Microsoft's Great Xpectations for China

As the computer company is poised to bring Xbox and Xbox live to the mainland, questions remain about Internet standards and profitability

One year ago, during a visit to Microsoft's headquarters in Redmond, Washington, President Hu Jintao said: "Because you, Bill Gates, are a friend of China, I am a friend of Microsoft."

It was a stunning recovery. Years of fumbling had left Microsoft's business in China a shambles. In 2004, it had struggled to save its government business from a campaign urging Chinese government bodies to purchase local software. Beijing had even flirted publicly with that home-wrecking vixen, Linux.

All of those bad memories vanished into the recycle bin as Microsoft earned the most public of endorsements from the most powerful man in China. A rash of new sales agreements with Chinese PC manufacturers followed in short order.

The resurgence was due largely to the efforts of Tim Chen, who took over Microsoft's Greater China business in 2003. Unfortunately, Chen's masterstroke in China came at the same time Microsoft's business overseas seemed to go into terminal decline.

Hit with delays to Vista, its next-generation operating system, fuming at Google's domination of search (and poaching of star researcher Lee Kai-fu in China), and sitting on the sidelines while Apple dominates online music and video, Microsoft seems past its prime.

Hard times

Given this tumultuous recent history, news reports in January suggesting that the company might launch its Xbox game console in China raised a few eyebrows. After all, the Xbox is sold at a loss to drive the sale of profitable game software but "profitable", "software" and "China" are three words that go together only occasionally. The Business Software Association's most recent global piracy report estimates an 86% piracy rate. And that's after improvement.

There are two reasons an Xbox launch in China might make sense. One is how the game console fits into Microsoft's future business model, not its current one. The other is the potential of China in that new business model.

Other companies may rule online applications and media now, but Microsoft isn't about to give up. In recent years, it has pushed aggressively into these areas, albeit with mixed success.

Xbox plays a central role in this transformation. It is marketed as a game console, but the games are bait for a set-top box on steroids. Packed with media and connectivity features, Xbox is everything the ill-starred Media Center PC never became: a true living-room media server.

Going live

But what really makes Xbox an expression of Microsoft's future is Xbox Live, a slick online service that provides a growing assortment of games, entertainment and other paid services.

Xbox Live is also the key to China. The country's 130 million internet users live for online communication, cheerfully pay for piracy-resistant online games, and increasingly breathe online media.

If online services can make money, the hardware can still lose it—especially if it means a generation of affluent Chinese consumers learns to love Microsoft, and gets tied to its online services.

Microsoft is already driving its online business hard in China, with a host of new services and partnerships being rolled out. The China Internet Network Information Center (CNNIC) reports that although Tencent's QQ is still the undisputed king of instant messaging services in China, Windows Live Messenger is most popular among affluent professionals in big cities, with 20 million users.

Xbox would snuggle nicely into this picture but it is still expensive by Chinese standards, at US$299 for a starter version.

Furthermore, credit card-driven models for paid online services don't work well in China. While Apple and Google have so far largely failed to make a mark in China, well-connected local companies as Shanda, Baidu and Shanghai Media Group covet promising new markets for themselves.

And, as anyone who uses it knows, "Chinese broadband" is an oxymoron.

Perhaps most critically, the HD-DVD and IPTV standards that Xbox uses will be subject to China's regulatory whims. And while a foreign game console—especially one that isn't Japanese—bothers no one, a foreign set-top box might set teeth on edge.

Expectant Chinese gamers had better hope that Microsoft remains a "friend of China".

    Before it's here, it's on the Bloomberg Terminal.