(FORTUNE Magazine) – Zhao Xinyu still swoons when she remembers her first Prada. It was 1990. After years as a soprano with the Harbin Opera, she had moved to Beijing and reinvented herself as a pop singer. But with the ban on concerts after the Tiananmen Square crackdown, she was barely scraping by. In desperation, she and a couple of friends launched a nightclub--and hit the jackpot. Zhao remembers marching to a luxury boutique at Beijing's Palace Hotel, her pockets bulging with cash, and pacing back and forth in front of the shop window for a "very long time" before plunging inside. For a single Prada handbag, she counted out a stack of notes worth $1,000--more money than the average Beijinger would see in a year. She thought the purchase so extravagant that for months after, she says, "I hardly dared use the bag for fear I'd wear it out."

These days Zhao's luxury bags are in little danger of overuse: She owns too many. With her husband's real estate investments flourishing, Zhao has grown accustomed to spending hundreds, often thousands, of dollars a month on the latest fashions from Prada, Dior, and Yves Saint-Laurent. She has filled two rooms of her Beijing apartment with designer clothing and a third with bags and shoes. "I'm running out of space," she says. And yet she yearns for more: "I'll scrimp on food, but not on clothes."

Such sentiments quicken the pulse of executives at the world's top luxury labels. Dazzled by the pace at which China's booming economy is minting millionaires and swelling the ranks of the middle class, global fashion giants like LVMH, Richemont, and Gucci are rushing to mainland cities to stake out shop space, tout their wares, and lay the foundations of a market they hope will include millions of conspicuous consumers like Zhao. Industry experts estimate that for now only some 1% of China's population (about 13 million people) earns enough to even consider purchasing high-end luxury-brand products. But Morgan Stanley analyst Claire Kent, noting that luxury-brand purchases tend to rise steeply after average incomes reach $2,500, predicts that China could eventually have as many as 100 million luxury consumers--and rival Japan as the most lucrative luxury market in the world. "The Chinese are a natural audience for luxury goods," she noted in a recent report, adding that after decades of socialism and poverty, China's elite are suddenly "keen to show off their newfound wealth."

Europe's fashion houses are happy to assist. In April, Giorgio Armani hosted a star-studded fashion show to celebrate the opening of his 12,000-square-foot flagship store on Shanghai's waterfront; Armani promises 30 stores in China before the 2008 Beijing Olympics. Just up the street, Ermenegildo Zegna--which already operates 40 stores in 24 mainland cities and counts China as its fourth-largest market--is putting the final touches on an equally lavish emporium. Gucci recently opened stores in Hangzhou and Chengdu, bringing its China total to six. Prada has six stores and plans to build nine more.

And it's not just clothes. Cartier, with nine stores in China and seven on the drawing board, sponsored an exhibition of antique jewelry and watches at the Shanghai Museum this spring. Cartier's China sales have doubled for the past several years, reports China representative Dimitri Kaczorowski, who sees "the beginning of a luxury consumption wave." And how else to celebrate at all the new store openings but with a glass of bubbly? "There are so many launches these days, and it is the expected thing to do them with champagne," says Anouk Blain-Mailhot, regional marketing director for Veuve Clicquot. China accounts for only a sliver of Veuve Clicquot's global revenue, but Blain-Mailhot says sales soared in the first six months of 2004. China's champagne market, she declares, "is finally taking off."

Carmakers, too, are racing in. In May, BMW CEO Helmut Planke flew to Shenyang, in China's industrial Rustbelt, to cut the ribbon on a new factory that will have the capacity to produce 50,000 BMWs a year by 2005. Luxury-auto companies do a brisk business in China selling imports, notwithstanding tariffs and taxes that can add as much as 65% to the base price. BMW sold 7,621 cars in China in the first five months of 2004, a 60% increase over last year. Audi's sleek A6 has emerged as the car of choice for the Communist Party's senior cadres, despite its $230,000 pricetag. Bentley, which sold 70 cars in China in 2003--including 19 limousines priced at more than $1 million each--boasts three dealerships in China, as does Rolls-Royce. In June, Ferrari announced the opening of its Shanghai showroom with a motorcade of dozens of cars that rumbled through the city's crowded streets. At the Beijing auto show a few days later, executives from DaimlerChrysler introduced James Wang, a 27-year-old golf-course developer, as one of the first two Chinese buyers of the Maybach 62. Wang, who paid about $900,000 for the car, including tariffs, taxes, and extras, turned up in a T-shirt and sneakers to collect his keys.

Not all the luxury brands rushing to China will find gold--especially at first. While executives at Zegna and Cartier claim their China operations are reaping profits, Armani acknowledges that its are not and declines to predict when that will change. Of more than a dozen makers of luxury apparel, watches, and wine contacted by FORTUNE, none would disclose profit or revenue figures for China. Despite an otherwise upbeat tone, the Morgan Stanley survey warns that foreign luxury houses should be prepared to lose money for at least their first five years in China. Notably, the report offers no dollar estimate of the current or potential size of China's luxury market. That figure, concedes Angela Moh, a Morgan Stanley consumer analyst in Hong Kong, is "anybody's guess."

