China's Telecom Market: Slow Train to Maturity

China's telecom service market roughly matched the country's
GDP growth at 11% to reach RMB648 bn ($85 bn) in 2006. Growth was driven
primarily by mobile and data communications. The leading mobile operator China
Mobile strengthened its dominant position, accounting for 45% of the total
telecom service revenues in 2006, while the two fixed line operators, China
Telecom and China Netcom, have been suffering from a growing mobile-fixed
substitution.

Mobile-fixed substitution accelerated in Q1 '07 with China
Mobile further strengthening its dominant position. It reported 19.5% revenue
growth. China Unicom, the other mobile carrier, reported just about 4.2% revenue
growth as it continued to lose market share to China Mobile. China Telecom and
Netcom have reported substantially lower growth in revenues at 2.2% and 0.2%,
respectively as a result of a flat subscriber growth, as well as declining local
voice traffic.

3G continues to be a focal point of the industry as the two
fixed line carriers are expecting to enter into the mobile market via 3G
licensing and industry restructuring. BDA believes that the delays in getting
the domestic 3G standard TD-SCDMA ready for prime time will continue to push
back the issuance of 3G licenses for all the three kinds of 3G technologies. BDA
also believes that 3G licensing will be further delayed until late 2008 or early
2009.

Major political events could also contribute to the delay. For
instance, an upcoming leadership reshuffle may slow down decision-making on
industry restructuring and 3G licensing issues. The Communist Party of China
(CPC) will hold its 17th National Congress (NCCPC) in September 2007. It could,
in fact, be October according to some sources even the date seems to be
classified as a state secret). This will be followed by another acronym-laden
event-the National People's Congress (NPC), six months later, in March 2008.
Any changes at the top echelon of the party leadership at the NCCPC must be
ratified by the NPC in March and reflected by a corresponding reshuffle in the
Cabinet. Regardless of the scope of any eventual changes, uncertainty and
speculation ahead of the NCCPC is bound to generate caution and consequently
have a slow-down effect on the workings of the government.

Rural Market is Key

China's mobile market is a duopoly of two mobile carriers: China Mobile
and China Unicom. Net subscriber additions remain robust at 5 to 6 mn per month.
China Mobile had 316.1 mn mobile subscriptions till March 2007, accounting for
68% of the total market. China Unicom operates both GSM and CDMA networks with
109.2 mn GSM and 37.7 mn CDMA subscriptions. Unicom is likely to spin off its
CDMA assets and sell to China Telecom in the long-expected industry
restructuring, likely to happen in 2008.

Benefiting from the delay in 3G, China Mobile continues to gain
share from Unicom accounting for 80% of the incremental market in Q1 '07.
China Mobile has aggressively implemented Calling-party-pays (CPP) and cut
roaming charges to land-grab subscribers ahead of 3G licensing. This coupled
with the entrance of more players will create more competition in the wireless
market.

Driven by low penetration in the rural market as well as
increasing competition, the mobile market will maintain strong growth with a
CAGR of 8% over the next five years. BDA forecasts China's mobile subscribers
to reach 526 mn by 2007, and 784 mn by 2011. (See Exhibit)

As a result of extremely low mobile penetration in rural areas,
subscriber growth in rural markets will be the key driver for growth. Declining
handset prices as well as reduced tariff charges have already reduced the entry
barrier for potential subscribers. China Mobile claims that over 50% of new
subscribers in 2006 have been from rural areas. BDA believes this trend will
continue over the next few years.

Without access to mobile licenses, China Telecom and China
Netcom have been offering a fixed wireless local loop service called PHS and
have accumulated 91 mn subscribers in 2006. However, as mobile operators are
offering CPP, cheaper tariffs as well as more attractive value added services,
PHS is losing traction. BDA forecasts PHS subscribers will decline in 2007 when
mobile tariffs further decrease, causing the user base to shrink from 91 mn in
2006 to 3 mn by 2011.

The two fixed line operators have substantially cut down
investment into PHS to save capital for broadband and future 2G/3G networks.

VAS on the Fast Track

Mobile operators in China have been aggressively promoting Wireless Value
Added Services (WVAS) to offset the decline in voice-based ARPU. WVAS accounted
for 23.5% of China Mobile's ARPU in 2006, effectively helping the carrier to
stabilize its overall ARPU.

