(FORTUNE Magazine) – Half a century ago Shanghai was East Asia's undisputed hub of finance. These days the city once hailed as the Paris of the Orient is straining to reclaim its glorious past--and succeeding by many measures. A decade of frenetic development, sparked by China's economic reforms, has lifted Shanghai to the No. 1 spot among potential new overseas sites for big U.S. corporations, according to a recent study from Cushman & Wakefield. But Shanghai aims to greet the 21st century as far more than just another Pac Rim boomtown: It wants to be nothing less than a global financial capital, in the same league as Hong Kong, Singapore, and Tokyo.

Fat chance. True, local civic leaders and Beijing's central planners are spending roughly $30 billion on the physical infrastructure a world-class financial center requires. Yet ideologically China remains mired in the muck of "market socialism"--no longer Maoist or Marxist or even communist, but still not ready to surrender to the forces of free-market capitalism. The result: Despite Shanghai's global aspirations and boundless potential, its financial scene is proving a bust for investors.

Trading on the Shanghai stock exchange, which reopened with much hoopla five years ago, has failed to generate anything like the level of investment Communist Party officials hoped for. Smart domestic players aren't about to invest heavily in the doggy companies that get listed on the A-share market, which is open only to Chinese nationals. Lacking rudimentary financial information and research, investors who do take a flier on A shares bet mostly on rumor--and more often than not get burned in what has become an extraordinarily volatile market. Says a professor at Shanghai's Fudan University: "There are bull markets and there are bear markets, but Shanghai is a monkey market, because it jumps up and down."

Things are equally dismal among the 38 dollar-denominated B shares, the only kind foreign investors can buy. Most are trading below the prices of their initial public offerings, with a daily volume that's usually under $4 million. To be sure, foreigners see plenty of opportunities in China--just not in the stock market. After five years the total market capitalization of the B shares is a mere $1.4 billion, less than 4% of the $38 billion in foreign direct investment that poured into China in 1995. To put things in perspective, the total capitalization of the Hong Kong market, where about 20 Chinese companies have met stringent requirements for listing, is $350 billion. Even adding in the larger market for A shares, Shanghai and its smaller cousin Shenzen together boast a capitalization of just $60 billion.

That other pillar of a healthy capital market, banking, is no more solid. Chinese banks remain crippled by the state's credit quota system, which has required them to funnel "capital" blindly to state-owned enterprises--loans as a form of backdoor subsidy. A legion of foreign banks have been licensed to set up branches in Shanghai, including the U.S. giants Citibank and Bank of America, but they are still waiting anxiously for permission to do business in local currency. Everyone drools over the $480 billion in deposits that prodigious Chinese savers have parked in bank accounts. But it's not clear how much of those nest eggs really exists. "A big percentage of this money isn't there, because it was loaned to the state-owned enterprises," says the Fudan University professor, who prefers not to be named. "China has a huge bad- debt problem, and nobody really knows what the bottom line is."

The most potent symbol of China's current impasse can be found in Pudong, on the east bank of the Huangpu River, where real estate speculation has frothed around an area designated as the Lujiazui Finance and Trade Zone. From the Bund, the west bank of the river that is lined with architectural treasures from Shanghai's financial heyday in the 1930s, one can see the hazy dust cloud of a sprawling construction site. Rising hideously above it is the new Shanghai Oriental East Pearl TV & Radio Tower, whose lavender orbs impaled on ferroconcrete skewers have been adopted as the city's futuristic icon. Just north stands a gleaming and seemingly empty tower belonging to the state-owned Industrial & Commercial Bank. Nearby, Japan's Yaohan International Group has erected Asia's largest shopping mall, and other Japanese investors plan the world's tallest skyscraper. Foreign investors have so far committed more than $2 billion to some 80 projects in the wider Pudong area, reports the local government newspaper, the Shanghai Star.

