(FORTUNE Magazine) – The three-story building in Pinghu had been raided a month earlier for making fake Rolexes. So when a team of Chinese government agents knocked on the door of the Wei Da watch factory in Guangdong province, they were admitted like familiar guests. Workers served them tea in fine chinaware, while two dozen blank-faced girls remained seated around a long, rectangular table, gluing tiny minute marks onto the faces of watch dials. After a half-hour, a manager gave the word and the girls fled down an alleyway--but not before lining up to punch a time clock. When the raiders were finished combing through the factory, they filled a truck with more than 10,000 counterfeit watch dials (mostly Omega, Rolex, Casio, and Citizen), along with 106 sets of molds. The boss was nowhere to be found, but on his desk were wads of cash and two thick catalogs filled with dozens of sample dials. His punishment: a $400 fine.

For the counterfeiters, it was a day like any other in Guangdong, China's richest and fastest-growing region. The unmarked factory in Pinghu is one of thousands like it in southern China. It is estimated that a quarter of the world's watch production is concentrated in Guangdong, and perhaps a third of that is counterfeit. The fakes are exported everywhere--to Europe, Russia, the Middle East. "Watches are perfect because they are small, easy to hide and transport, and have high profit margins," says Jack Yang, an agent with Kroll Associates, the world's largest investigative agency, which spearheaded the raid in Pinghu.

China's Communist rulers, hoping to join the World Trade Organization next year, want to appear serious about cracking down on counterfeits. Raids like the one in Pinghu now occur in many cities, sometimes followed by orchestrated "destruction parties," in which the seized goods are steamrollered in the presence of local media. But these actions are barely stanching the epidemic, estimated by Chinese officials to be a $16-billion-a-year business and costing foreign firms tens of billions of dollars annually in lost sales.

China produces more fakes than any other nation--everything from autos to aircraft parts, beer to blades, soap to shampoo, TVs to toilets. Moreover, exports of fakes are rising (72% of the counterfeit Beanie Babies seized in the U.S. last year were from China), and crime syndicates are entering the racket. "The problem is getting worse rather than better," says David Holloway, who until October ran Kroll's Asian operation. "There's been no pre-WTO cleanup."

That view is shared by an increasing number of foreign brand owners. With Kroll's aid, FORTUNE traveled deep inside China, meeting with investigators, diplomats, and executives, as well as shopping for fakes in several cities. This reporter dined in secret with a Chinese enforcement official, reviewed government memos, and joined the raid in Pinghu. The picture that emerges is both grim and complex: The nation is hooked on fakes, and extricating itself might severely damage its economy. Even foreign governments suspect this; counterfeiting has not been an issue in the WTO negotiations, nor was it in the Sino-American trade agreement that passed the Senate in September. As for China's bureaucracy, the world's biggest, it seems designed to thwart a solution, with its overlapping agencies, weak and confusing laws, and economic conflicts of interest among the enforcers.

Nowhere is the problem more evident than at the Liangfeng Food Group factory near Shanghai. A Chinese success story, the factory churns out chocolates that look just like those made by Italy's Ferrero-Rocher, a world-class confectioner. Not long ago Ferrero spurned a joint venture offer from Liangfeng, which continued to produce them anyway, under the name Jin Sha (a brand Ferrero uses in other Asian markets). Today those treats are sold alongside the Ferrero brand in China's supermarkets, with nearly identical packaging and at half the price. But don't expect to see any raids against Liangfeng. The chocolates are not considered counterfeit under Chinese law. And a company brochure carries an inspiring slogan from President Jiang Zemin, who presents the sweets to world leaders as gifts.

No nation has ever built a healthy, modern economy without protecting intellectual-property rights. But it's hard to escape the conclusion that China's rulers may be gambling on an exception. "The historical lesson appears to be inapplicable to China," says Ohio State University law professor Daniel Chow, an expert in global trade. Until recently Chow worked for Procter & Gamble in China, where he helped spark an anticounterfeiting crusade by multinationals. "Can China defy history?" he wonders. "Despite the worst counterfeiting problem in world history, the economy continues to grow. We've never seen that before. So for someone to say that this is a serioous national problem for China...the government, frankly speaking, says, 'We don't see any of the signs.'"

It's impossible to know what percentage of China's manufacturing base is dependent on fakes and other illegal knockoffs--estimates range from 10% to as high as 30%--but Beijing is surely not going to decimate its economy if it doesn't need to. Even in Guangdong, a showcase province, one need only ride the train between Shenzhen and Guangzhou to glimpse the poverty that helps fuel the counterfeiting trade. Rickety homes, slapped together with boards and sheet metal, line the tracks. The shantytowns are separated by factories. "One in five factories along the train from Hong Kong to Guangzhou is infringing at one time or another," says Kroll's Holloway. "There are thousands and thousands of them--those are just the ones you can see."

