(FORTUNE Magazine) – Take a stroll along the crowded, bustling streets of Hong Kong today, and you can't help getting caught up in the buzz of a place rushing toward its rendezvous with history. Workers perched on bamboo scaffolding are toiling around the clock to finish a series of grand building projects, from the giant new Chek Lap Kok airport to the convention center where Britain will officially hand its colony over to China at midnight on June 30 in a globally televised extravaganza. Alex Au, chief executive of Hang Seng Bank, speaks for many local people when he says: "I'm excited as a Chinese about Hong Kong returning to China."

Yet probe a little deeper and these same Hong Kongers betray a gnawing anxiety. They have already watched their new masters' efforts to roll back their personal freedoms, such as the right to stage demonstrations and to form political parties without asking permission. While two-thirds of the people in Hong Kong say they are "happy" about the handover, according to recent opinion polls, a local government poll last month showed that more people worry about the territory's political future under Chinese rule than about any other problem during the next five years.

Such ambivalence is understandable. On July 1, when the fireworks are over, the television cameras are turned off, and the British have sailed away into the sunset, Hong Kong will be entering uncharted territory. War and revolution have always altered nations' psyches and landscapes, but never has a thriving capitalist state been voluntarily and peacefully handed over to a still communist (albeit more open) regime.

Even so, to focus, as most people have, on the damage that could arise from China's political control over what has arguably been the world's freest economy is to overlook a more certain threat. The truth is, Hong Kong's famed competitive edge was already being dulled--and would have desperately needed sharpening even if no handover were occurring. As Raymond Ch'ien, managing director of food processor Lam Soon and a vocal civic leader, puts it, "If Hong Kong dies, it will be caused by suicide, not by China."

Not that sudden death is imminent. Indeed, the worst-case scenario Hong Kong faces is more like slow strangulation--year after year of slower-than-expected growth and rising outflows of capital. To many in this frenetic city of getting and spending, the very notion of economic weakness seems absurd. Developers are paying record prices for land. Business is humming along nicely, with expected economic growth of 5.5% this year, buoyed by an influx of money from the People's Republic of China, a $20 billion airport project, and lots of bullish investors. Insists Donald Tsang, the government's Financial Secretary: "Hong Kong will start life as a Special Administrative Region [of China] in sound economic shape, with every prospect that we will remain the most attractive business location in the region."

But that depends on how well Hong Kong manages a big wok of simmering problems. The biggest is that the place--which makes almost nothing locally except deals--has become painfully expensive. What's worse, Hong Kong's work force lacks the skills and creativity to run a world-class service center, a reflection of the shortcomings of the territory's education system. Finally, the very thing that makes many outsiders and locals so bullish--the expanded opportunity that union brings to serve as a gateway to China's huge market--could end up causing more harm than good. That's because preoccupation with the mainland may well erode the open, internationalist mentality that has long been Hong Kong's comparative advantage in Asia.

Already the old growth engines are starting to ping and cough. The world's highest rentals for retail space have crumpled Hong Kong's reputation as a shopper's paradise. Nothing is a bargain in a town where a room at a second-class hotel can run to $375 a day. Prime office space costs more than comparable locations in Tokyo. Admits Victor Fung, chairman of both the investment bank Prudential Asia and the Hong Kong Trade Development Council: "We are known in the international business community as an expensive place to operate. That is hard to deny and harder to change."

Most striking, the ability of Hong Kongers to communicate in the English language--long an invaluable business asset--has seriously eroded. Phone a manager at a Hong Kong company, and don't be surprised if a secretary says brusquely in broken English: "Not here, call back." Remarks Miron Mushkat, chief economist for Asia at Lehman Brothers in Hong Kong: "To be an international finance center, Hong Kong must maintain its split personality of Western and Chinese culture. But it is becoming more inward looking."

At the same time, rival Asian business centers are beginning to offer the very advantages that long underpinned Hong Kong's supremacy. Singapore, for instance, has invested heavily in upgrading its workers (who speak impeccable English) and woos multinationals with tax breaks often comparable with Hong Kong's standard 16.5% tax on corporate profits. Taiwan and mainland China are edging toward direct commercial relations, which would diminish Hong Kong's lucrative role as the middleman that now handles half of China's total exports. Already Taiwan has started its first direct shipments from South China, provided that the goods are bound for other countries--a move that will divert business from Hong Kong's busy but expensive container port.

Western and Japanese corporations are also dealing directly with the mainland, bypassing Hong Kong. Says Marc Faber, a congenital contrarian and shrewd Swiss investment adviser in Hong Kong: "If China is successful--and it's moving ahead amazingly fast--I think that Hong Kong, perhaps a lot sooner than many people expect, will become just another city in China."