Problem is, not many foreigners are moving into this centrally planned Wall Street. Pudong has the aura of a Potemkin village, reminiscent of the grandiose false fronts once slapped up to impress Russia's Catherine the Great. Vacancy rates run as high as 50%, by official reckoning--much higher according to unofficial sources--for the more than seven million square feet of new commercial floor space in the redevelopment zone. More than five million square feet of additional floor space is expected to come onstream annually over the next several years. Despite leases that are available for about half the cost of offices in comparable buildings in western Shanghai, Pudong remains a veritable ghost town. In any other global capital this would be a major real estate bubble waiting to pop. But Pudong is being built primarily with funds from state-owned enterprises, which answer to a different set of expectations. "Financial disasters in China don't look the same, because nobody uses their own money," says a veteran foreign banker in Shanghai. "It's not opium, but it has the same effect on people."

Foreign financial institutions aren't exactly getting shanghaied into Lujiazui; they're getting coaxed with carrot-and-stick incentives. Authorities at the People's Bank of China, the nation's central bank, have teased the 40 foreign banks holding branch status (and another 120 with rep offices) by suggesting that priority for permission to conduct lucrative local-currency transactions will go to banks moving a chunk of their operations to Pudong. The implication is that those who don't will be left on the sidelines fighting for diminishing margins in the market for foreign-currency financing.

One who is upbeat about Pudong's prospects is C.P. Cheng, Citibank's top executive in China. "The competition is getting fierce, but the pie is already getting larger," he says, adding that he hopes to open a Citibank subbranch in Lujiazui this year. "If you're looking 20 years down the road, with the assumption that nothing bad happens politically, I think Pudong will be thriving,'' says a Western diplomat in Shanghai. "Of course, from the point of view of investors, that's a long wait."

Foreign brokers will have less incentive than banks do to move across the river later this year, when the stock exchange swaps its temporary home on the Bund for new digs in Pudong. Foreign securities firms have been allowed to purchase seats on the stock exchange and set up offices in Shanghai to conduct research, but they can't trade locally. Foreigners exploit their "seats" on the exchange by buying and selling B shares over telephone lines from their offices in Hong Kong.

The market may yet stir to life this year as interest rates come down, say observers like Hoong Yik Luen, the local research analyst for J.M. Sassoon & Co. And Beijing's decision in late June to make it easier to convert local currency into foreign exchange could alter the dynamics of capital markets and even speed the hoped-for merger of the B- and A-share markets.

Still, Shanghai is not the place to wager any part of your retirement fund. Analysts sigh when they recall that cash raised in some of the earlier listings was used by state-owned companies for real estate speculation rather than restructuring. Last year a bond futures trading scandal ruined one of China's top brokerages. To clean house, authorities in Beijing sacked the charismatic young president who had expanded the exchange aggressively, Wei Wenyuan, and gave greater authority to enforce securities regulations to the state's China Securities Regulatory Commission. Unfortunately, no one is quite sure what the regulations are. Draft legislation for a new securities and exchange law has been held up in the National People's Congress for several years.

Shanghai won't really take off as a financial center until there is a fundamental change in attitude among its Communist Party bosses. And that doesn't appear likely anytime soon. "No matter how rapidly Shanghai grows, it will still practice socialism," Lu Ping, China's director of Hong Kong and Macau affairs, recently promised. By contrast, he added, "Hong Kong will maintain the capitalist system."

It's not hard to understand where such reluctance stems from. This observer was accosted near the stately People's Bank of China building in Pudong by a gang of begging street urchins, who had to be pried off the legs of the hapless visitor, one by one. A guide from the city's foreign affairs office was aghast: "This kind of thing never used to happen in Shanghai." Migrants from the impoverished rural hinterlands are already pouring into the rich coastal cities. Now imagine the massive layoffs that would be unleashed in the state industrial sector if true financial reform was enacted, and you begin to see why the cadres in Beijing are ambivalent about changing too much too fast.

REPORTER ASSOCIATE Ed Brown