(FORTUNE Magazine) – China's flagrant piracy of American pop music, movies, and computer software is more than the biggest rip-off in global commerce. It's also the latest evidence of the growing and increasingly visible risks confronting Western and Asian companies doing business in the People's Republic.

None of these risks--galloping inflation (21% last year), erratic policy shifts, rampant corruption, a penchant for treating contracts like disposable Kleenex tissues, or the imminent prospect of even greater turmoil following the demise of 90-year-old supreme leader Deng Xiaoping--are new. Nor do they undercut the long-term logic driving businesses to stake a claim in what could within 15 years become the world's largest market. In the past two years, U.S. corporations have poured nearly $4.3 billion into China. What could well slow the flow of that investment are the prominence of the companies running into trouble, the size of their potential losses, and growing awareness of just how deeply rooted China's problems are.

McDonald's, for instance, is being evicted from its prime site in Beijing despite a 20-year lease that has 17 years left to run. Lehman Brothers is suing two state corporations for failing to pay nearly $100 million of losses in foreign-exchange trading. And a group of Japanese, German, and Italian banks has been reduced to begging Beijing to make good on some $600 million of defaulted loans they made to state enterprises.

Nowhere are the stakes bigger--or less amenable to a quick and lasting solution--than in the current U.S.-China dispute over heisted copyrights. More than a trade war, think of this fight as a clash of civilizations. The new American economy, with its edge in handling information technology, confronts an ambitious Asian giant with a voracious appetite for capital, know-how, and export markets--and a primitive legal system that lacks almost any concept of the Western notion of intellectual property. Says Kenneth DeWoskin, a University of Michigan business school professor and China specialist: "Most Chinese do not understand the notion of intangible assets like brands or copyrighted material. We're in for a long siege on these issues."

Beijing would have a hard time fixing the situation if it wanted to: It has devolved economic power upon the provinces, which control the pirate factories and the courts. Further complicating matters, senior politicians, military men, and their families are often involved in the pirating industries. Says Howard Lincoln, chairman of Nintendo of America: "We have evidence that government officials have ownership stakes in companies doing the counterfeiting." One of the most egregious violators of Nintendo's copyrights is state-owned Tianjin New Star Electronic Co., whose president heads a department in the Ministry of Electronics and Machinery. New Star has even sought to raise equity capital in the U.S. to expand its illegal operations.

Showbiz products such as Madonna recordings and Mickey Mouse films grab the spotlight, but the intellectual property of corporations with manufacturing plants in China is equally at risk. To get into the PRC, companies must disclose to authorities details of their products and processes. Says DeWoskin: "Chinese research and design institutes look for the best technology in the country and spread it around. They also examine plans and specifications of new ventures, so there's bound to be some leakage."

Indeed, after Du Pont introduced into China its Londax herbicide, which curbs weeds in rice fields, it decided in 1992 to open a $25 million plant in Shanghai to make the product. By then state-owned Chinese competitors had jumped into the market with cheaper knockoffs of Du Pont's weed killer. Shortly after Pilkington opened a plant in China to make architectural glass, a state glass factory sent an order for production equipment to Germany--complete with detailed and obviously filched plans emblazoned with Pilkington's name. Johnson & Johnson, which got into China early to make prescription drugs, constantly has to ferret out counterfeit versions of its products. Smart investors are careful not to bring their latest technology into China.

Protecting a brand name in the China market often resembles a mission impossible. A bogus Chinese breakfast cereal product called Kongalu Cornstrips has a trademark and packaging identical to that of Kellogg's cornflakes. A small Chinese computer manufacturer, Mr. Sun, has appropriated the trademark of Sun Microsystems for its machines. And mineral-water drinkers in China can enjoy Pabst Blue Ribbon Water.

As for videos, movies, compact disks, and computer software, virtually the entire Chinese market is a pirate's den because Beijing denies market access to most of the legal products. Nor is there much shame about the grand larceny, which costs U.S. companies alone more than $1 billion a year. According to a report issued by the U.S. Trade Representative's office, "Anyone can walk into a store in Beijing and buy a pirated copy of Microsoft's popular Windows software package. The store simply copies it onto a few blank floppy disks while you wait."

In plain sight of policemen, Chinese music fans can pick up on the streets of major cities the latest CDs by such artists as Whitney Houston, Billy Joel, and Kenny G-for the equivalent of $1.70. Though PRC authorities have staged a few raids on retailers, they have done nothing to stop 29 high-tech factories in southern and central China that can turn out a total of 75 million CDs annually for a market that absorbs only about five million disks. Much of their output is exported, robbing U.S. companies of sales in other markets.

These flagrant violations of intellectual property are what prompted Mickey Kantor, the chief U.S. trade negotiator, to slap stiff tariffs worth some $1 billion on Chinese products. In the trade equivalent to a surgical air strike, however, the U.S. targeted such items as cellular phones, fishing rods, and bicycles, which would hurt the PRC without causing pain for American companies and consumers. The Chinese retaliated with rhetoric about defending their "national dignity" and retaliatory tariffs that also would have little real effect. Example: China threatens to impose punitive import duties on U.S. cigarettes, most of which are smuggled into the PRC anyway.

The crisis atmosphere has at least sent everyone back to the bargaining table. Negotiations, in fact, had to fail before the senior leadership of China would take the issue seriously. Remarks an experienced U.S. business negotiator in China: "Only when there's total paralysis does an issue get kicked upstairs to a level where something can get decided."

Though the U.S. is leading this fight, in an Information Age all advanced economies have a stake in seeing it satisfactorily resolved. Nintendo, the Japanese videogame maker, for example, is suing Samsung Electronics of South Korea for allegedly providing memory chips with Nintendo software to pirates in China and elsewhere. Samsung denies the charge and is countersuing Nintendo for defaming its reputation. Can a solution emerge? Optimists point to Taiwan. Only a dozen years ago that island nation harbored a vigorous underground export industry that skillfully copied leading global brands. A visitor could buy good-looking knockoffs of Rolex watches in the back streets of Taipei. The counterfeiting abated once Taiwanese companies developed their own intellectual property and thus a deeper appreciation of its value.

Given time and a few more knocks in the game of global trade, the Chinese too should eventually come to see piracy as more expensive than it's worth. Until then, expect it to remain one more reason to cast a cautious eye on China's red-hot but risky market.