(FORTUNE Magazine) – Lee Kuan Yew is not one to shy away from controversy, whether by expounding on the superiority of Asian values or hounding his critics in court. But lately Singapore's senior minister and the successful system he largely created have been in the spotlight for a different reason: A growing number of leaders would like to emulate them. Tung Chee Hwa, the new Chief Executive of China's Hong Kong, has expressed his open admiration for Lee's Singapore; China, too, looks upon the island state as a model. Even one of Asia's former colonial powers, Britain, is seeking to learn from Lee: Prime Minister Tony Blair has dispatched a team to study Singapore's Central Provident Fund, a national retirement and savings scheme.

Lee's model has much to be said for it: Singapore was ranked the world's most competitive economy for the second year in a row in the Global Competitiveness Report released in May by the World Economic Forum in Geneva. Singapore also looks set this year to surpass the U.S. in terms of per capita wealth: Each citizen's share of GDP will hit $30,000.

Yet one aspect of the model that outsiders rarely remark on is the undercurrent of anxiety that keeps this tiny island of three million people striving to improve. "There's always a certain anxiety in Singapore that our geographic, economic, and political positions are vulnerable. This anxiety is also a galvanizing force, in some ways an obsession," says George Yeo, the cerebral, Harvard-educated Minister of Information and the Arts. "Our success is the result of anxiety, and the anxiety is never fully assuaged by success. Perhaps most city-states feel that way. It keeps people on the ball."

For example, rather than celebrate its status as the world's most competitive economy, Singapore immediately appointed a panel of government officials and local and international business executives to devise ways to sharpen this nation's edge for the next decade. And though Singapore's primary-school students have just scored among the world's best in science and math, its government is already shaking up the education system to stress greater creativity. Says Prime Minister Goh Chok Tong: "We must get away from the idea that it is only the people at the top who should be thinking and the job of everyone else is to do as told."

That would be quite a change for Singapore, where public discussions and a docile press now stick to an agenda set by a government that frowns on sharp dissent and divisive debate.

Is all this worrying just a technique to spur better performance? Partly yes, but some of Singapore's anxieties are more concrete. Its economy slowed last year to a mere 7% growth, from 8.8% in 1995, and electronics, which accounts for half its manufacturing output, is just starting to come out of a slump. And politically, Singapore, where ethnic Chinese are the majority, thrives by cooperating with a pair of large, predominantly Malay Moslem neighbors, Malaysia and Indonesia. Only by containing the ethnic and religious tensions that have long plagued the region can Singapore continue to prosper.

A strong reminder of how important that peace is came earlier this year, when a comment by Lee about neighboring Malaysia sparked an acrimonious dispute that is only now beginning to fade. Lee apologized twice and withdrew his remarks, while Prime Minister Goh said the Senior Minister was "offside." Even so, Malaysian politicians began calling for a review of agreements that supply Singapore with most of its drinking water. Says a report by Political & Economic Risk Consultancy, a business advisory firm in Hong Kong: The dispute "reopened a quiet discussion among many observers about the extent to which Lee Kuan Yew is becoming a national liability."

Yet Lee, 73, a British-educated lawyer, personifies the endless striving--and insecurity--of his city-state. Instead of mellowing with age, he is as sharp-spoken and combative as ever--his remarks about Malaysia were actually made in an affidavit for a defamation suit against an opposition politician. (Lee and his colleagues won $5.7 million in damages. The opponent, who lost at the polls, had already fled the country.)

Although he turned over the reins to younger successors like Goh seven years ago, Lee retains power of the sort once wielded in China by the late Deng Xiaoping. In an exclusive interview with FORTUNE, this elder statesman offers blunt advice about both managing an economy and coping with turbulent political changes in the region, from Indonesia to South Korea.

Leaders in China and the new Hong Kong say they want to emulate Singapore. What is the essence of this Singapore model?

What [Chinese leaders] found attractive was a certain cleanliness, both physically and in administrative terms. As an administration we run a clean ship, and the workers have their stake in home ownership. But we also had the free market and were able to grow. We have trade unions that played a part in productivity with management and the government. I think that was the beginning [in 1992] of the desire to pick up features of Singapore and introduce them into China.

C.H. Tung is different. He knows Singapore. He's been back and forth over the years.... My guess is he also disapproves of the general permissiveness, laxness in society, and would like a certain propriety of behavior in public.

Is rather firm political control part of the Singapore model?