BDA estimates China's WVAS market to be $9.6 bn in 2006, and
expects the market to reach $34.5 bn in 2011, that translates into a five-year
CAGR of 29%. (See Exhibit 3)

SMS and Color Ring Back Tones (CRBT) are the two most popular
WVAS services in China. They currently constitute the major revenue sources for
service providers, but we believe the market will shift from basic SMS to faster
and more interactive applications such as WAP and Java. CRBT saw the most rapid
revenue growth in 2006, driven mainly by promotions. We believe the growth of
CRBT will begin to slow down in H2 '07 as its penetration reaches saturation.

Operators' expanding EDGE network and future commercial 3G
services will address the data transmission speed issue and enable operators to
offer more WVAS offerings.

Improvements in both terminals and networks will create huge
potential opportunities for interactive WVAS applications in China. Mobile
operators are aggressively promoting new applications such as 2D barcode, mobile
search, and mobile IM as the next growth drivers.

Mobile is Making Music

With the success of CRBT and ringtone services, mobile music has become a
key driver in China's WVAS market. BDA forecasts the market will reach $1.4 bn
in 2006 and $2.8 bn in 2011, translating into a five-year CAGR of 14%. Mobile
music, which mainly includes CRBT and ringtones, currently contributes to the
largest share of revenues from non-SMS WVAS applications. Mobile operators have
adopted music as their core WVAS business.

Currently, mobile music market growth is largely driven by CRBT
services. As CRBT growth momentum starts to slow, full-track music download will
become a new driver once commercial 3G is available.

China Mobile established its mobile music portal, 12530.com, in
June 2005. China Mobile launched M.Music Club on July 18, 2006 in cooperation
with CPs (including EMI, Warner, Sony-BMG and Universal), SPs and handset
vendors. China Mobile plans to grab more share from the mobile music pie by
sourcing content directly from the CPs.

China Unicom has formulated a music strategy similar to that of
China Mobile. After having launched its mobile music portal www.10155.com, it is
now constructing its central music platform. China Unicom is increasing direct
cooperation with music CPs, and has already signed contracts with Warner Music
and Global Music International on content sourcing.

Long-term Growth

WAP is central platform for operators seeking to develop their wireless Internet
related businesses. The WAP market totalled $1.2 bn in 2006 and will continue to
grow rapidly, reaching $7.2 bn in 2011, at a 5 year CAGR of 43%.

Increasing penetration of WAP-enabled handsets and declining WAP
traffic tariffs will pave the way for future development of WAP business.

In 2005, mobile operators launched monthly flat traffic fee
packages for unlimited GPRS or CDMA 1x usage in most provincial markets.

Operator promotion is a key driver in China's WAP market. Free
WAP portals are gaining popularity. Free WAP portals such as 3g.net.cn and
Kong.net are becoming key services, driving WAP usage. Free WAP portals'
collective traffic exceeded that of China Mobile's Monternet WAP portal in H2
'05.

The improvement of network data transmission speed with the
deployment of 3G will boost service growth. Faster data transmission rates will
enable more advanced services and encourage the use of WAP. Currently, picture
and ringtone downloads, together contribute to 60% of the WAP revenues. BDA
believes that going forward mobile commerce will further drive WAP usage.

Mobile TV: Yet to Arrive

Regulatory barriers for telecom-media convergence and the lack of broadcast
mobile TV technology standards are key issues deterring mobile TV development in
China. BDA believes China's mobile TV market will not take off before 2009 due
to uncertainties in mobile TV standards selection and 3G rollout.

China will develop home-grown broadcast mobile TV technologies
for its mobile TV services, following the government's efforts to cultivate
innovation and develop proprietary industry standards. However, the MII and the
State Administration of Radio, Film and Television (SARFT) are struggling to
develop their individual visions for mobile TV.

SARFT is developing a broadcast mobile TV standard for handheld
terminals, China Mobile Multimedia Broadcasting (CMMB), and is targeting a
commercial launch by 2008.

Mobile operators will be key players for mobile TV services as
they control billing and have strong marketing capabilities. In addition, CMMB
largely depends on mobile networks for data uplink.

SARFT is unlikely to be able to deliver mature CMMB service on
time without the close cooperation of mobile operators in technology development
and service promotion. SARFT aims to introduce CMMB-enabled terminals in H2 '07
and commence commercial services by H1 '08. China Mobile will primarily focus
on promoting mobile TV based on 3G streaming technology.

POTS Down, VoIP Up

With cheaper mobile tariffs and growing demand for mobility, consumers are
opting for mobile phones over PSTN. The annual additions of POTS subscribers in
China also declined from 24 mn in 2003 to 12 mn in 2006. BDA forecasts the
number of POTS subscribers will drop by 20 mn to 276 mn in 2011 (See Exhibit 4).

