Sources within Microsoft and at development studios which have been briefed about the Xbox 2 specification have previously indicated that the company is seriously considering dropping the hard drive from the console in favour of high capacity solid state memory devices.
The deal with M-Systems fits perfectly with these reports, as it would suggest that an extremely large removable flash memory unit would replace the hard drive. Flash units of up to 512mb - half a gigabyte - are already commonplace in pen and keyring devices, and it's possible that Microsoft could aim for an even larger unit for the Xbox 2 memory system.
Such a unit would be large enough to store hundreds, possibly thousands of save games, and even small-scale downloadable content such as new skins or models for multiplayer titles. However, the console would probably lose the ability to rip music CDs and run custom soundtracks - although Microsoft would probably prefer that you do that by playing music on your Xbox over a network link with a Windows XP Media Centre enabled PC anyway.
Microsoft will save significant amounts of money on the production cost of Xbox 2 by not including a hard drive, as well as allowing the case for the unit to be smaller and opening up a potential revenue stream from sales of flash memory units. The company will also be hoping that the lack of a hard drive will make Xbox 2 less attractive to hackers than its predecessor - whose hard drive has made it into a prime target for hackers who have turned the console into everything from a functional Linux system to a home media player, as well as enabling easy piracy of Xbox game titles.