(FORTUNE Magazine) – IN A MODERN INDUSTRIAL PARK ON THE EAST SIDE OF Shanghai, General Motors can't keep up with demand. Its plant is churning out new Buicks on three shifts, 24 hours a day, five days a week. The cars--compacts, minivans, and luxury sedans fitted with sunroofs and DVD players--wouldn't look out of place in U.S. dealer showrooms. With 4,000 workers producing 240,000 cars a year, says Tom Wilson, executive director of manufacturing, "we're pushing everybody to the limit."

A complex of Volkswagen factories is running even faster on the other side of Shanghai. Last year its 15,000 workers assembled more than 400,000 Passats, Polos, and other models in facilities that are as automated as any in Germany. Stamped steel moves automatically between giant transfer presses, robots use lasers to weld the pieces together, and parts reach the final assembly line in modules instead of individual pieces to speed installation and reduce defects. Carbuyers have repaid the investment by making VW the largest-selling car brand in China.

Neither GM nor VW has achieved this prodigious success alone. Even though they compete, both giants are linked to the same Chinese partner--Shanghai Automotive Industry Corp., or SAIC--which owns half of the operations and shares half of the profits. The joint ventures have proved a bonanza for SAIC, which has more than doubled in size since 2000. Last year it produced 612,216 cars with VW and GM, a startling increase of 57% from 2002. That has catapulted SAIC onto FORTUNE's list of the world's largest companies at No. 461, with revenues last year of $11.8 billion and profits of $689 million.

The best may be yet to come. GM is ramping up production in China and is so bullish that it will start building Cadillacs there this year, beginning with the midsized CTS, which will sell for $63,170. Chairman and CEO Rick Wagoner expects China to become the world's second-largest auto market by the end of the decade, reaching eight million in annual new-car sales by 2012 (the U.S. has annual sales of 17 million units). "The size of the industry is such that even if the growth rate slows down, there's a huge amount of demand," he told securities analysts in June. "It's probably a once-in-a-lifetime opportunity that you don't want to be shy on."

There's nothing shy about SAIC. It has an enormous appetite for growth and is already casting its eyes beyond China's borders. Officials have immodestly declared their intention to become one of the world's six largest automakers by 2020, joining GM, Toyota, Ford, DaimlerChrysler, and VW. To get there, they expect to quadruple vehicle production. Analysts believe those ambitions are realistic. "SAIC will become one of the top ten car companies in the world within the next ten to 15 years," says Graeme Maxton of Autopolis, an industry consultant in Britain. "It is likely that teenagers in Europe or the U.S. will be considering a Shanghai Auto car within the next decade."

SAIC has devised a multipronged strategy for expansion. Inside China, it will continue to support the growth of its joint ventures with VW and GM, both of which have announced plans to more than double production over the next three years. SAIC is also targeting foreign markets. It is taking a 48.9% stake in South Korea's Ssangyong Motor, primarily a maker of sport- utility vehicles. Besides building Ssangyong sales in China, it can use the brand to gain a foothold in the Korean market. The new initiatives should help SAIC fend off challenges from its chief domestic rivals, First Auto Works and Dongfeng Motor.

As the third leg of its growth plan, SAIC expects to develop and sell a passenger car in China in 2007 under its own marque (its only consumer product now is a tiny minibus that resembles a loaf of bread). The initial sales goal: a modest 50,000 a year. Whether SAIC plans to develop its own car or simply market one of its partners' remains unclear. China expert Paul Gao of McKinsey believes that SAIC approached the Western companies for help in the project but was rebuffed. "What they realized is that the partners would not allow them to copy whatever products the joint venture was making and put their own logo on them," he says. But SAIC had a backup plan. It has begun talks with MG Rover, the last independent car company in Britain, about developing a car together.

THE COMPANY'S steely confidence and soaring ambition are embodied in its president, Hu Maoyuan. A short, powerfully built man, he radiates a sense of accomplishment and power. Born in 1951, Hu came of age during China's Cultural Revolution and went to work at Shanghai Tractor, SAIC's predecessor, at age 17. As government controls over the economy loosened, he was able to pursue a career in management and rose quickly. By 1983 he had obtained a graduate engineering degree and become managing director.

In an ornate conference room on the fifth floor of the company's headquarters in downtown Shanghai, Hu lays out SAIC's plans. The company's immediate goal, he says, is to produce 1.5 million vehicles a year by 2007, including one million passenger cars, and two million vehicles, including 1.5 million cars, by 2010. "With the increase in private buyers, the market potential is very huge," he says. "We want to seize this precious opportunity to make ourselves bigger and stronger."