No one seems more aware of the potential threats to Hong Kong's economic well-being than Tung Chee Hwa, the wealthy shipping magnate selected by China to be the territory's first postcolonial leader. Dismissing the West's constant focus on things like freedom of speech, Tung insists that "the spiraling cost of housing" and the mismatch of skills with the needs of business "are the real problems people care about." Tung has indicated that he thinks the government, which is running a surplus, needs to spend more on these "livelihood issues."

Meanwhile, in another departure from Hong Kong's usual short-term perspective, its business leaders have spurred debate on the economy by sponsoring two large studies of its competitiveness by teams of predominantly American academics. Most optimistic is The Hong Kong Advantage, by former Harvard business school assistant professor Michael J. Enright and two colleagues. Enright's team basically calls for shoring up those things that already make the economy work so well--including the rule of law, honest administrators, minimal government, and openness to information and ideas. Advantage argues that if these continue, Hong Kong companies can solve most of their problems.

Taking a more sharply critical stance, the Massachusetts Institute of Technology's Industrial Performance Center maintains that the basic solution to Hong Kong's soaring overheads will be upgrading its industry. Says Suzanne Berger, a political scientist and co-author of the study Made by Hong Kong: "Being a good trader and coordinator is not going to be enough to sustain Hong Kong."

Oddly enough, the biggest cost burden in Hong Kong--astronomical real estate prices--is partly created by its own government, which owns all the land. About 30% of annual revenue comes from auctioning off land and collecting other fees from a handful of property developers. The government, in effect, rations land supply--and has overdone it. "Hong Kong is in the throes of a housing crisis," says an analysis by the investment bank Salomon Brothers. A 750-square-foot apartment in the outlying New Territories (comparable to Queens in New York City) can fetch close to $500,000--more than twice the price of a year ago.

Salomon describes the housing situation as "a potential tinderbox" for social unrest because Hong Kong's wealth is concentrated in property, and half its 6.4 million people own none. The pressures are bound to worsen as the city's population expands to around ten million sometime after the turn of the century. Already many young professionals switch jobs every year or so to get more money in hopes of accumulating the 30% down payment required for an apartment. This practice fuels one of the world's highest employee turnover rates, which in some garment companies runs to over 100%. To cope, the government needs to release enough land to meet the strong demand, even if that takes some of the froth out of prices--and its tax revenues.

Compounding expensive overheads has been Hong Kong's high inflation, which averaged 9.2% for five years through 1995. Those pressures have led many top corporations to flee the city in ways that are barely visible. Even its airline, Cathay Pacific, is shifting operations to less costly cities. Says Tony Tyler, director of corporate development at Cathay: "Something had to be done or we'd hit a wall. So if we can do anything cheaper elsewhere, we do it elsewhere." The airline's computer center has moved to Sydney, where the land costs only 1% of the price of a comparable site in Hong Kong. Cathay's revenue-accounting back office has been shifted to Guangzhou, China, and even some of its aircraft maintenance is now done in Xiamen on the South China coast. The labor-intensive part of its reservations, such as special meals for passengers, is handled out of Bombay.

The search to cut costs has also hollowed out the Hong Kong operations of Vtech, one of the territory's most successful electronics manufacturers. (Its original products include a 900-MHz digital cordless phone, sold under the Tropez brand, and electronic educational toys, such as the talking Whiz Kid notebook computer). Says Chairman Allan Wong, an engineer educated at the University of Wisconsin: "The sharp rise in costs here is my biggest problem, so we're a virtual corporation with nearly everything based somewhere else. The only reason we need to be in Hong Kong is that a few guys at the top like living here." Most of his design engineers work in North America, England, and China. His products are made in Dongguan, China, where Vtech employs 17,000 people, vs. 700 in Hong Kong.

However much companies pay, says Wong, they cannot find adequate talent in Hong Kong. Its higher-education system has rapidly expanded, but Wong rates local graduates as "very low quality" prospects. The "fatal flaw," as he puts it, lies in secondary schools that teach by rote rather than by training young people to solve problems creatively and communicate clearly in English as well as Chinese. Adds Wong: "Some classes have 45 to 50 students, so only those in the front rows can hear the teacher. Consequently, the quality of education goes down."

Yet if Hong Kong is to compete, the work force must be trained--and constantly retrained--so that productivity catches up with the need for endless pay increases. "The new economy requires people who can think independently and make decisions," says Harvard's Enright.

To remedy this lack--as well as steal a page from countries like Singapore and Taiwan, which are growing in part on their strength in computers and other higher-tech products--some young business leaders want to go further. They are calling for a modest rethinking of the government's staunch hands-off approach to the economy. After all, this crowd points out, total public and private R&D spending in Hong Kong amounts to just 0.1% of GDP, vs. 1.2% in Singapore and 1.8% in Taiwan.

