(FORTUNE Magazine) – It's Saturday night in the central Chinese city of Chongqing, and at the Cygnet Hot Pot Palace restaurant, the evening's fashion show is reaching a climax. As the models sashay onstage for the final number, six Chinese toothpaste executives--including a rep from Unilever's Shanghai plant--rise from their table for one last toast. "We're attending a seminar on political and ideological work," one of the group tells FORTUNE. "No, it's just a toothpaste function," a female colleague interjects.

Actually, they're both correct. Back at their hotel, a sign "warmly welcomes the Fourth Annual Convention of the Political Study Session of China's Toothpaste Industrial Society." This is a typical business junket in China's "socialist market economy," where toothpaste executives take time off from studying Deng Xiaoping Theory to check out a racy floorshow.

It is not only in Chongqing that the shadow of old-style communism looms over the seemingly capitalist present. China is trapped between a flashy corporate culture of fast cars and sharp suits, and a moribund political system that still demands obeisance to Marxist ideals. The 20 years since Deng routed the Maoist diehards and tilted China toward a market economy have transformed China. Between 1979 and 1997, its GDP soared from $43.6 billion to $904 billion. Exports grew at an annual rate of 52%. Foreign companies invested more than $220 billion. Officially, around 200 million people escaped "absolute poverty"--meaning they now have enough to eat.

In China's cities and towns, the monochrome tones of Maoism have largely disappeared, replaced by brasher capitalist hues: blue glass and chrome (for corporate offices), neon red (for the company logo), and lime green (for the micro-skirts worn by the CEO's mistress). What has not changed is that the Communist Party continues to repress anyone who questions the regime's legitimacy. In the latest crackdown, launched in December, a clutch of dissidents who attempted to register their independent China Democracy Party have been sentenced to lengthy prison terms for subverting the state. Yet despite such continuing human rights abuses, Chinese citizens today have more mobility, greater access to information, and less fear than at any time since the 1949 revolution.

For all the surface glitter, the heavy lifting of market transition remains to be done. The chief roadblock: a largely unreformed state manufacturing sector, numbering 300,000 enterprises, that employs 70% of the urban labor force (109 million workers) but generates only 30% of industrial output. Officially, around 40% of these enterprises are losing money; the true figure is certainly higher. Against this background, China's ability so far to evade the full impact of the global economic storm offers little cause for comfort. Warns Gerald Segal of London's International Institute for Strategic Studies: "The fact that the Chinese system is more closed than the rest of Asia only gives them the illusion that they are still standing tall.... [Without further reform] China's fall will be harder."

A mass shutdown of these money-losing companies is infeasible because the regime, rightly, dreads the social unrest that would follow. That leaves restructuring. But old Maoist practices endure. Visit a typical Chinese state factory, and you find employees either churning out goods nobody wants to buy or observing the three timeless rituals of a communist party work unit: drinking tea, reading government newspapers, and attending party meetings.

To measure the distance China still has to travel down the free-market road, it's best to avoid the glitzy showcase cities of Beijing, Shanghai, and Guangzhou. Instead, venture into the interior. China's landlocked hinterland remains, for the most part, an overcrowded world of poor peasants, rapacious officials, and indolent factory managers, with walk-on parts for disaffected ethnic minorities. It's here, where foreign investment is thinnest, that Premier Zhu Rongji must overcome the toughest resistance to reform.

Chongqing, once China's wartime capital, now an industrial city of six million people, illustrates the scale of the task. The city's state-owned sector, dominated by money-losing chemical, steel, and auto plants, still accounts for 70% of Chongqing's economy, as well as for air so thick you can slice it. "It's not pollution," claims Zhou Zhaofeng as he peers through the sickly haze: "Chongqing is famous for its fog."

Zhou, a former steelworker, was laid off by his factory several years ago--as were 400,000 more city residents in the first nine months of 1998. Officials say 70% have found new jobs after attending retraining programs, but locals like Zhou (now a taxi driver) dismiss this boast. They point instead to an August demonstration by hundreds of unemployed workers and pensioners, who blocked a street to protest unpaid welfare benefits.

The local economic picture isn't entirely bleak. Chongqing has an energetic mayor, Pu Haiqing, who has scored some significant recent hits, including a $29 million investment by French retailer Carrefour. The biggest foreign project is BP's 51% stake in a $200 million joint venture to produce acetic acid. The state-of-the-art plant is due to come onstream in early 1999. "From Mayor Pu all the way down, everyone's been very supportive," says Graham Hunt, chairman of BP China.

Trouble is, BP's experience isn't the norm for foreign investors. At a municipal meeting in October, Pu ordered cadres from the misnamed Chongqing Economic Cooperation Commission to apologize to the local office of Siemens after a routine application by the German company for foreign-registered vehicle license plates had been held up for two months. Pu also lambasted Chongqing health administrators for levying an arbitrary $78 "quarantine fee" on resident expatriates. Such scams typify the fleece-the-foreigner mentality rampant among middle-ranking Chinese officials. Far worse, however, is the way the same provincial deadbeats--largely beyond the control of the central government--shovel resources into state-owned white elephants (and bribes into their own pockets) while doing their best to drag down China's homegrown entrepreneurs.