Despite its rapid development, China remains a land of 800 million peasants. Unemployment is estimated at more than 150 million people, many of whom float around the nation as temporary migrant workers or counterfeiters. According to People's Daily, the main Communist Party newspaper, illegal economic activity grew at a faster pace than the nation's legitimate economy in the first half of this year. With entrance into the WTO sure to attract yet more foreign competition, and more unemployment, piracy will probably grow, at least for the near future. "If you're a small-business man in China, will you really spend money on R&D, or just copy someone else's design, patent, or copyright work?" asks Barry Yen, an intellectual-property lawyer in Hong Kong.

The inclination to copy is also cultural. If imitation really is the highest form of flattery, then China has been the Land of the Laud for nearly 2,000 years. Counterfeiting is so ingrained that many Chinese view it as harmless--or at least not the same as stealing. For Chinese consumers, most of whom can't afford the genuine articles, an almost fetishistic obsession with Western brands is fueling the racket. Toss in a long history of foreign incursions, and copying has morphed into a sport. "Most Chinese are aware that this country was bullied and carved up by aggressors, and there's a backlash against it with counterfeiting," says Peter Humphrey, who manages Kroll's China operations. "There's a sense of humiliation and a national getting-even going on here."

Fake-making has infiltrated nearly every sector of the economy. Industry experts believe that 90% of the videodisks and computer software on sale in China are fake. "Some provinces want to create Silicon Valleys, but there's no way they will do it if they don't handle their piracy problems," warns Tom Robertson of the Business Software Alliance.

Fakes are so common, says a Western diplomat, that his friends use magnifying glasses to examine beer labels when they drink in Beijing's bars. Copycat versions of Hollywood blockbusters are available on the streets of China within days of their U.S. premieres. Case in point: The first fakes of Mission: Impossible 2, which was released in the U.S. on May 24, were found on the streets of Hong Kong two days later and in Shanghai a day after that. The industry suspects that scripts are somehow being obtained in advance because the fake Asian versions are subtitled.

The horror stories go on and on. Toilets? A survey found that 35% of the American Standard toilets purchased in Shanghai in 1999 were fake. Drugs? Pfizer only began selling Viagra in China in July. But by last year three local producers had already introduced ripped-off versions of the erection pill, and more than 30 enterprises have since pirated it. There are Viagra wines, Viagra soup, even Viagra clothes.

Personal-care-product giants like Germany's Henkel and America's P&G estimate that about a quarter of the goods bearing their names in China are fake. (Henkel has identified more than 300 counterfeits of its brands.) China produces nearly half of the world's 14 billion batteries, most of them fake versions of Panasonic, Gillette (sometimes artfully called "Gillelle"), and other big brands. In the footwear market, Nike's potential annual losses in China resulting from fakes "approach the size of our legitimate business here," says company lawyer Nina Chen.

In the auto market the situation is so bad that Beijing Jeep, a joint venture with Chrysler, can barely sell its own parts because of a cottage industry of knockoff vendors. In Guangzhou, says Victor Kho, an investigator with Quest IPR, 99% of Suzuki motorcycles are fake. Even whole vehicles are being cloned: Earlier this year 22 fake Audis were discovered in Hubei province, and experts say that look-alike Mercedes are being assembled in the south.

Nobody knows how many Chinese are employed making fakes, but some experts put the figure well into the millions. Most work at small to midsized factories, but many stay at home, doing things like filling Head & Shoulders shampoo bottles from large vats in their living rooms. Last year 10,000 bottles of fake Evian water were found inside a building controlled by Beijing's correctional department, while investigators for Yale, the U.S. lockmaker, found a factory producing knockoffs inside a Chinese army compound. (The People's Liberation Army had rented the space to the counterfeiter, a not uncommon arrangement.) Fakes are also produced by state-owned enterprises trying to survive in the wake of having their subsidies cut. "Taiwan and Korea were never this bad," says Joseph Simone, an intellectual-property lawyer with Baker & McKenzie in China.

To be fair, China has adopted most of the international treaties that frown on counterfeits. And China's leaders are finally spouting the right rhetoric. In a letter to a business conference last November, Premier Zhu Rongji wrote, "If we tolerate fake and shoddy commodities, there will be no hope for the state." Similarly, a committee of the National People's Congress notes that "the most serious issue is the production and selling of poor-quality and fake commodities, which has become rampant despite unceasing bans and crackdowns." But China has failed to enact the tough laws and rigid enforcement that are needed to get the job done. In fact, one of the ironies of China is that it is a police state with a lack of basic policing.

