’s big win in China

Who remembers Red Flag Linux? Born during the dot-com boom and officially financed and adopted by the Chinese government, Red Flag Linux was supposed to be China’s answer for avoiding the double-team of Windows and Microsoft Office that dominates the rest of the world’s PCs. In some circles, the potential spread of Red Flag Linux in the world’s most populated nation was even hailed as a critical sign that Microsoft was not going to be able to spread its domination of the software market to the rest of the world.

However, Red Flag Linux has turned out to be little more than a key bargaining chip in a high stakes game of commerce between the Chinese government and the world’s largest software maker. Thanks to some major concessions on source code and a precipitous price drop, the Chinese government has now thoroughly embraced Windows and Office. And thanks to a major about-face in the way that it deals with piracy, Microsoft has also won over the Chinese people.

In April, Microsoft Chairman Bill Gates took a victory lap in China, and Fortune magazine’s David Kirkpatrick went along for the ride, writing an account of the trip and an excellent synopsis of Microsoft’s rocky path to success in China in a piece called “How Microsoft conquered China – Or is it the other way around?

Photo by Paolo Pellegri of Fortune — view full gallery

Kirkpatrick wrote, “No other Fortune 500 CEO gets quite the same treatment in China. While most would count themselves lucky to talk with one of China’s top leaders, Gates will meet with four members of the Politburo … As one government leader put it while introducing Gates at a business conference, the Microsoft chairman is ‘bigger in China than any movie star.’ Last spring President Hu Jintao toured the Microsoft campus in Redmond, Wash., and was feted at a dinner at Gates’ home. ‘ You are a friend to the Chinese people, and I am a friend of Microsoft,’ Hu told his host. ‘Every morning I go to my office and use your software.'”

Just five years earlier, the Chinese government was doing everything it could to avoid Microsoft software. The government balked at the high price of the software and had serious security concerns about saving sensitive government data in a proprietary operating system built by a company located within the borders of one of its chief international rivals. China was worried that the U.S. government could use the Microsoft OS to spy on Chinese government activity. The city of Beijing even began installing Red Flag Linux, supported by the government-run Chinese Academy of Sciences, on the computers of city workers.

In 2003, Microsoft began a program that allowed select partners to view the source code of Windows, and even make some modifications. China was one of 60 countries invited to join the program. Then Microsoft got serious about competing on price by offering the Chinese government its Windows and Office software for an estimated $7-$10 per seat (in comparison to $100-$200 per seat in the U.S., Europe, and other countries).

These moves, coupled with building strong relationships within the Chinese government and opening a major research center in Beijing, completely changed Microsoft’s fortunes in China. Today, the Chinese government uses a version of Windows that includes its own custom cryptography software. In Beijing, where many of the workers avoided Red Flag Linux and used a pirated version of Windows instead, the government has taken inventory of pirated software and forked over cut-rate licensing fees to Microsoft.

Of course, piracy among the Chinese population at large is still one of the major issues Microsoft has to overcome. Microsoft’s initial strategy was to work to get intellectual property laws enforced in China, but that was an unmitigated disaster. Microsoft realized that it was powerless to stop widespread piracy in China, so it simply threw up the white flag. If Chinese users are going to pirate software, Microsoft wants them to pirate Microsoft software. Plus, Microsoft has made it easy for Chinese users to purchase legal copies by offering a $3 Windows/Office bundle to Chinese students.

Even with the cut-rate fees for students and the government, Microsoft will still collect an estimated $700 million in revenue from China in 2007. That amounts to only about 1.5% of Microsoft’s total revenue worldwide, but the battle for mind share has been won. Windows now has roughly 90% market share in China. There are currently 120 million PCs in China, but that number is expected by grow exponentially in the coming decades, and Microsoft is in a great position to reap the benefits.

Sanity check

Microsoft’s strategy in China and the ascendancy of Windows and Office there could have important implications for Linux, the software market worldwide, and the future of China and its citizens.

One of the necessary aspects of competing in China was that Microsoft has had to cozy up to the Chinese government, which has long been the target of international scrutiny for its censorship policies and its human rights abuses.

Photo by Paolo Pellegri of Fortune — view full gallery

When Red Flag Linux was at the height of its hype cycle and China was being viewed as the start of something big for Linux, Eric Raymond, the open source advocate, was wary of people making too close of a connection between China and Linux. He said “any ‘identification’ between the values of the open-source community and the repressive practices of Communism is nothing but a vicious and cynical fraud. [We] would not care to be associated with the totalitarian and murderous government of Communist China — unrepentant perpetrators of numerous atrocities against its own people.”

During Gates’ tour of China this spring, David Fitzpatrick asked Gates how he could reconcile Microsoft’s relationship with the Chinese government with China’s suppression of freedom of speech and disregard for human rights. There was a long pause, after which Gates finally said, “I don’t want to give an answer to that.”

Microsoft, Yahoo, and Google have all come under scrutiny recently for their cooperation with China censorship:

There are two divergent arguments for whether establishing a relationship with China is a good thing or a bad thing in helping the Chinese people achieve freedom and justice:

1.) By doing business or building a relationship with China, you are giving tacit approval to their suppressive government practices and only encouraging them to continue. Therefore, nations and organizations should unequivocally shun China unless the government changes its policies.

2.) By establishing strong ties with China, you bring it closer to being part of the international family of nations in the hope that it will eventually curb its more radical practices because of natural peer pressure. This is often viewed as a better alternative to isolation, which can lead to extremism.

Microsoft obviously subscribes to the latter. But its primary motivation seems to be that there’s a lot at stake in China and it must have a strategy to compete in China if it wants to continue to lead the software market. As a result, Microsoft has taken an apolitical stance.

The fact that Red Flag Linux failed to gain a major foothold in China is yet another blow to desktop Linux. After nearly eight years of being on the verge of a breakthrough, Linux seems more destined than ever to be a force in the server room but little more than a narrow niche and an anomaly on the desktop.

As for the price of Microsoft software worldwide, Gates has admitted that the gap between the price in China and the price for the rest of the world will naturally meet in the middle over time. In other words, Gates wants to eventually charge China more and realizes that Microsoft won’t be able to keep charging everyone else so much. For analysts and pundits (myself included) who have said that Microsoft’s best strategy for combating software piracy in the U.S. is not with product activation but by simply charging less for the software, this is great news and a little bit of vindication. I guess we have China to thank for that.

What do you think about the victory of Windows and Office in China? Do you think the relationship of Microsoft with the Chinese government is a good thing or a bad thing? Join the discussion.