The core of this rotten system must be seen to be believed. So for a glimpse of the socialist heart of the socialist market, linger with FORTUNE at the Changan Automobile Co. in central Chongqing. Don't be fooled by the spanking-new headquarters. From the women snoozing in the self-described Propaganda Department to the telltale silence on the factory floor, Changan bears all the hallmarks of the typical state enterprise.

By its own reckoning, it has come a long way. Until the late 1970s, Changan was a military factory controlled by the People's Liberation Army. "But we realized we had to enter the market in order to survive," explains Peng Minggeng, deputy secretary of the factory's party committee. First the factory tried making alarm clocks; sales were slack. Next it switched to sewing machine parts; more disappointment. Then it moved into oil-drilling equipment--a venture crushed by the petroleum ministry, which was determined to protect its monopoly. Changan's luck turned in 1984, when it signed a licensing deal with Japanese auto giant Suzuki to produce the Alto mini passenger car.

Last year Changan produced around 20,000 Altos, almost exclusively for the domestic market; although demand is currently flat, the model, which sells for $6,520, could conceivably become China's long-awaited economy family car. All told, Changan's core automobile business now employs about 5,000 workers. But if you think Changan has reinvented itself as a market-oriented enterprise, think again. Peng is bemused when asked for Changan's annual revenue figures. Instead he refers to the company's "value of production," which last year reached $5.6 billion. That sounds impressive, but the figure simply tallies the aggregate cost of material, labor, and "administration"--a traditional communist accounting device.

Fortified by the works of Chairman Mao on his office bookshelf, Peng is much clearer about the welfare system that Changan, like all large state enterprises, must support. At the main plant alone, the portfolio includes two kindergartens, three primary schools, two polytechnic colleges, two hospitals, housing for 14,000 families, and an old people's home. Subsidiary Changan plants have their own welfare rolls. Under Zhu Rongji's reform master plan, state enterprises are supposed to transfer this social burden to the local government, but in Chongqing the process has scarcely begun. Why the delay? Peng won't elaborate, but it's a safe bet that Chongqing, like other inland cities, is unable to cover its budget because tax income from state enterprises has virtually evaporated.

That leads to the next nightmare in the dream world of socialist market economics: despite the relative success of the Alto, state factories like Changan are producing goods for which there is little or no demand. By August, according to government statistics, unsold inventories nationwide were 9% higher than those of a year before. At Changan, officials brag that they don't have stockpiles of unsold vehicles, but that's only because they regularly halt production.

Naturally, then, Changan must be working overtime to sharpen its competitive edge. Not at all. "Private companies can't produce to the same quality as state enterprises," boasts one of Peng's propaganda colleagues. Not so. In 1997, China's private sector, with just 17.4% of total industrial output, registered 37% of all retail sales. Such arrogance is echoed by Changan's corporate brochure, which records "inspection tours" in recent years by President Jiang Zemin and former premier Li Peng, plus a clutch of vice premiers.

None of these dignitaries, it's safe to say, helped Changan build better products. Beijing knows that many state factories are broken, but there is no easy way to fix them. "Before the Asian troubles, they [the leadership] believed rather foolishly that they could make huge state-owned enterprises into versions of the South Korean conglomerates," observes Lucian Pye, a China scholar at the Massachusetts Institute of Technology. "Now they are really unsure of what they can or should do."

One possibility: At the National People's Congress in March, China is set to change its constitution to recognize private ownership rights. That might allow private banks and other independent financial bodies to develop, providing an alternative capital source for the efficient but cash-starved private sector. Meanwhile, the state-owned enterprises would gradually wither away.

That seems to be what Zhu and his band of reformers have in mind. Few question Zhu's commitment to a more open economy. But the reformers must overcome the Communist Party's deeply ingrained hostility to any power it cannot control. Only in 1997 did the leadership endorse "the nonpublic sector [as] an important component part of our socialist market economy." The tortured language speaks volumes about the communists' residual suspicion of China's handful of genuine entrepreneurs.

To appreciate how it feels to be part of that small band, meet 61-year-old Yin Mingshan, erstwhile "rightist and antirevolutionary element," now president of Lifan & Hongda Motorcycle Co. in Chongqing's western suburbs. "Speaking as a private businessman, life is getting better," says Yin, who spent more than two decades after 1957 in prisons, labor camps, and farms as punishment for his capitalist tendencies. With just over 1,000 workers, Yin estimates his overhead is 30% lower than that of his state competition. He also has a three-pronged growth strategy: Redouble R&D, upgrade technology, and seek out export markets.

Even so, he still operates in an environment that discriminates against private enterprise. Chongqing's obdurate cadres, who presume to "regulate" wealth-creating mavericks like Yin, often get in the way. Yin recalls bitterly how local officials spent a year considering his application for an export permit. They gave no reason, and indeed, they don't have to. As soon as the permit came through in September, Yin secured a $1.6 million order from Iran.