Firm government is part of this model. You've got to take tough decisions. We had to change people's habits. Let me give you the background [on] why we did these things. When we were turfed out of Malaysia in 1965, we knew a way of life had come to an end. We were the entrepot center for Malaysia and for Indonesia. Confrontation [by Indonesia against Malaysia and Singapore] was on. Malaysia had established its own direct trade, and so we were really on our own. From being the hub of the British Empire in Southeast Asia, we were now a head without a body. So we either perish or we find some new way to pump blood into it, to keep the circulation going.

After casting about for two, three years, by about 1968 we settled on two strategies. First, leapfrog the region and link up to the developed world--America, Japan, and Europe. Get their companies, multinationals, to come here, set up shop, [and] export back to...industrial countries. That was one strategy, which meant we needed a better-educated, cooperative work force. So we had to change attitudes from communist, noncooperative unions to cooperative unions. And some multinational corporations, like Hewlett-Packard, didn't want any unions.

The other strategy was to make Singapore, in a Third World region, a First World base, with standards of administration, health, education, security, communications ... that would approximate what they are in Europe, America, and Japan. So the infrastructure was put in, and the people's behavior had to change because it was a rough-and-ready society. That required not an overpowering government but a government that's able to make hard decisions and get its people to support it.... They responded because they knew that if we didn't change, we would not make a living, we would perish....

We had four official languages: Malay, Chinese, Tamil, English....Now everybody learns English as the main language of instruction, and their mother tongue as their second language. So we had the work force geared to the international community. That is the reason we got here.

There's a popular impression in the West that it's not enough for Singapore's government to win elections, but it seems to want to punish opponents by suing and bankrupting them. That's the press side of it. Let me explain. Let us look at all the libel cases.... In all these cases, about 15 or 18 of them in the past 30-odd years, three-quarters alleged corruption, and they did not even attempt to contest the case. When they went to see their lawyers, they just surrendered. So there's no contest at all, and I had to make them bankrupt because that's the penalty for not paying your damages. That disabled them, and that checked these heinous lies--unless I check it and check it openly by coming out and saying, "Here I am. I am the plaintiff, you can cross-examine me. Not just about this particular case, about my whole life, and I'll answer you." In that way I have been able to destroy every single rumor of misconduct, either financial or in any other way. One-quarter defended their cases. They had lawyers, Queen's Counsels from London, to cross-examine me, and I won because they were untrue statements....

This latest opposition candidate who disappeared immediately after the polls: He scooted [out of Singapore] and issued more libels on CNN, BBC, newspapers worldwide.... He's a lawyer of 38 years' standing but has not come back to defend his case. But if we did not sue him, we would leave his allegations in a gray area, that in fact we are conspirators who had created a criminal conspiracy to fix him--that's what he said--and that we were liars and we are rogues. So I said, "Well, prove it." But on our part, we said publicly that he is anti-English-educated, anti-Christian, and a Chinese chauvinist, and we are prepared to prove it....

Some might say that the electorate spoke and rejected the charges of this person, who was not elected.

We did not think so. We think that if he purveys this line, it would do great damage and undo some of the work we have done over the past 30 years. This is a very sensitive issue: heritage and culture. And with the rise of China and the growing importance of the Chinese language, this could become, once again, a political and emotional issue, that we have degraded Chinese culture and language. [In a multiracial society] we either use English, a neutral language, or we're going to have conflict. So this wasn't a simple matter, not something we could laugh off.

There is some skepticism in America about whether China will keep its promise that Hong Kong will have a high degree of autonomy.

As an Asian, I ask: Are Americans really interested in the future of six million Chinese in Hong Kong? I think the answer is yes, but only marginally, compared with their interest in the future of 1.2 billion Chinese on the mainland. That's the real focus of interest. If I can quote Newt Gingrich, either China becomes democratic or "one country, two systems" will fail. That's the nub of it. What America wants is for China to be democratic.

It's like Singapore. Why are we being clobbered, hammered, and attacked by the American press as authoritarian, lacking in freedom, liberties? Not because of three million Singaporeans but because, as the American press and Freedom House say, we are a bad example for China, whereas Taiwan is a good example, and that is the way we should be going. Well, my job is not to be an example to anybody. If they think Singapore is a good example, I am flattered.

Now if I were a Hong Konger, I would not want to be the catalyst to either democratize China or cause a conflict between China and the U.S. Hong Kong has existed all these 150 years not as a place for democracy or freedom but as a place to get on in life, make money, and have a good life. When Deng Xiaoping promised "one country, two systems," that's what he meant.