China's legal system is riddled with loopholes. In much of the world, counterfeiting refers to the unauthorized production and sale of exact copies of genuine goods, down to the trademarks, and there is a growing trend to enact comprehensive anticounterfeiting criminal laws. But in China there isn't even a clear definition of counterfeiting. An old trademark law utilizes vague terms like "large" and "relatively large" to determine whether cases rise to a criminal level. In 1993, China issued more specific regulations (i.e., suggesting the prosecution of thrice-captured offenders), but a criminal-code amendment in 1997 leaves enforcement officials scratching their heads as to whether the seven-year-old regs still apply.

In most countries possession and intent to sell are enough for a counterfeiter to face criminal liability. But in China evidence of prior sales is required--a high hurdle considering that few counterfeiters keep records. The bottom line is that few offenders ever go to prison. And those who knowingly assist counterfeiters by providing transportation, storage, and raw materials are largely ignored. The problem is exacerbated by China's "first to file" trademark rule, which allows fast-filing firms like Liangfeng to use the Jin Sha name--even though Ferrero already owns it in other Asian territories. (In the U.S. and Britain, a "first to use" rule is in effect.)

More than 85% of China's counterfeiting and trademark cases are handled by noncriminal administrative agencies that overlap and often fight for turf. They include the country's patent and customs agencies. But the main agencies are the Administration of Industry and Commerce (AIC), which has the conflicting role of overseeing all commercial development in China, and the Technical Supervision Bureau (TSB), a consumer-protection agency. Neither agency has arrest powers, nor are they empowered to kick open a locked door if nobody answers. Moreover, they are inept at investigating, tracing records, and searching for bank accounts. Business licenses are rarely revoked, while seized equipment and confiscated goods (with the labels removed) are often returned to offenders. Brand owners that opt for the civil route often find their court cases dragging on forever, thanks to ill-trained, biased, or corrupt judges. As for civil remedies, such as attaching property, freezing accounts, or seeking preliminary injunctions, forget about it. They're almost impossible to get.

Both the TSB and the AIC are raiding counterfeiters in record numbers, but the fines they issue are rarely collected or laughably low (1999 average: $700). Two years ago the Chinese government authorized police bureaus to handle all cases that seem to rise to a criminal level. But for the most part, the police don't have the training or the desire, and the administrative raiding agencies, eager to pad their own stats, aren't transferring the cases. In 1998 only 35 AIC cases were transferred to the police (a ratio of one to 421), and the numbers appear to have declined since then. To make matters worse, the enforcement pyramid has no clear top. Complains William Dobson, P&G's China troubleshooter: "There is no central government oversight going on." Dobson and others would like to see China appoint a "piracy czar."

But tampering too much with the system could hurt China's purse. At the heart of the country's counterfeiting racket lie nearly 1,000 wholesale markets that serve as the links between the factories and the retailers. Many of the markets are run by local AIC branches, which typically invest in their construction, then collect management fees and rent from vendors. In other words, it's the fox guarding the henhouse, Chinese-style.

Take Yiwu, China's largest wholesale distribution center, a five-hour drive from Shanghai on dusty, congested roads. At first glance, Yiwu looks like a typical modernizing Chinese city. A closer look reveals streets teeming with carts, trucks, vans, and flatbeds, all heavily laden with boxes and packages. Yiwu was farmland in the 1980s; now it's a $3-billion-a-year wholesale nerve center. Each day 200,000 visitors stream in to buy or unload goods at 33,000 stalls and stores. The local AIC invested $10 million in the center's construction and continues to manage the market, while many ex-AIC officers own their own warehouses and businesses.

At Yiwu's center is the multistory China Small Products City, where ex-government officials administer an enclosed shopping arcade with a seemingly endless supply of cheap consumer goods--toothpaste, shampoo, lighters, batteries, hangers, brooms, lamps, toys, watches, slippers--much of it labeled with names such as Colgate, Gillette, Pantene, Safeguard, Philips, Duracell. Surrounding this mega-mall are streets specializing in different products: a shoe street, an appliance avenue, a lane for leather goods.

Shutting down the fakes at Yiwu (it's estimated that 80% of the consumer goods here are counterfeits or other trademark infringements) would cripple the city's economy, because many hotels, restaurants, and businesses cater to the trade. And since Yiwu supplies many of the smaller wholesale markets, any disruption would have ripple effects all over the mainland. "I don't think it's an exaggeration to say that Yiwu was built on the back of the counterfeiting trade," says P&G's Dobson. On a recent visit Yiwu's streets were filled with foreigners making deals. Distributors have opened branches in Brazil and South Africa, and there are plans for expansion into Nigeria, Uruguay, Pakistan, and Thailand. All this activity is being done with at least the tacit approval of China's government.

