By Winter Wright

Yes, it's a huge potential market for foreign software. But China presents U.S. software companies with a dizzying array of issues and pitfalls.

China is giving the software industry a run for its money these days. As if making a profit weren't enough of a challenge, the industry must contend with a diverse range of issues such as political fallout from offshore outsourcing, preference policies that may put them at a disadvantage against local vendors, and problems related to intellectual property rights (IPR). All have become hot topics with a direct bearing on the bottom line of American software companies operating in China.

Outsourcing has unquestionably become a political hot potato-but is it more than that? Newspaper editorials cite U.S. Bureau of Labor Statistics showing the fastest-growing sector of the U.S. employment market is in unskilled, low-paid jobs: fast-food workers, waiters, nursing aides, janitors, security guards, etc. The implication: all the good jobs have been shipped to India and China. It's true that some jobs are moving to the Middle Kingdom, and not just in manufacturing. Gartner, a technology consultancy, expects China to become a global mecca for outsourced IT services by the end of the decade.

The idea that white-collar jobs are being sucked out of the United States and transferred to China angers many Americans, forcing the IT industry to confront the issue head-on. "It's the single most politically volatile IT issue in the U.S. and Europe today," says Robert Kramer, vice president of public policy at CompTIA, an IT industry association with about 15,000 members. So volatile, in fact, that the industry has come up with a new term for it-worldwide sourcing-a label intended to convey a more neutral tone. Whatever you call it, the rationale for outsourcing has become a familiar refrain: In the global economy, companies scour the world for a combination of skill, expertise, and low labor costs that allow them to compete. Outsourcing enables them do this.

In hopes of mitigating the political repercussions, CompTIA and other industry associations have formed a coalition to explain the benefits of outsourcing, and to balance the negative sentiment with some reassuring facts. For example, outsourcing is compatible with job growth, and was already taking place in both manufacturing and services in the 1990s, when jobs were plentiful and the U.S. economy was strong. Another calming factoid: Even as the global economy ships some U.S. jobs offshore, the domestic economy creates even more new employment at home. Although some estimates show 3 million U.S. jobs will be outsourced over the next 15 years, CompTIA claims 6 million jobs will be created through foreign direct investment into the United States during that same period. Past trends would appear to bear out this prediction. Except for 2003, FDI has created more than American jobs than it has eliminated annually for the last 15 years. Moreover, U.S. government statistics indicate offshore outsourcing is responsible for less than 1 percent of the Americans currently registered as unemployed.

Even so, the trend has sparked a surge of patriotic sentiment in Washington, where the U.S. Congress looks more favorably on protectionist measures now than at any time in recent memory. Congress has held hearings on outsourcing featuring testimony from workers whose jobs were eliminated or jeopardized. Eighty federal bills and 28 state-level bills have sought to limit outsourcing to some extent. In March, the U.S. Senate approved a bill forbidding federal government agencies from outsourcing contracts to foreign entities, and some states have introduced laws mandating a review of all state-level commitments made under the World Trade Organization.

Some of the proposed legislation focuses on business practices related to commonly outsourced functions such as back-office operations or international call centers. One bill, for example, requires call center operators to tell callers they are speaking to someone outside the United States, and to offer the option of transferring the call back to an American operator-requiring, in effect, that every company with an with an overseas call center maintain a corresponding backup center in the United States. Other legislation targets outsourcing indirectly, by restricting transmission of information such as credit card data to countries without protection standards equivalent to those of the United States. "Not all of these bills will get out of committee," Kramer says hopefully. "But they're out there."

The bottom line, at least according to critics, is that enacting protective legislation is ultimately bad for business, and that governments should encourage companies to train workers to make them less vulnerable to outsourcing. CompTIA suggests current legislation be broadened from a relatively restricted focus on laid-off manufacturing workers to encompass a wider range of employees. The Workforce Investment Act, for example, is a US$14 billion government program that distributes job re-training funds through a series of boards composed of employers, labor unions, and other groups. But CompTIA says board members often know little about IT or other high-growth sectors, and tend to channel funds into areas they're more familiar with-traditional sectors such as trucking. Legislation could also be expanded from a narrow emphasis on manufacturing to include the service sector, and to target not just laid-off workers but also those who may be at risk of losing their jobs.

Given that companies outsource shift jobs to countries where labor costs are lower, will training really help? Supporters of the idea say what ultimately matters is not labor costs generally but costs per unit produced. And because highly productive workers turn out more units, productivity can easily shrink unit cost to acceptable levels, thereby protecting U.S. jobs.

Freedom to Choose

Another concern for software companies these days is the issue of preference laws-policies that restrict government use of foreign-made software. More than 70 such laws have been proposed by governments worldwide, including China's. Although Chinese authorities have not carved anything in stone, a clearly stated preference for domestic software by the central government could deal a serious blow to American software companies. Government agencies represent a huge market in many developing countries. Oracle, for example, derives about one-third of its China revenues from the state.