China's government is used to controlling everything and has made a commitment to have very light control in Hong Kong. Can China do that?

What will happen in the longer term is a different problem. By longer term I mean after 20 years. Because with the interaction between six million in Hong Kong and 60 million Cantonese in Guangdong Province and all the big cities in China, there is bound to be interpenetration of each other's culture, including administrative culture. That I see as a real problem--not direct interference but almost subconsciously an intermingling of two different administrative cultures, one completely based on the rule of law, the level playing field, and open tenders and so on, the other based on the judgment of the minister or mayor, or official, and where personal relationships, guanxi, are a factor in decisions. But the business culture in China itself may change and move toward the rule of law. Then all's well.

This is where I feel that the British have not done enough for Hong Kong, by leaving it so late before they put senior Chinese in key positions.... Subconsciously they [Hong Kong administrators] will begin to want to accommodate the other fellow, and over time, because Hong Kong businessmen are also to-ing and fro-ing, the Hong Kong system will undergo a certain change. That is a real danger. Then Hong Kong loses its attractiveness.

It never bothered us whether the governor or some other British officials made the decisions. We will continue to do business under a Chinese Chief Executive. We have about $6 billion of private investments in Hong Kong. And we have about $3 billion in China. Because our relationship with Hong Kong has been longer, there's more in Hong Kong. But I cannot tell you what the percentage commitment in 20 years will be. We've got to see how things develop. It may be that in time it makes no difference whether we're in Hong Kong or in China.

The Clinton Administration says that the military regime in Burma is brutal and profits from drug trafficking. So why does the Association of Southeast Asian Nations (ASEAN) want Burma as a member?

If you [in the U.S.] are just going to apply sanctions and hope that they will collapse, that there'll be a change of government and everything will be fine, I don't share that optimism. For a country that's been isolated for so long--self-imposed isolation from 1962, when Ne Win took over--they will just go back into their shell.

Now they are coming out. I think change will come gradually but inevitably because the people will change. They get tourists, they will begin to have an appetite for consumer goods, and a chain of events will be set off. I believe that's a more likely outcome, and a more desirable outcome, than one where either they have closed up and become more repressive or they have collapsed and the country breaks up into many countries and we have refugees fleeing out....

There is no other instrument of authority and power [in Burma] than the army. It is the sole instrument of power and authority. It's a very unhappy position. Aung San Suu Kyi, Nobel Prize winner notwithstanding, cannot run it. If the army disintegrates, [Burma] disintegrates.

Is what the World Bank terms the "East Asian miracle" fading or slowing?

We are all dependent on external demand. It's not an economically self-generating region yet. Without the American market, this miracle can't complete its course. It may in another 15 to 20 years--after the Japanese have deregulated and opened up, and ASEAN has become a free trade area, and WTO has progressed further with China a big market--then it may be a different equation. It will not be so vulnerable to a slowdown in electronics in the U.S. That's the basic reason for all of us doing poorly last year.

Is economic progress in the region endangered by political turbulence in such places as South Korea and Indonesia?

You know the problems in Indonesia [where the party of President Suharto, 76, has won another election marked by violence, and he has not chosen a successor]. It's not something that can be resolved easily. This is the last few laps of a very strong ruler who's brought many good changes to Indonesia. See how far they've gone, and they've held over 13,000 islands together. No mean feat. The key question now is: Will there be an orderly succession that will consolidate the gains they have made since 1965? If the succession goes awry, 32 years of consolidation could be frittered away. Certain institutional principles have been established, certain rules of the game which are generally understood by the people. If I were an Indonesian, I would allow nature to take its course and have an orderly succession. To try and upset the succession now would be unhelpful to Indonesia.

In Korea it's largely self-inflicted. President Kim [Young Sam] had a very strong program against corruption. Unfortunately, he has run into trouble, and they've questioned and arrested his son over the big losses [of the bankrupt Hanbo Group]. That must knock down confidence in the system of government. What it proves is that democracy and a free press do not produce clean and good government. The preconditions are not there.

I may be old-fashioned, but had the liberalization or the unwinding of military rule been more gradual, not these dramatic purges with two ex-Presidents in jail, which can't do much for the history of the country and its sense of self-esteem, South Korea would not be in such a difficult position. To say this is not politically correct. But I'm not interested in being politically correct. I'm interested in being correct.