What are foreign brand owners to do? For the most part, they rely on private investigators to develop cases against counterfeiters, which are then turned over to the administrative agencies for raids (known in China as da jia, or "hitting fakes"). In this way, the anticounterfeiting movement is essentially a freelance war. Kroll, the leading outfit, with 14 branches in China, says that its anticounterfeiting work on the mainland and in Hong Kong is one of the agency's most profitable arms. Two years ago Kroll bought Fact Finders, China's elite anticounterfeiting agency. Together they work about 50 cases in the region, utilizing 150 full-timers, plus hundreds of consultants, informants, and undercover workers, and a dozen front companies posing as traders. But private investigations are technically illegal in China, so firms such as Kroll are registered as "market research" firms, allowing Beijing to keep them on a leash that could be yanked at any time.

The point man at Fact Finders is Joseph Tsang, a 50-year-old former Hong Kong police inspector who has spent half his life doing anticounterfeiting work. Tsang is considered by many to be the best intellectual-property investigator in the region. He has a quick wit, a constant smile, and a calm, unflappable demeanor. With his tiny silver cell phone (one agent calls it "his nerve center"), Tsang oversees Fact Finders cases like an air-traffic controller landing planes. "Joe has 100 eyes, like a fly," says Humphrey, who adds that his colleague is "too busy to learn a computer," preferring to send handwritten faxes to troops in the field.

One thing Tsang and many rival investigators have mastered is the Chinese art of guan xi, or relationship building. The wining and dining of AIC agents, who earn about $200 a month, is today the stuff of karaoke legend. "They [AIC officers] are very busy," laughs Xue Chuang, a Kroll agent in Beijing. "They go from banquet to banquet." AIC officials, she adds, "have bought nice apartments and new cars with cash from corporations," and "holiday bonuses to division chiefs are distributed." The local branches of raiding agencies, often lacking in resources such as mobile phones and copy machines, typically extract "case-handling fees" from the corporations. For American firms, such gifts and payments could violate the Foreign Corrupt Practices Act. But that law normally applies to making payments to government officials in order to get business, rather than to greasing the wheels of an agency to get it to perform its mandated tasks. "It's a sensitive issue," says Ohio State professor Chow. "The higher the fees, the more doubtful that it's legal." (Kroll says that if any of its clients are making high payments, they are doing so on their own.)

In addition to issuing fines against counterfeiters, the AIC is permitted to force them to pay a token compensation to the brand owners (1999 average: $40 per case). Many foreign firms kick most or all of that back to the AIC's coffers. And since some corrupt government enforcers sell seized goods through the open market, corporations will often pay to have them destroyed, or buy their own fakes at rigged auctions. "We're willing to pay for enforcement, but the costs come nowhere near justifying the results," gripes attorney Simone. Indeed, last year police in Yiwu asked P&G for $6,000 per arrest. (The offer was declined.)

A deeper look inside China's provinces shows how systemic the problem is. "Local governments contribute to the rise in counterfeiting by helping create the distribution channels," says Chow. In fact, the economies of many areas have become identified with the fakes of particular brands. The Kaihua district in Zhejiang province is known as the "Philips light-bulb town." Fake Gillette razorblades are keeping the Yangzhou area afloat in Jiangsu province. Yunxiao in Fujian province is "Marlboro Country." Government raiding parties in that region take place at least twice a year and typically involve more than 100 agents. "Philip Morris doesn't make cigarettes in China, but that doesn't stop the counterfeiting," says Michael Fawlk, a senior attorney with the tobacco giant. "Fujian province is the worst; many local officials own such businesses."

For years, local governments could protect counterfeiters because they controlled the appointments, housing, and salaries of enforcement agents, as well as the police and judges. That power is now slowly shifting to the provinces, but the national AIC office still can't punish a local branch for turning a blind eye to counterfeiting. Some foreign firms complain that within 30 minutes of lodging a complaint, their private eyes can watch counterfeiters removing all the goods from warehouses and factories. "Sometimes the AIC tips off the plants," says attorney Yen. "Now we say to the AIC, 'To help us with the raid tomorrow, we will pick you up, and, when you are in the car, we will tell you the place.' " Adds Kroll's Humphrey: "Entire villages live off counterfeiting. If you suddenly throw these people out of work, you'll have riots. It's like the argument over poppy farmers in Thailand. What will they do for a living?"

