Facebook’s China problem

September 10, 2012, 9:00 AM UTC

FORTUNE — Last May when Mark Zuckerberg wed his Chinese-American girlfriend, Priscilla Chan, a joke began to make the rounds on China’s version of Twitter, a microblog — or weibo — run by the Internet portal Sina. It went something like this: Chan brings Zuck to meet her extended family in Shanghai. “What do you do?” they ask him.

“I run the most popular website in the world,” he responds. So they plug “Facebook” into a browser, and nothing pops up.

 “You’re a fraud! This Facebook doesn’t exist!” they reply.

It’s hilarious to everyone except Facebook (FB). The company’s stated mission is to connect the entire world, but it can’t reach a third of the globe’s population. The Chinese government has blocked its citizens’ access to the site since 2009. That’s 513 million Chinese Internet users (more than twice the number of wired Americans), who make up an increasingly powerful consumer block. And they’re passionate social networkers. They spend 46 minutes a day visiting social-media sites, according to a recent McKinsey study, compared with just 37 minutes in the U.S.

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Zuckerberg has said publicly that the company has no immediate plans to enter China. “There are so many other places in the world where we can connect more people more easily,” he told Charlie Rose in a February interview. “A simple rule in business is, if you do the things that are easier first, then you can actually make a lot of progress.” That may be so, but the global social-networking market is consolidating rapidly. The longer Facebook waits to hammer out a China strategy, the more difficult it will become to break into it. And since Facebook’s May IPO, the company’s stock has lost half its value as users jump to mobile devices, where the Facebook app has been clunky and there are fewer advertising opportunities. The company recently overhauled its primary app, but it needs to find new areas for sizable growth.

An ad for Sina Weibo at a Chinese tech conference

Rumors of Facebook’s efforts in China abound. Zuckerberg started learning to speak Chinese in 2010, after all, and Chinese paparazzi snapped photos of him wandering through Shanghai (and ducking into the Apple (AAPL) Store on Nanjing Road) in May. Last year there was gossip that Facebook was contemplating a partnership with the Chinese search engine Baidu (BIDU), but a public deal never came to fruition. (Baidu and Facebook declined to comment.) So in June I traveled to Beijing to understand exactly what the social giant was up against. I found a government increasingly fearful of social media and a plethora of homegrown competitors with thriving business models. And though most people I met there know about Zuckerberg — they’ve seen
The Social Network
— only a handful of expats and techies with virtual private networks have Facebook accounts. As a local university student told me, “Most people I know have never been on it.”

Facebook’s most immediate hurdle in China is a communist government that limits free speech and allows officials access to company data. In return for a license to operate, Chinese companies are required to employ censors at their own expense. It’s a stipulation other American consumer Internet companies face as well. Google (GOOG) pulled its search engine out of China altogether in 2010 over concerns about censorship. Given Facebook’s high-profile role in mobilizing people and facilitating protests, such as those that helped topple the Egyptian government in 2011, it seems unlikely that the Chinese government would be interested in granting Facebook a license to operate locally.

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Even if Zuckerberg did obtain permission to do business in China, there’s no guarantee consumers would sign up. The local market is dominated by competitors with diversified business models, like Sina (SINA) and Tencent, whose stocks are rising. On top of that, Beijing has a robust startup scene where entrepreneurs are turning out mobile applications and other digital products. I met one of its key players, Kai-Fu Li, for breakfast at the Opposite House, a modernist boutique hotel frequented by the tech investor crowd. The Taiwanese American was the founding president of Google China and now runs an early-stage Beijing venture capital fund and incubator called Innovation Works. “I thought Facebook’s window closed here a year and a half ago,” Li told me. He had met with Zuckerberg during a 2011 visit to Facebook headquarters. “It’s a lot more difficult now,” he says.

A man in Chengdu in front of a digital screen streaming live Sina Weibo content.

The most popular and influential of China’s social media services is Sina’s Weibo — a mashup of Twitter and Facebook that makes money selling marketing services to business customers and offering paid memberships to individual VIPs. Revenue last year topped $480 million. Like Twitter, it invites users to post 140-character messages (140 characters communicate a lot more in Mandarin than in English); users can include images and video and comment directly on posts. With an educated, urban audience of 368 million, Sina Weibo has become the top platform for breaking news and adding editorial commentary; a mouthpiece for celebrities; and an increasingly important venue for advertisers. When Wal-Mart-backed (WMT) retailer 360buy.com decided to drop prices on big home appliances by 10%, the CEO first announced it in a Weibo post.

Sina’s biggest competitor is Internet conglomerate Tencent, which got its start as an instant-messaging service in 1998. That platform, called QQ, today boasts 784 million accounts and helps Tencent attract users for its other services, such as Tencent Weibo, which has some 469 million users. Because of its scale, Tencent can attract large audiences quickly, mostly of gamers and younger users often coming from smaller cities and rural areas. Tencent also offers the country’s largest straight-up Facebook clone, a social-networking service called Qzone that is especially popular among teens, who post photos and videos, keep journal entries, and play games on it. All those games and posts add up: Tencent last year reported $4.5 billion in revenue, 22% more than Facebook’s 2011 revenues.

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There are also dozens of smaller social-networking services that allow China’s surfers to game, chat, post, and share videos and photos. There’s Renren, which, like Facebook, began as a social-networking site for university students. Though it has opened up to a general audience, Renren has remained mostly students, with 140 million registered users. Internet company Sohu also has an entertainment-focused weibo, with 80 million users. And with 10 million users, location-based flirting app Momo may be small, but it’s adding a million users a month — a growth rate that just landed it $40 million in funding.

These companies are successful because they have designed products that are culturally relevant for a Chinese audience, but also because they have become experts at navigating an ever-changing relationship with the government. As the services grow more popular, attempts to censor them grow more aggressive. Starting last March, the Chinese government began to require any user posting on a social-networking account to register using a real name. The mandate, which had an immediate dampening effect on Sina’s weibo traffic, has been poorly enforced so far. But in May, Sina introduced an attempt at self-policing: an 80-point demerit system invites users to report each other for inappropriate posts.

A dynamic map showing the location of users of Tencent QQ, an instant-messaging service

New leadership will come into power this fall. Most people believe that Facebook’s executives are waiting until after the government changeover to reopen conversations about a China strategy in hopes that new leaders may have a more relaxed attitude toward social-networking services. But as Zuckerberg waits, his Chinese counterparts are contemplating their own global strategies. Social networking’s next competitive frontier will be the mobile platform. At the start of 2011, Tencent launched mobile group messaging service Weixin, and it already has more than 100 million users. This year the company offered support for the service in English; it’s available in the App Store as WeChat.

Back home in New York City, I recently gave the location-based service a test drive on my iPhone while sitting in a suite in a midtown Sheraton. The design was serviceable — nothing special — but while I was playing around with the tool, which lets you see where other users are, I discovered 30 other people using it within the hotel. Tencent doesn’t plan a broad U.S. rollout, but it’s conceivable that the Internet behemoth could eventually compete with Facebook on its own turf. Perhaps Facebook’s real problem isn’t getting into China, but keeping Chinese social media at bay.

This story is from the September 24, 2012 issue of Fortune.