By Paul Carsten, Sophie Knight and Malathi Nayak
BEIJING/TOKYO/SAN FRANCISCO (Reuters) - For the past five years, Zhang Yang has sold Xboxes, Wiis and PlayStations at his Beijing shop, but the Chinese merchant is a thorn in the side of video game console makers now allowed into the world's third biggest market.
The consoles that Zhang sells are smuggled into China because they are illegal, although that may change after the government lifted a 14-year-old ban on the devices this week.
But most have been modified, or "cracked", to play pirated games which can go for less than 10 yuan ($1.65) compared with $60 for the latest licensed titles.
The proliferation of these bootlegged games, along with China's reputation for weak intellectual property rights, means console makers Microsoft Corp, Sony Corp and Nintendo Co Ltd will lose out on lucrative royalties from software sales.
Combine that with the fact that most Chinese gamers prefer to play free games on their PCs and mobiles anyway, and the decision to lift the ban on console sales presents a challenge, rather than a big opportunity.
"Console vendors will need to incorporate a business model for a piracy-rich environment," said Lisa Hanson, a U.S.-based managing director at Niko Partners, a research firm focused on the Asian games market.
"They need to understand who the gamers are, what they demand, what are they not getting out of the current PC game experience that they could from a console game," she said.
China banned video game consoles in 2000, citing the games' negative effect on the mental health of its youth. That has resulted in a whole generation growing up without a PlayStation, Wii or Xbox and fuelled the popularity of alternative ways to play.
The absence of consoles means PC games dominate two-thirds of China's video game market, which saw revenue growth of almost 40 percent last year and which trails the United States and Japan in size.
Mobile and browser games are also extremely popular, in line with a global trend that has seen the console market shrinking.
To get around losing revenues to rampant piracy, video game providers in China offer a free-to-play, or "freemium" business model, where players get games for nothing but are offered to buy in-game items such as weapons and extra lives.
"It's a business model China basically championed and invented and it basically eradicated the risk of piracy: just give away everything but if you want to do well you got to pay," said David Gibson, senior research analyst of games and IT at Macquarie Securities in Tokyo.
Console makers, however, operate differently and that makes piracy an even bigger concern. Sony, Nintendo and Microsoft all declined to give details about how they would tackle video game piracy in China.
Sony PlayStations, however, have better security than their competitors and are more difficult to modify for pirated games, so piracy is less of a threat to their business.
Currently, companies get, on average, a 30 percent cut from game developers, industry analysts say. Software, services and royalties accounted for about 40 percent of the sales revenue of both Nintendo and Sony's video games division in financial 2012, the companies' financial statements shows.
Microsoft does not break down its Xbox revenues, but said it generates money from its Xbox Live, which allows online multiplayer gaming, as well as games sales.
The consoles themselves make little profit. Sony and Microsoft sold their older PlayStation 3 and Xbox 360 models at cost price for years, and companies only cut down costs later in a console's life cycle to bring down the price.
When asked about China, Nintendo's public relations manager, Yasuhiro Minagawa, said the company had no plans to enter the market now. "We have no plans or schedule to put out our products in China at the current time," he said.
Sony also sounded a note of caution. "We do recognise that China is a promising market, and we will continue to study the possibility," Satoshi Nakajima, a company spokesman, told Reuters this week.
Microsoft declined to comment on specific plans for console gaming in China. Instead, Ralph Haupter, Microsoft's Greater China chief executive, highlighted the company's partnership with Chinese technology firm BesTV New Media Co Ltd, with which Microsoft invested $237 million in "family games and related services" last year.
"Our local partnership with BesTV combines our strengths in entertainment and technology to foster a new development ecosystem within China," he told Reuters.
YEARS OF BATTLE
China's government is cracking down on piracy, but counterfeiting of everything from luxury goods to software remains rife.
China's illegal software market was worth nearly $9 billion in 2011. In the same year, 77 percent of personal computers in China had pirated software installed, according to a May 2012 report by the Business Software Alliance, a trade group which monitors intellectual property rights infringement.
Microsoft has battled Chinese software piracy for years. In 2012, Chinese state media reported Microsoft had lodged an official complaint against a number of large government-owned corporations, saying as much as nine out of 10 of their Windows service client software was unlicensed.
The lifting of the games console ban shouldn't impact Zhang's business, said the Beijing game merchant, adding that he barely gets any customers anyway.
"We don't have very big profits, so the business isn't too successful," said Zhang, playing a game at his stall in the starkly lit basement of tech mall Bainaohui.
"It's my passion, not my most important business." ($1 = 6.0512 Chinese yuan)
(Editing by Miral Fahmy)