Given the stakes involved, antipiracy work can be treacherous. In the city of Shantou in Guangdong province, armed confrontations between the national police and pharmaceutical and tobacco counterfeiters are common. The business is "heavily protected by local authorities," says Kroll's Tsang. "We won't allow you [FORTUNE] to go. Even Chinese strangers who walk into Shantou get beaten up." After one raid, he adds, counterfeiters chopped off the foot of a police chief who had promised them protection.

In Shantung province in northern China one of Tsang's agents was punched and briefly held hostage in a fake Honda motorcycle factory after he was spotted taking photographs. And executives with Germany's Henkel firm have received death threats from a counterfeiter who is now a fugitive. "Death threats are a common form of retaliation in counterfeiting disputes," says Humphrey. Last year, during a Gillette-inspired raid in Hunan province, agents had to withdraw after being surrounded by locals. During a raid of a counterfeit spice factory in Pudong, police were attacked with steel clubs and knives. And nearly 100 screaming villagers and workers surrounded the raiders of a fake Barbie doll plant.

One of the most dangerous places is the island of Macao, which Portugal gladly handed back to China last year. The Macao flag features a lotus flower--for purity and integrity. In reality, the place is a gang-infested gambling haven, as well as a nucleus of Asia's fake CD-ROM manufacturing racket. Macao is so corrupt and violent that big investigative agencies like Kroll won't open branches there. "A lot of counterfeit CDs are done by triads [Asian crime societies] in Macao," says Humphrey. "Nobody dares touch them."

The reluctance of China's rulers to rock the boat is chillingly obvious in the city of Shenzhen, a one-hour train ride from downtown Hong Kong. A six-story, glass-enclosed building, Luo Hu Commercial City, sits defiantly at the border crossing. It is a monument to crime, a glistening Oz of fictional merchandise. Every day, 20,000 to 50,000 people (mostly day-trippers from Hong Kong) stream into the mall to buy cheap fakes in hundreds of shops and stalls--Hermes bags, Rolex watches, Fendi baguettes, Sony microphones. "It's hard to find a genuine article in the place," gripes Kroll's Holloway.

If a healthy Ronald Reagan were standing at the border today, he might be tempted to say, "Mr. Zemin, tear down this mall!" But Zemin is not Gorbachev, and China is a long way from Berlin. "In this district, the mall is the main source of income, taxes, and employment," concedes a senior official at the TSB, one of the enforcement units that regulates the mall. Adds the official, who agreed to a lunch interview on the condition he not be named: "If they're top-quality counterfeits, and they're not hurting the consumer, the government in China tends to take it easier on enforcement."

Luo Hu certainly has it easy. Since 1997, more than 300 shops in the mall have been raided, but most of the operators are back in action within a week, often under new business names. The mall's manager is not held accountable, nor are the various lease owners who rent out the units. Today the counterfeiters have developed an elaborate system of lookouts and security monitors to warn them when enforcers are on the way. The bulk of their goods are kept hidden in ceilings or in nearby unmarked warehouses. Last winter, a survey by luxury-goods maker Louis Vuitton found more than 100 shops at the mall selling Vuitton fakes. But a visit by government officials 11 days later--news of which leaked in advance--turned up only five such shops. In June, a memo from Beijing stressed that enforcement at Luo Hu "must be handled more strictly and quickly" in order to "enhance our international image" in light of the WTO drive.

It sounds good, but why not begin with Silk Alley, a massive counterfeiting market just ten steps from the U.S. Embassy in Beijing? "It's like China is doing this to the U.S.," says a private investigator, holding up his middle finger. Rather than bulldoze the place, the Chinese authorities have built a fancy entranceway. At Booth 35, Section Two, a jeans peddler with spiked hair explains that a 1,000-pair order of Levi's jeans (with "Made in the U.S.A." labels) will take 20 days and cost $10 apiece. The sand-washing is done in south China, he explains, while the pants and labels are made in Beijing. He wants a 30% cash deposit. At Booth 55, a bulk order of 5,000 pairs of fake Timberland boots can be had for less than $25 a pair but may take time because "the factory is very busy." Also available: Guess, Fila, Adidas, Nike, and Wrangler. Nearby, a Rolex faker named Huang Nan Mei promises 500 real gold watches from his Guangzhou factory at a price of just $300 apiece.

While Chinese officials are loath to wipe out an entire market, they sometimes act swiftly in individual cases. Last year executives from Adidas suspected that local officials in Fujian province whose assistance they had sought were corrupt. "When we weren't allowed in the factory with them, we were suspicious," says investigator Philip Curlewis, who runs his own agency in Hong Kong. "They went in and came out and said all was fine. The next day we returned with Beijing officials and had a very successful raid. We caught them totally off guard." Similarly, when Gillette conducted a raid with the TSB in July against 20 battery factories in the Chaoyang area of Guangdong, the company ran into resistance from the local police. In the end, a deputy police chief and the village head were dismissed.