For the moment, keeping up with the gyrations of the Chinese market is challenging enough. After demand grew last year by 65%, analysts were expecting gains of 25% to 30% this year. Instead the market has been squeezed by government attempts to put a lid on consumer spending. In July sales rose just 3.7% over the previous year.

The growth slowdown has taken its toll on VW, SAIC's largest partner and China's sales leader for two decades. Shanghai Volkswagen (SVW) is losing market share because of an aging product line and increased competition. Two years ago cars made by SVW had 26.8% of the China market; in 2003 they slipped to 21%, and for the first seven months of this year they fell further, to 15.5%. Critics' complaints about the aging of the model line don't sit well with SVW executives. "Bullshit," says Chen Zhixin, managing director of the joint venture, through an interpreter. "The Passat and Polo are up-to-date. We tore down competing models, and our quality surpassed them."

VW's difficulties have created an opportunity for GM, which passed SVW in sales briefly in June to become the market leader. "Over the past few years, Chinese consumers have become more savvy shoppers through greater access to information," says Phil Murtaugh, who runs GM's China operations. "They have higher expectations for the products they buy and their quality." He points to the explosion in Internet usage and the greater number of Chinese auto publications.

Despite this summer's slump, nobody at SAIC doubts that China's auto population will continue to grow--and lift SAIC with it. "SVW is very confident in the future of the Chinese auto market," says Chen, the company's managing director. "It's different from the U.S., Europe, or Japan--it is leaping development." Leaping development? Chen explains that his neighbor rode a bike for ten years, then leaped from the 19th century to the 21st by buying a Passat. GM's Murtaugh likes to show a chart that measures market potential by comparing the ratio of personal vehicles with the number of people who are old enough to drive. In the U.S. there are 940 vehicles for every 1,000 drivers. In Japan the number is 502. In China it is eight.

But as SAIC grows, it runs the risk of bruising the feelings of its joint venture partners. VW and GM increasingly are going head to head in the marketplace as they expand their product lines, and SAIC may find itself competing with both when its own car goes on sale. At the same time, VW and GM run the risk of being shunted aside as China's domestic auto industry develops. "Foreigners often assume that joint ventures are essentially controlled by the foreign partner," writes Arthur Kroeber, editor of China Economic Quarterly, "but the Chinese government views them as pawns in a larger game whose basic rule is that foreign automakers need China more than China needs any of them; there are a dozen global automakers but only one China market."

For now, SAIC needs its partners. Despite being a longtime maker of commercial vehicles and components, it lacks the capital to develop a full line of cars, the technology to make them powerful, safe, and up-to-date, and the brand names needed to lure consumers. Meanwhile, the Chinese government makes attracting foreign automakers as partners easy because it bars them from producing vehicles in China any other way. It keeps import tariffs high and forbids overseas automakers to manufacture in China on their own.

So when Volkswagen decided to break into the China market in 1984, it approached what was then Shanghai Tractor & Automobile to form a joint venture. They created Shanghai Volkswagen, with Volkswagen taking a 50% stake, Shanghai Automotive 35%, and the Bank of China, along with a government agency, 15%. One year later the VW Santana, China's first foreign passenger car, rolled out of the SVW factory.

In the mid-1990s, GM and Ford both came calling on SAIC. Ford wanted to build the Taurus in China, but SAIC thought GM's Buick Regal was better suited to government officials, who dominated the consumer market then. The Regal made its appearance in 1999 and remains a bestseller, with 19% of the upper sedan segment, despite a price of some $40,000, which includes a 17% VAT (a comparable model would sell for about $30,000 in the U.S.).

The two joint ventures have adopted divergent manufacturing strategies. SVW has invested heavily in automation, while Shanghai General Motors relies more on manual labor. In the SGM body shop, where steel stampings are fused together, some 75% of the welding is done by hand; in GM's U.S. plants, only 5% is. Since hand welding produces more variability in results, GM performs more quality checks in China. The labor-intensive system seems to work. To an amateur eye, the quality of the body panels on the Chinese Buicks and the gaps between them are comparable to those of body panels made in Michigan.

BOTH VW AND GM have created technical centers to train Chinese engineers and modify Western designs for the Chinese market. SGM says more than 600 design and engineering changes were made on the original Regal alone. The company has lavished attention on the back seat, where most of the owners ride. That meant hollowing out the back of the front seats to increase legroom and installing DVD screens in the front-seat headrests.

As GM develops local engineering and design capability, it transfers technical knowledge to the Chinese staff. That's an explicit goal of the Chinese government's Automobile Industry Development Policy, the latest version of which was adopted in May. It pointedly encourages Chinese manufacturers to "study advanced international technologies, actively engage in international cooperation, and develop appropriate technologies that shall claim intellectual-property rights." When SGM was created, the joint venture got a license to use GM's technical know-how in the form of drawings, blueprints, math data, and computer files.

