Tesla’s big gamble in China

FORTUNE — The salesman in Tesla’s only showroom in mainland China (or what the company likes to call “experience center”) says the rich people who travel from all over the country to see the gleaming Model S react the same way when they hear the $118,000 price tag: “Wow.”

As in: Wow!  That’s cheap.

This is the opportunity Tesla Motors (TSLA) hopes to capitalize on when its executives says China will become its largest market in just a couple years. It’s why the company plans to open stores in a dozen other cities by the end of 2014 and invest hundreds of millions of dollars in the country. In fact, China is the driving force behind Tesla’s goal of boosting Model S sales by 56% this year.

Even with a 25% import fee and value-added taxes pushing the cost to about $118,000 in China, from $71,000 in the U.S., the car isn’t considered super-expensive. That’s in part because other car brands are subject to the same levies. And so BMW’s X5 SUV, for example, costs much more than a Tesla in China despite selling for less than one in the U.S.

The real promise for Tesla in China is if it can build cars here. Not only would it bypass the hefty import duty, but its customers would become eligible for local governments’ electric vehicle tax credits, an incentive not offered for foreign-built autos. In a visit to Beijing last month, Tesla’s founder Elon Musk laid out both the promise and potential pitfalls for Tesla when he said the company would seek to manufacture cars in China in three to four years.

The dream scenario is that Tesla builds cars, everybody buys them, the central government is happy that more people are driving electric, and Tesla is championed for decades.

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But in reality, Musk’s ambition will face many hurdles.  Foreign companies typically find that building their own stuff in China is never easy. They’re forced to partner with a local Chinese company, which often wants to get its hands on the outsider’s technology. In a joint venture, political power often trumps controlling stakes. Furthermore, China is a country with deep-seated suspicions of foreigners.

“Time after time, when foreign companies have come here with huge ambitions and a short timeline in obtaining them, it doesn’t work out” says James McGregor, an expert on foreign businesses in China and author of One Billion Customers: Lessons from the Front Lines of Doing Business in China.

Tesla faces two gigantic hurdles in China. The first is setting up a joint venture with a domestic company to build cars. Tesla’s goals will likely be very different from its Chinese partner’s. China released a long report in 2006 called “The National Medium- and Long-Term Program for the Development of Science and Technology 2006-2020” that outlines the country’s plan to develop “indigenous innovation” and make China a technological powerhouse by 2020. One key way it plans to match Western technology: absorbing and tweaking that same foreign technology.

As McGregor wrote in a 2010 paper on the report, “The plan is considered by many international technology companies to be a blueprint for technology theft on a scale the world has never seen before.”

You can imagine a scenario where Chinese companies start emulating Tesla’s battery innovations and then sell their vehicles for much less than Tesla’s sticker price. Tesla would likely have little recourse.

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The second hurdle Tesla faces is building a charging network in China with state-owned power companies. It wasn’t an accident that Musk dropped the names of two of China’s biggest power companies when he was talking about potential partners. But again, China is unlikely to share Tesla’s exact interests in building charging stations. What happens when priority is given to domestic electric automakers? How many hundreds of millions is Tesla willing to risk in China?

“This is likely to be much much harder, and take a lot longer, than he expects,” says McGregor, of Musk. “Does he have the management capacity, the patience, and the capital to handle that? That’s a question he should be asking himself.”

It should be no surprise that China is welcoming Tesla with open arms. On his trip to the country, Musk met with top government level officials and local Shanghai politicians—a big reception for a relatively small player in the global automotive scene.  The meetings happened in part because China clearly needs electric cars and it’s woefully behind its goal of putting 5 million on the road by 2020. In Beijing’s latest lottery round for license plates, the number of applicants for electric vehicles didn’t even meet the limit while regular gasoline plates were oversubscribed by 90 to 1.

Tesla is pretty straightforward about the wall of challenges it faces. “As much as everyone is hoping we’d disclose negotiations with governments, potential joint ventures, where we’re building supercharging stations, the key thing for us is that we’re working on it,” says Peggy Yang, Tesla’s spokesperson in China. “ I don’t have very concrete plans to lay down to say by June we’ll have this, by July we’ll have this.”

It’s unfair to focus only on Tesla’s challenges. Musk faced almost as many in the U.S. before Tesla came out with its first model, and again before building a charging network. But building goods in China creates unique headaches, even for a company as daring and successful as Tesla.

Back in the Beijing showroom, the salesperson is explaining the Model S’s aerodynamic door handles, which retract to reduce drag. He touches the driver’s side handle to extend it. Nothing happens. “Okay, not working,” he grins. He tries again and it slides out.

It may have been the smallest problem Tesla ever faces in China.

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