The authorities act more forcefully when consumers are hurt. Last year, after dozens of people were blinded, and ten killed, by counterfeit rice wines, the factory owner was executed. (More than 1,000 people overall have been injured by such "wine," which is usually just coloring added to industrial alcohol.) According to official figures, cases involving "serious harm" from fake or inferior goods are growing at an 80% annual clip. They include dozens who are maimed or killed each year by exploding fake beer bottles. One phony Johnson & Johnson baby oil has been causing rashes. Sometimes fakes are responsible for serious harm overseas: In 1996 a counterfeit cough syrup, made in China and shipped through Germany, killed 88 children in.

Indeed, one of the most alarming trends in Chinese counterfeiting is the rapid rise in exports. Until the mid-1990s, foreign brand owners could stomach some fakes in China as an unofficial tax for doing business there--as long as the knockoffs stayed on the mainland. But now their overseas markets (and brand goodwill) are being chipped away. Last year Mattel broke up a counterfeiting ring that stretched from China to the Netherlands, and Oakley smashed a ring in South Africa, seizing 200,000 fake sunglasses, lens-cutting and frame-molding machines, and sample frames originating in China. Unilever says that fake Dove soap is making its way from China into Europe. Bose, a maker of high-end audio systems, is finding Chinese fakes in overseas markets. And in August, Brazilian authorities shredded 45,000 pairs of Nike sneakers--all fakes from China.

In the U.S., China is the leading country of origin for fakes confiscated by customs (30% of all seized imports). Since 1997, seizures have more than tripled in size. "There are zigzag routes, through three or four territories, for getting the goods into the U.S.," says Kroll's Humphrey. "It's a bit like money laundering." Indeed, when investigators seized seven million counterfeit CDs in 1998 at a Panama airport, they were shocked to trace them back to factories in China, as well as to a freight company in Florida. One of the ring's masterminds was a major courier for moving heroin from Hong Kong to New York. "He was using very similar routes and tactics with CDs," says Robert Youill, a music industry investigator who helped crack the case. Similarly, a new British intelligence report says that organized crime groups in Britain are raising money to finance drug deals through the burgeoning trade in counterfeit toys, clothing, and music, much of which arrives bythe container-load from China.

The simple reason for the explosion in counterfeits is the big money and low risk involved. A Chinese counterfeiter knows he'll get a slap on the wrist if caught, while a drug trafficker will get a bullet in the head. "There's so much money to be made, it's beyond your imagination," says Curlewis. "If you run a [fake] video CD production line, you can recoup a $1 million investment by the seventh month." A counterfeiter who invests 2 cents making a low-grade zinc battery can retail it as a high-grade, brand-name alkaline battery for 60 cents--a return of 2,900%.

Not surprisingly, the fakes are becoming more sophisticated. Ten years ago, China's knockoffs were not up to Western standards. Now, many fake Duracells look so genuine that Gillette has to send them to a forensics lab the firm recently opened in China. Buyers of fake Louis Vuitton purses at the Luo Hu mall sometimes bring them to the real Vuitton shops in Hong Kong for repairs, says Curlewis: "The Vuitton shops assume they're genuine and don't question it." As for watches, yesterday's fakes could be spotted by their flimsy weight; today they often contain full-sized Swiss movements and real gems. Even the transporting of fakes is getting cleverer. Last year, Hong Kong police intercepted a Chinese fishing boat entering their port from Macao--towing a submerged submarine vessel filled with hundreds of thousands of smuggled CDs.

Foreign corporations that fight back are doing it gingerly, ever wary of angering their Communist hosts. "Chinese officials tend to link economic issues in other areas to a willingness to enforce your intellectual-property rights," says an executive with a large European manufacturer, who requested anonymity. "You have to ask for favors all the time, rather than law enforcement being a self-acting drive. The moment there is a political hiccup, they use this as an excuse not to engage anymore in strict enforcement. It's like balancing on a rope."

A year ago a dozen companies--led by P&G, Gillette, and S.C. Johnson & Son--launched an association to lobby for tougher laws and better enforcement. At first the meetings resembled AA sessions, with participants only grudgingly admitting they had a real problem. It also didn't help that the initial sessions were held inside the U.S. Embassy in Beijing, causing some fear among the members that they would be viewed as agents for U.S. trade policy. Today, the group, the China Anti-Counterfeiting Coalition, distances itself from any government, and its membership has grown to 50 major foreign companies. But they're still waiting for one of China's top rulers to agree to see them.