Still, the fact that the posh brands are descending on China in such force shows how far the country has moved from the socialist ideals of Mao Zedong. Popular resentment of the rich stoked Mao's victory over the Nationalists in 1949. In later decades Mao exploited class antagonisms to maintain his grip on power. During the Cultural Revolution, his Red Guards seized upon even the smallest of possessions --a pocket watch or silk scarf--as evidence of "bourgeois consciousness." Change came rapidly in the early 1990s, after Deng Xiaoping uttered the phrase that quickly became the credo of the new China: "To get rich is glorious."

But the boom that followed has proved more glorious for some than others. China's once egalitarian society has developed a wealth gap that is among the widest in the world. By most estimates, the richest 20% of China's population controls more than 80% of the wealth. At a World Bank conference in Shanghai this year, President Hu Jintao boasted that China has reduced the number of people living in absolute poverty to 30 million from 200 million two decades ago. But many poor Chinese hover just above that threshold. The World Bank estimates that more than 400 million live on less than $2 a day.

How, then, can purveyors of $2,000 handbags and $20,000 watches thrive? Easy, says Cartier's Kaczorowski: "Remember, even medium-sized cities in China--Harbin, say, or Qingdao--have populations larger than Switzerland's. So it doesn't matter if the percentage of people in those cities who can afford our products is very small. It's still a very respectable market." Rupert Hoogewerf, who tracks the net worth of China's richest individuals for AsiaMoney, estimates that as many as 50,000 Chinese have accumulated fortunes of more than $10 million, while as many as 200 have amassed $100 million or more.

The disparities can be jarring. In Shanghai, locals in brightly colored pajamas turn out to gawk at black-clad glitterati arriving for the Armani opening. Panhandlers and peddlers of fake luxury merchandise prowl the pavement outside Plaza 66, the tony Shanghai shopping arcade that includes boutiques of Louis Vuitton, Burberry, and Versace. In Shenyang, laid-off factory workers hawk vegetables in front of the Mercedes and BMW dealerships.

National pride runs deep in China, but high-end designers have learned that it pays to play up their foreign origins. When Armani opened his Beijing store in 2001, he ordered the installation of a large red-lacquer door--a nod to motifs of traditional Chinese architecture. But Chinese patrons hated it; the door was later replaced. Vivienne Tam, a Hong Kong--born designer now based in New York, said local staff howled when she insisted on stocking her new Shanghai boutique with items featuring the same Asian design elements she uses outside China and keeping labels identifying her clothing as "Made in China." But Tam has held her ground. She says she looks forward to the day when "Chinese people have enough self-confidence to support their own luxury brands and stop buying stuff just because it comes from somewhere else."

For many Chinese shoppers, though, acquiring stuff from somewhere else is the whole point. "I want luxury fashions we don't have here--things you can get only if you have some kind of overseas connection," says 26-year-old Shenyang ad agent and part-time model Wang Siman. And what good is owning such items if no one notices? Retailers say luxury products move faster in China when logos are prominent and designs scream brand identity.

Unlike Japan, where the key luxury customers are single women in their 20s and 30s, in the Chinese market, analysts estimate, middle-aged men account for at least 60% of spending. That gives a lift to male-oriented brands like Zegna and Hugo Boss. But it doesn't seem to have hindered sales of women's fashions: Boutique managers report brisk sales to men lavishing presents on their mistresses.

Corporate gift giving is another distinctive feature of China's luxury trade. To curry favor, Chinese business executives routinely proffer luxury watches to key clients, business partners, and government officials. The preferred brands--Cartier, Rolex, Bulgari--can retail for upwards of $30,000.

For big spenders on the mainland, cash is king. Since the 100-yuan bill, worth about $12, is China's highest denomination, it's not uncommon for patrons to settle tabs worth thousands of U.S. dollars by counting out hundreds of notes. Luxury retailers say they'd just as soon not know where customers get all that money. But privately many acknowledge that the purchasing habits of their Chinese clientele bear increasing resemblance to those of luxury customers in Russia, a society often deplored by Chinese leaders as overrun by gangster capitalism.

All the flash and cash is kindling old resentments. Consider the furor that erupted last year after a court in Harbin dealt leniently with a BMW driver who had run down an elderly peasant woman whose husband had scratched the BMW while trying to negotiate Harbin's crowded streets in a tractor hauling onions. According to press accounts, the BMW driver struck the man's wife with her purse, climbed back into her sedan, and stomped on the accelerator, killing her and injuring a dozen bystanders. The driver, whose husband is one of Harbin's best-known property moguls, was let off with a suspended sentence after the court accepted her claim that she had meant to put the car into reverse.

As the wealth gap widens, some of China's nouveaux riches--and there aren't any other kind--have grown wary about flaunting their fortune. "These days, when people find out you have money, they get jealous and they hate you," complains Zhao Wenxin, who runs a prospering auto-parts factory in the northeastern city of Panjin. "You don't want people asking for money or trying to blackmail you. And if the government thinks you have too much money, they come after you for taxes. So now the thing to do is make everyone think you're poor." Or hire a good bodyguard. Zhao, who recently received an envelope containing a bullet and a letter threatening him with death unless he handed over half a million yuan, has four. Born to a poor peasant family, he lives simply, working in a bare office and often sleeping in the bed next to his desk. But Zhao confesses to a weakness for expensive toys. He owns seven luxury sedans, two small planes, and a Russian helicopter he has never flown. And still he has the urge to splurge. "I'm very interested in owning a Rolls-Royce," he confides. "Do you know where I can buy one?"