In the absence of private banks, Yin also has a hard time raising capital. Last summer, in a reversal of a previous "reform," the central government quietly resumed "policy loans" to money-losing state enterprises. Worse than a retreat, the move is counterproductive because private companies like Yin's are far better equipped to create the new jobs that China needs. Nicholas Lardy, a scholar at the Brookings Institution, estimates that between 1992 and 1996, private-sector employment rose 180%, or 14.9 million workers; the public-sector labor force increased by just 3%, or 3.5 million employees.

Despite the conflicting policy signals, Beijing says it wants more people to join the private sector. Zhu's reform blueprint, for example, calls for a 50% cut in the civil service payroll by 2000. No doubt he would approve of the career switch made by Sun Yan, a 31-year-old executive. Three years ago, Sun worked for the municipality's external affairs office, a Soviet-model bureau that receives (and monitors) foreign delegations. Today she's Chongqing branch manager for Philips, the Dutch electronics group. Sun has put even more distance between herself and the old socialist system by moving out of her mother's place and purchasing her own apartment. It's in a private, middle-class development--one of hundreds that have sprouted during the 1990s in China's larger cities.

The problem--at least for a regime desperate to nurture highfliers like Sun--is that she may eventually leave China altogether. Sun has already spent six months in Australia on an accountancy course, and next year will go to business school in France. Further ahead, she'd like an Australian residence permit. Why? Sun gives an elliptical answer: This is, despite all the social changes, still a place that brooks no direct criticism of the political system.

"If China opens up, I won't need a foreign passport," she reasons, adding that she wants to have the right to live abroad if necessary. Sun is clearly a prime candidate to join China's brain drain. Since the late 1970s, China has sent 300,000 students overseas for education. Only one-third have come back. That exodus represents a massive vote of no confidence by China's best and brightest in the Communist Party's ability to deliver the kind of modern, open society they desire.

So how might Beijing break this vicious circle? The leadership could begin by accepting that market reform inevitably brings demands for corresponding political reform. David Shambaugh, director of the China Policy Program at George Washington University, points out that the past two decades have seen "substantial political change" in China. But the party's retreat from absolute control of all public and private life has been grudging, the result of market forces undermining a previously totalitarian regime. The question is whether the powers that be would ever lead the way toward genuine political reform. "Don't count on it," Shambaugh warns. "They are, after all, Leninists who approach political power in zero-sum terms."

Hence Beijing's enduring fear of social change. At Chongqing's dockside, FORTUNE found one seemingly harmless object of official dread, Dai Nengsi. Until 1994, this 51-year-old peasant was also the party secretary of a village six hours downstream from Chongqing. Short of money, he quit his post and left for Shanghai to work on a building site. In 1995, Dai drifted back to Chongqing, where he now earns between $35 and $45 a month (a healthy wage for an unskilled laborer) as a foot soldier in the local "pole army," lugging cargo up the steep riverbanks with the aid of a bamboo rod. "Business is not so good anymore because of the southeast Asian crisis," he grumbles knowledgeably.

As Dai sees it, he's still a loyal communist who pays his party dues. But from the government's perspective, he's a harbinger of social chaos. Dai is part of a rural swarm, estimated by the World Bank to number 80 million, who have descended on China's cities in search of work.

At the start of the Deng era, China's 900 million peasants were the first beneficiaries of market reform, winning back their land on long leases. Now, as the wealth gap widens between town and countryside, they are the principal casualties. Alarmed by the strain on resources, the government refuses to legitimize the resulting exodus from the villages by migrants like Dai. Under China's residency-permit system, Dai has no right to be in Chongqing and must dodge the municipality's regular roundups as best he can.

Step back from the personal histories of Yin, Sun, and Dai, and it's clear what China requires: a leadership that genuinely (rather than selectively) embraces the logic of the market. In Yin's case, that would mean the freedom to make money; for Sun, more intellectual breathing space; for Dai, simply the police off his back. But what's also needed is a government that knows where China is headed. And this, unfortunately, is precisely what's lacking. Zhu Rongji's hugely ambitious industrial, financial, and social welfare overhaul, launched last March, has stalled. Jiang Zemin "realizes there are a host of problems with the reforms," notes Pye. "The catch is that he is still not prepared to offer a new vision for China--something Deng was willing to do."

Zhu Rongji, a lifelong central planner, has sounded the tocsin, but his warning bell has an uncertain ring: On all fronts, reform has slowed to a crawl. Meanwhile, Zhu has authorized a massive binge of public works in a bid to maintain official GDP growth at around 7%. In the short term, that may help windproof China against the global economic storm. But further ahead, the political clouds are gathering.

Zhu must also deal with China's self-policing one-party state, which is now rotten to the core. In November, for example, the country's two leading anti-corruption prosecutors were sacked for--what else?--corruption. Twenty years after Deng's coup, the socialist market has become a Chinese variant of crony capitalism. That's cause for alarm, not reason to celebrate.