Even a hint of interventionism appalls traditionalists, such as Financial Secretary Tsang, who frets about any retreat from Hong Kong's freewheeling capitalism "and an advance toward socialist policies." But the rethinkers may have an ally in CEO-designate Tung, who has allowed that the government may have a role to play in helping bolster the technology of local manufacturers.

Businessman Ch'ien, an adviser to Tung, is one who minces no words about what he'd like to see. Ch'ien wants to make Hong Kong "the Silicon Valley of the Pacific Rim"--with more public money for R&D. "If we don't push the youth of Hong Kong," he says, "the bright ones of mainland China, who are paid at a fraction of our level, will outdo us." Ch'ien, among other things, proposes to open local universities to the best minds of China and employ them in Hong Kong. He helped persuade the British colonial government in 1995 to grant land and $32.5 million in seed money to establish the Industrial & Technology Center Corp., which is now nurturing about 30 high-tech startups with cut-rate office space and mentoring help from established companies. None of the neophytes have yet gone public--but that's the ultimate goal. Says Ch'ien: "We want to give our young engineers the chance to become millionaires, like in the U.S."

Even without a big boost from government, Hong Kong's dwindling band of manufacturers need to rethink their addiction to cheap labor in South China, which costs 10% to 20% of Hong Kong's own levels. In the past, simple-mindedly seizing this opportunity discouraged managers from exploring ways to improve factory processes, develop more sophisticated products, and create their own brands. To counter this trend, the experts from MIT recommend that Hong Kong "strike out in a new direction as a leader in the production of new generations of products." These should be "service-enhanced products"--goods that gain much of their value from associated services, such as jeans that are custom-cut to a customer's measurements.

That kind of creative repositioning could marry well with Hong Kong's proven skill at living on its wits as a superb trader, financier, shipper, and arranger of production work done elsewhere. Consider Li & Fung, Hong Kong's oldest and largest trading firm. "We call ourselves a trading company, but we are really packagers and coordinators of borderless manufacturing," says managing director William Fung, brother of Prudential's Victor, who makes a science of finding the cheapest sources of supply in 17 developing countries for 350 customers in the U.S. and Europe. He sees the trend continuing: Both the U.S and Europe, he says, are "targeting China" with trade barriers to protect their own markets. Moreover, retailers in the West are demanding delivery in four weeks instead of three months to stay atop fashion trends, a schedule that requires manufacturers that are based closer to customers. Consequently, Li & Fung now sources only about 20% of its orders in the PRC and increasingly relies on manufacturers in such places as India, Turkey, and Honduras. As William Fung puts it, "We've evolved from a Chinese trading company into a genuine multinational."

In the end, continuing to foster such an internationalist mentality may be the key to maintaining Hong Kong's competitiveness. Though its economy has already become deeply intertwined with China's, to the benefit of both, as an enclave of the People's Republic, Hong Kong will find it hard to escape the jolts of power struggles and economic bumps on the mainland. "With the change in sovereignty, our future depends very much on stability in China. If China gets into difficulties, we will suffer, and there's not much we can do about it," says Jennifer Wong, a partner at KMPG Peat Marwick in Hong Kong.

While Beijing has pledged in a formal treaty with Britain to preserve Hong Kong's free and open ways, China has already ordered the rolling back of a few civil liberties granted during the final years of British rule. Demonstrations will require police permits in advance, for instance. CEO-in-waiting Tung, who insists that Hong Kong must avoid becoming "a base to destabilize China," dismisses those planned changes as mere technicalities. Yet diluting the city's freedom of expression has provoked a rash of self-censorship, something that can do serious harm to an economy that depends on the free flow of information.

A pro-China political correctness is already creeping into business dealings. Evidently fearful of offending China, Sun Hung Kai Securities backed out of underwriting a stock issue for Next Media, which publishes the most popular Chinese-language newspaper in town and at times assails Beijing. The head of China research at CEF Securities in Hong Kong criticized the cabin service of PRC-owned China Eastern Airlines at a stock-listing road show--and lost his job. A senior analyst at an American investment bank told FORTUNE that he had been warned by his own boss to refrain from commenting on political matters, even though they certainly affect the economy.

While many local business leaders argue that such problems are minor, U.S. Deputy Secretary of Treasury Lawrence Summers begs to disagree: "Even a perceived risk that China is seeking to undermine Hong Kong's autonomy or de-emphasize the formulas that have made it so successful could severely damage Hong Kong's standing in financial arenas and, by association, damage its economic prospects." Hong Kong's 50 or so international fund managers, for instance, could quickly pack up and fly off to another Asian business center. Capital can flee even faster. Western admirers of Hong Kong can only hope that its new masters will not wake up one morning to find that tinkering with practical, proven liberties has reduced one of the great global business centers to "just another city in China."