Some firms are taking off the kid gloves. Last year Gillette hired ex-U.S. Army Special Forces expert Philip Yang to lead its anticounterfeiting crusade. Working almost nonstop from his base in Shanghai, Yang is approaching China like a war zone. He has divided the country into sections and given his soldiers quotas. At least 25% of Gillette's products in China are fake--from razorblades and Duracells to Parker pens--and Yang wants to cut that to 5%.

It's a bold goal, and nearly every foreign brand owner is rooting from the sidelines. Yang's raid results are certainly impressive: In the first half of this year, he seized 2.4 million batteries, 25 million blades, and 140,000 pens, nearly the total seized by Gillette in the past seven years combined. (He says most of those goods were bound for overseas markets.) But even Yang is exasperated. "The more we raid them, the more there are," he says. The situation is so bad that Yang often ignores the retailers, focusing on the "capture of the masterminds." Among them: state-owned foreign trade companies, which Yang calls the "lifelines of the Chinese export economy."

Yang estimates there are thousands of fake blade factories in China. Last year, he stumbled on tellers inside a bank wrapping counterfeit blades during their spare time. More recently, he discovered a prison camp in Guangzhou making blades for export. "How do I raid them?" he asks, his eyes bugging. Batteries are another nightmare. On the Internet, Yang found several outfits falsely advertising themselves as makers or suppliers of Duracells; one required a minimum order of a container-load. "Blank batteries are usually stored in warehouses, and then middlemen will take a million batteries and divide them among a dozen villages," says Yang. The batteries are labeled by families in the village, then collected and sent to another location for blister-plastic wrapping. "You need damn good intelligence," he adds. "It's a war, the worst we've ever seen. Counterfeiting is now a way of life in China."

P&G estimates that 20% of the company's products in China are fake, but that figure doubles for certain brands. The company has discovered line extensions that the firm doesn't even make--such as Safeguard shampoo and Head & Shoulders soap. "China is by far the single largest problem for us for counterfeits," says P&G's Dobson. "You could do raid actions every day and never get ahead of it."

Similarly, S.C. Johnson estimates that at least 20% of the spray products bearing its Raid and Pledge names in China are fake. It now takes a Chinese counterfeiter less than 90 days to copy a new aerosol product down to the holograms, says Frank Guerra, the firm's general manager in China. Over the past two years, Guerra has overseen 148 raids, and the situation, he says, keeps growing worse: "It's impossible to test a market in China without a counterfeit product preempting you."

In tobacco, the battle against fakes is clearly being lost. China is the world's largest producer of cigarettes (nearly two trillion per year), and as many as 200 billion of them are believed to be knockoffs. During the first half of this year, 1,500 cigarette production sites were closed down. More than 100 brands are being copied, up from 30 last year. There are more than 35 different types of fake Marlboros, many impossible to distinguish visually from the genuine. "We rarely see such obvious printing errors as 'Mane in America,' which were once common," says Philip Morris lawyer Fawlk. Cigarette-making machines are sometimes literally underground, inside mountains, or built on ships in order to be mobile. Some look like bomb shelters, their entrances hidden and controlled by computers or protected by armed guards. During a raid last year of one underground factory in Guangdong that was making phony Marlboros, agents had to use sledgehammers to get inside.

Despite all this, no major corporation has pulled out of China because of counterfeits. In one case, a flood of fake Lux soap decimated the real soap's market share so severely that its owner, Unilever, had to temporarily stop production in two plants. And sources claim that counterfeits have caused Henkel and Johnson & Johnson to close some production lines, but neither firm would talk to FORTUNE about it. "Many multinationals are shutting or shrinking some product lines in China because these products are overrun by counterfeits," says Kroll's Humphrey. "But some companies in this situation are too embarrassed to admit it." Unfortunately for them, until they step up to the plate--or quit China entirely--the nation's rulers may never take the problem seriously. And that isn't likely to happen anytime soon. "No one can seriously ignore the Chinese market," says Tan Loke-Khoon, an intellectual-property lawyer in Hong Kong. "With WTO in the wings, any boycott would be folly."

If its commitment to wipe out fakes were truly genuine, mainland China could learn a few things from Hong Kong, where authorities have been beefing up the laws and penalties. The former British colony has long been the world's center of music piracy, but customs officials insist there are now only 100 shops selling fake CDs--down from 1,000 a year ago. In 1999 officials seized a record 16.5 million disks, most of which were fed into a giant "crusher." All CD factories now have to register with customs, and agents can visit anytime without a warrant. As a result, many of Hong Kong's fakesters are moving their operations abroad. Last year one crime syndicate dismantled a Hong Kong CD factory and rebuilt it in Paraguay, staffed with Hong Kong engineers. A second syndicate, involving top financiers from Hong Kong, built a CD plant in the Philippines that was raided last June.