Technology transfer has the potential to create more conflict in the joint ventures. "The Chinese are very good at playing off one foreign company against the others," says Autopolis's Maxton. "VW was accused of holding back on both product and manufacturing technology and of building the Santana [a VW design that is sold exclusively in China] for years to a design that was 20 years old. China wanted to have the latest thing. That's when GM was brought in. One side is playing a clever game of chess, while the other side is dancing a merry jig."

More problems could arise if, say, SAIC decides to take the technology it learns from one joint venture and apply it to another, or simply grab it for itself. GM's Murtaugh says that, thanks in part to confidentiality agreements, that hasn't been a problem. "Shanghai Auto has done a good job of managing its joint ventures with GM and Volkswagen as two separate companies, in essence building a firewall between the two," he says, "They don't allow proprietary information from one to flow to the other." Yet others worry about the future. Says Michael J. Dunne, who studies the industry from Beijing and Shanghai as president of Automotive Resources Asia: "China's never made a secret about its strategic intentions. It has set up joint ventures for the purpose of learning the business. Global automakers implicitly believe that time is on their side; their technology, scale, and global reach cannot be matched. In contrast, the Chinese are confident that they in time will dominate their own industry by making cars more cheaply, just as they have done with cellphones."

TAKE THE Chery QQ, a minicar manufactured by a Wuhu City company that until last year was 20% owned by SAIC. GM says the car--especially its headlights, grille, and air-intake system--looks suspiciously like its own Chevy Spark, a small car built by SAIC and GM in western China. GM has complained to the Chinese government for a year about the issue without resolution, but it has not sued. A top Chinese commerce official said recently that GM hasn't provided enough evidence to prove that its design and technology were copied. The copycat issue was complicated by SAIC's stake in Chery, though there is no suggestion that SAIC was involved in Chery's creative design. A spokesman for SAIC told FORTUNE that the company currently holds no interest in Chery. "Shanghai Auto," he says, "has always been consistent with the position to object to any kind of pirating activities."

Under the best of circumstances, joint ventures can be difficult to manage. They've gone out of fashion among U.S. auto companies because the interests of the individual parties frequently diverged before the ventures had run their course. What's worse is that SAIC owns 50% of each joint venture by government regulation and gets half the votes when decisions are made. That's normally a recipe for frustration and deadlock. Asked how disputes get resolved when neither party has a tie-breaking vote, SAIC president Hu says: "When we have different ideas, we close doors and argue against each other. It is okay to lose your temper as long as the door is closed." He adds that he has learned a few things about conflict resolution between different nationalities. "Americans have more flexibility than the Germans, who are very serious once they make up their mind," he says.

Could disagreements unravel the ties to VW and GM? Some China experts believe the joint ventures will be unwound once the Chinese are capable of competing on their own. "Foreign automakers should be afraid of domestic competition--very afraid," wrote economist Kroeber. "In sector after sector, foreign manufacturers have piled into China only to see their technology copied and their prices undercut with alarming speed by domestic competitors operating with government support. Chinese firms have picked up technology much faster and kicked foreign competitors out of the market far faster than anyone predicted."

Others believe that China will moderate its practices as its economy matures and it becomes more attuned to international opinion through its membership in the World Trade Organization. Says Garel Rhys, who watches the global auto industry from the University of Cardiff Business School in Wales: "China has determined it will not be a haven for multinationals to engage in warfare and plunder the market. It will be its own player. Looking out over the next decade, a modus vivendi will be worked out with joint venture partners. China realizes that it never wants to sever completely its links with other manufacturers as long as they can be used to advantage, such as opening up foreign markets and shrinking costs."

The pace of investment by foreign automakers signals that accommodation is the prevailing attitude--or at least that the risk seems smaller than the reward. They have unveiled plans for investing some $13 billion in China to triple capacity to about six million cars a year by 2010. That's a vote of confidence, but the growing capacity is likely to crush margins. Manufacturers are already cutting prices to grab sales and hold down inventories. "Auto profit margins in China are expected to decline to similar levels as developed auto markets within the next two to three years," says John Bailey, an analyst for Standard & Poor's in Hong Kong.

How SAIC will fare in this chaotic environment is anyone's guess, though its track record to date is impressive. Its challenge will be to build a sufficiently solid foundation to support its unusually ambitious growth, even when the local market weakens. That will mean strengthening its ties with VW and GM while it goes about developing its own car business. For his part, president Hu is unconcerned. "China's auto industry is just beginning a period of growth," he says. "At some future time, growth will be less than today. Some companies may lose in the game, and some may keep growing." There's no doubt about in which category he expects to find SAIC.

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