Furthermore, VoIP has been eroding POTS long-distance voice
service, provided by carriers and emerging companies, over the internet. BDA
forecasts VoIP will account for 77% of the long-distance voice market by 2011,
up from 46% in 2004.

Carriers are providing VoIP through soft-switch and media
gateways for long-distance voice. Emerging companies providing broadband VoIP
over internet, such as Skype, are taking off in China. There are over a hundred
small companies providing broadband VoIP in China. However, due to regulatory
obstacles in the country, they are experiencing difficulties in scaling up their
businesses.

The Bright Spots

China's internet users totaled 137 mn in 2006, just behind the US. As per
BDA forecasts, Internet users will reach 239 mn by 2011 with a 5-year CAGR of
11.7%. (See Exhibit 5)

Even with 210 mn Internet user's penetration in China was
still low at 10.5% in 2006, compared to around 70% in the US.

Desktop and laptop sales in China remain strong. BDA forecasts
total sales of desktop and laptop to continue to increase, hitting 16-18 mn per
year by 2011, up from 12.5 mn in 2004 and 14.9 mn in 2006.

BDA estimates 75% of the new PCs, purchased between 2003 and
2005, to have been connected to the Internet, and we expect this will increase
to 94% by 2011.

The broadband market will also see continued development in the
next 5 years, driven by surging Internet growth and carriers' promotions. BDA
believes broadband subscribers will reach 128.3 mn by 2011, with a 5-year CAGR
of 19%. (See Exhibit 6)

In 2006, there were 14.5 mn new broadband subscribers in China,
a record high since 2003. Broadband has become the mainstream Internet access
technology in China, accounting for 68% of the user base in 2006. Carriers are
also cutting prices and upgrading network infrastructure, as well as introducing
time-based charging schemes for low-usage subscribers.

ADSL has been gaining share since 2004 due to promotions,
accounting for 68.1% of total broadband users. BDA believes ADSL will continue
to maintain the majority share over the next 5 years, thanks to ADSL2+'s
higher bandwidth and low cost.

ADSL2+ can achieve a speed as high as 24 Mpbs and 512 Kbps to
users as far as 5 km away. ADSL2+ accounted for over 50% of DSLAM shipments in
2006, and is expected to make up 90% in 2007.

For most current IPTV trials, ADSL2+ is the major type of
broadband access. The cost of ADSL2+ has dropped to RMB250 per line, similar to
ADSL's price. ADSL2+ can also help fixed-line operators retain PHS users by
utilizing existing copper lines.

Challenges for IPTV

The IPTV market in 2006 saw slowing progress in terms of trials, user base
and IPTV licenses. Commercial IPTV service and trial users totaled 0.6 mn in
2006, up from 0.2 mn in 2005. BDA estimates IPTV services were offered in about
twenty cities nationwide, up from less than ten cities in 2005.

China's IPTV users growth trebled in 2006, to a total of 0.6
mn subscribers, translating into a penetration rate of 1% among China's 54.6
mn broadband users.

China Netcom had 144,500 users at year end 2006, up from 48,000
in 2005. China Telecom reported 190,000 subscribers, with 128,000 from Shanghai.

Hangzhou. Huashu, a JV between local cable operators and China
Netcom, had 100,000 IPTV users

However, BDA believes IPTV user growth will continue at a
moderate pace in 2007 due to regulatory barriers and carrier concerns over
technology standards and business models, as well as growing competition from
DTV services. BDA forecasts users to increase to 1.3 mn by 2007 and 9.7 mn by
2011 that translates to 2% and 8% of broadband users respectively in those
years.

We believe that IPTV subscriber growth in 2007 will be
concentrated in twelve cities, where local governments have given a green light
to commercial IPTV services, notably in Shanghai, provided by China Telecom, and
Harbin (China Netcom).

The regulatory environment will remain restrictive over the next
couple of years as China has yet to achieve regulatory convergence of telecoms
and media. We believe this situation will not change until China promulgates a
Telecom Law. Meanwhile, IPTV will continue to face other obstacles such as the
lack of attractive content, and competition from DTV.

Furthermore, the adoption of domestic coding standard-AVS
(Audio Video coding Standard)-by China Netcom will further push things off as
carriers are forced to wait for the domestic standard to mature. Both China
Telecom and China Netcom will test new applications and AVS in the next few
years.

Dongming Zhang,
research director, BDA, Beijing