"Governments have a right to prefer domestic vendors," says Anne Stevenson-Yang, who heads the U.S. Information Technology Office (USITO) in Beijing. "But in software, there really aren't a lot of other competitive Chinese products." As a result, she says, policies favoring domestic vendors tend to exacerbate the problems of an already weak IPR regime by encouraging Chinese developers to come up with software that closely resembles a foreign product. And because China doesn't yet produce much high-quality software of its own, the needs of most government agencies are better served by buying foreign software-at least for the time being.

Stevenson-Yang also points out that because pirate software is cheap and easily available, preference policies may force government agencies to buy local products they won't actually use. City or provincial governments will buy a domestic product to satisfy the requirement, but will then use pirate foreign software for their daily needs, at little or no extra cost. Finally, preference laws could be extremely difficult to implement. Software is produced collaboratively, and an application may have been jointly written by developers in Silicon Valley, Ireland, and China. Under such circumstances, it's hard to pinpoint what's a domestic product and what's not. "You don't want to start counting lines of code," Stevenson-Yang says.

For its part, the Chinese government has promised that new regulations on government software procurement will be issued soon, and that they will treat foreign and domestic companies equally.

The Issue That Won't Go Away

Then there's the matter of IPR infringement, a problem that costs foreign software companies millions of dollars each year. The International Intellectual Property Alliance estimates pirate software in China cost its members US$1.64 billion in 2002-about 86 percent of the losses attributed to every sort of IP violation. "It's the key issue," says Stevenson-Yang, "but the trends are all in the wrong direction."

Perhaps for that reason, the Bush Administration recently has begun pushing China for better IPR protection. U.S. officials had hoped Chinese Premier Wen Jia Bao would announce concrete actions to fight software piracy and other IPR violations during his visit to Washington last December, but no such announcement came. China and the United States did elevate to cabinet level the Joint Commission on Commerce and Trade, a bilateral panel formed to deal with sensitive trade issues. But U.S. Commerce Undersecretary Grant Aldonas has warned that a commission meeting scheduled to be held in late April could be canceled if progress on software piracy and other trade issues is not forthcoming.

Better IPR protection is not just designed to help foreign companies; once enough Chinese software companies begin developing commercially successful products, they too will require better IPR protection. And China has every intention of developing a thriving domestic software industry. As far back as 2000, the State Council signaled its intention to make software an economic priority by issuing a blueprint for developing the domestic IT and software industries. In Beijing, the municipal government and the Beijing Science and Technology Commission jointly operate the Beijing Software Promotion Center, a non-profit organization that helps Chinese software companies scale up their business. Even outside of the capital, software and IT services have become growth industries. Tianjin expects to generate revenue of US$2.4 billion from software and IT services this year, Qingdao has 300 registered local software and IT companies and is building a dedicated software park, and Jiangxi Province last year reported industry sales of US$176.3 million for software and related services, up 64 percent from 2003. Clearly then, an economic incentive for alleviating at least one of the software industry's hot button issue exists. Whether the political will exists is another matter.

Preferende Laws and OSS

Preference laws (see main story) encourage government agencies to buy locally made software-a cause for concern among foreign software developers. But many preference laws also promote open-source software (OSS) whose internal code is visible to anyone who wants to see and modify it. While some companies have commercialized OSS, most make their money selling proprietary applications.

Probably the best-known OSS is Linux, an operating system created as an alternative to Microsoft Windows. Like other OSS, it's free, and source code can be viewed to satisfy users concerned about security-one reason the Chinese government seems to prefer it. Linux has a band of hard-core devotees who praise it as being stabler and easier to customize than Windows and less susceptible to computer viruses, most of which are written to attack Windows-based applications. But some say installing and learning Linux is difficult, as are finding applications compatible with Linux and technicians qualified to service it.

Although nothing official has been announced, Chinese government authorities have promoted the adoption of Linux as an alternative to Windows because Linux is (a) not American, (b) open source, and (c) inexpensive or free. Many companies have responded with alacrity to the potential market created by such a government preference. Sun Microsystems last November announced plans to sell the Chinese government 200 million copies of its Linux-based Java Desktop System, a product that goes for one-third the price of Windows. In March, the Beijing Software Testing Center announced a partnership with Open Source Development Labs, a U.S.-based Linux group, to cooperate on adapting Linux for China. And just a few days later, Hewlett-Packard signed an agreement with China's Ministry of Information Industry to build a Linux software lab for the State Software Public Service Platform, an MII-backed entity that provides resources and technical support for Chinese software companies.

The Beijing Post Office and municipal government already use some open-source software made by Red Flag Software, a company financed by a venture capital outfit run by the son of Jiang Zemin. This year, Red Flag announced a tie-up with Miracle Linux, an Oracle-backed company based in Japan. The venture is aimed at creating an Asian version of Linux and making it the region's dominant operating system within three years-not just for government agencies, but for businesses as well.

Indeed, non-government users represent a big potential market for open source software. Oracle and Dell said in March they would extend their global Linux partnership into China in hopes of selling Oracle database solutions running on Dell's Linux software to China's estimated 10 million SMEs. Oracle said Linux use in Asia-Pacific was more than doubling each year, in part because of government enthusiasm for the software.