(FORTUNE Magazine) – The Chinese military is making threatening gestures in the direction of Taiwan. U.S.-China tensions are mounting over human rights. Can America afford to slap a billion dollars of punitive tariffs on China when relations are already so bad? Can the U.S. afford not to, with China stealing more than a billion dollars a year in American software, music, and movies?

In recent weeks the U.S. has been turning up the trade heat. February 26 was the first anniversary of China's narrow escape from sanctions, and U.S. Trade Representative Mickey Kantor has raised the possibility of punitive measures, expressing impatience at China's lack of progress in stemming piracy. "We will not wait forever," he said recently.

Last year China promised to crack down on pirates, and it has hounded retailers of counterfeit CDs with gusto in 3,200 raids that claimed two million fake CDs. In at least one high-profile case, the contraband was pulverized by a road-paving machine. Chinese officials like to throw pornographic movie CDs--their real concern, say some industry insiders--into the crusher too. The government also set up intellectual property rights courts in several major cities.

But China has done little to stem production. There are now 34 CD factories, up from 29 last year, most of which churn out pirated material. Most disturbing, the outlaws have shifted their focus from music to CD-ROMs. One disk, retailing for $5, can hold dozens of software titles worth $10,000.

Chinese counterfeiters do not take kindly to outside pressure. In November, threats from hitmen linked to local pirates forced a shutdown of an antipiracy office run by the international music industry in Guangzhou. Industry watchdogs say many outlaw factories have ties to the People's Liberation Army or local officials.

Policing pirates is problematic, even with cooperation. "We're talking about agents who might never have seen a PC before," says Alix Parlour Grice, a lawyer with Microsoft in Hong Kong. Lawyers and software engineers provided by foreign companies sometimes go along on raids to help identify the fakes.

Another issue: local politics. "Each region is almost like a different country," says Grice. A U.S. official visiting China in February to push for progress made sure to visit officials in Guangdong province, a piracy center, as well as their bosses in Beijing. Remote factories are often the sole enterprise in a small village and a source of local pride.

Nearly all software used in China--something like $500 million worth--is pirated, according to Grice. Not only does China use stolen software, it exports it with exuberance, particularly to Hong Kong, where organized crime groups have created a huge transshipment zone. Software developers say the Hong Kong situation is urgent because enforcement may be iffy after the Chinese takeover in 1997. "We've got until next year to get the situation under control," says one industry advocate. "But it doesn't look very good."

--Susan Moffatt