Hong Kong still has a long way to go. Its free port, one of the world's busiest, is a transit point for fake goods from China. (The cargo inspection rates run at a mere 3%.) Half the software in use in Hong Kong is believed to be pirated. And shopping for fakes is still fairly easy there, although it hardly compares with the motherland. At the 298 Computer Zone, three floors are chock full of counterfeit goods. Netscape and Microsoft Office 2000 software programs sell in one booth for $4 apiece (the latter normally retails for about $500 in Hong Kong). At another booth, a clerk insists the goods are genuine, even as two fellow clerks are busy stuffing CDs into empty sleeves. With a proposed racketeering statute still being debated, the shops can be raided but are rarely closed down. Moreover, while rental leases typically prevent "illegal" activities, Hong Kong's powerful landlord lobby has managed to dodge liability for knowingly renting to counterfeiters.

Even so, one can't escape the impression that Hong Kong is more serious about cracking down. During a recent visit, FORTUNE was invited to go along on raid No. 1959 of Operation Terminator, a special CD-enforcement unit set up by customs in 1999. Eighteen members of the unit, most of them in their 20s and 30s and dressed in blue jeans and black vests, assembled at a government office. One, nicknamed Rambo, is a hulk of a man who likes posing for photos with his gun in his holster. At 25, he had already been on 600 raids.

Rambo's squad conducts about ten raids a day, and this one at the Winner shopping arcade was routine. The group was largely silent during a long van ride across the city but sprang to life at the raid site. The four shops hit during the blitz were owned and protected by triads, according to Warren Lee, the officer in charge. Inside one, a 13-year-old girl was selling TV cam disks and Sony PlayStation games for $2.50 each. Her wages: $50 a day. It was her first arrest, she said; the customs agents let her call her parents.

The operator of a second shop, an 18-year-old boy selling fake Microsoft programs, had been employed only four days. He too was earning $50 a day, and it was his first arrest. He said his boss had promised him a $1,300 bonus in the event of a raid. He'll need the money: He got three months in prison. "We're containing the problem," boasts William Chow, a top Hong Kong customs official. "But it's much more complex in [mainland] China. There are many agencies. So everybody just pushes the problem around."

Will China get real? When the country's rulers decide to attack a problem, little stands in their way. Just look at the two-year-old crackdown on smuggling, which involves a special 10,000-strong police unit, numerous prison terms, and even executions. The anticounterfeiting movement would like to see a similar crackdown. After all, a recent study commissioned by Beijing concluded that the nation was "drowning" in fakes and that the $16 billion annual value of counterfeits had matched the traffic in goods smuggled across China's borders. But, as Chow explains, "smuggling is a direct offense against the state, while counterfeiting is against the brand owners."

Even more to the point, smuggling was ravaging China's economy. In the oil and steel sectors, the struggling state-owned enterprises were finding it impossible to compete. In addition, government corruption in smuggling had become a way of life by the 1990s, while Beijing's treasury was losing billions of dollars annually in unpaid duties. In contrast, some counterfeiters do pay taxes, particularly on the legitimate goods they produce in factories alongside fakes. And many wholesale markets agree in advance on a fixed tax rate. "China has a lot of problems and limited resources," says Chow. "If you have a serious crackdown on counterfeiting, there's going to be serious social turmoil and costs to the central government. I don't think the government wants to incur those costs unless it has to."

For the time being, nobody is forcing China's hand. Membership in the WTO requires compliance with an international intellectual-property agreement known as TRIPS, which, in turn, requires "effective" sanctions and the criminal enforcement of "willful" counterfeiting. But the WTO rules in this area are as vague as China's, and trade leaders are not spelling out exactly what Beijing needs to do to comply. As a result, endless raids and "destruction parties" are all China has to offer.

That much was crystal clear on a humid afternoon in July, when more than 11,000 watches were dumped onto an empty lot in Guangzhou, in southern China. The condemned wore faces that had led to their capture: Citizen, Seiko. As a patriotic red banner flew overhead, police shooed away peasants trying to salvage a few of the fakes. A Casio executive, sweating in his business suit, scooped up one of the impostors, shook his head, and chuckled softly before tossing it back onto the pile. After several engine sputters, a yellow steamroller lurched forward, crushing the watches into mangled shards. But a few of the flattened timepieces began beeping incessantly--as if reminding everyone that their creators would soon be back in business.

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