STORM OVER HONG KONG China takes over the British colony in less than five years now. Will it really honor its pledges to let capitalism flourish? The answer has suddenly become iffy.
By Louis Kraar

(FORTUNE Magazine) – A POLITICAL STORM is sweeping Hong Kong, shaking confidence within Asia's most vibrant business center and sending dark clouds as far as the U.S. and Europe. China's promise to allow the capitalist enclave great autonomy after it takes control from the British in mid-1997 suddenly looks more hollow than ever. Beijing's new belligerence casts doubt on a host of deals between Western companies and China. Most prominently it threatens the $22 billion Hong Kong airport project, in which Morgan Stanley, American construction giants Bechtel and Morrison Knudsen, and a consortium of British companies have major roles. But it could affect transactions outside of Hong Kong too. Says economist Miron Miskat of Baring Securities in Hong Kong: ''If there's uncertainty about contracts, we're all in trouble.'' China itself faces the most potential trouble. Its intimidating stance in Hong Kong not only jeopardizes the dynamic growth of southern China but also could trigger a serious confrontation with the West. As Winston Lord, a former U.S. ambassador to Beijing, put it in Hong Kong just before becoming the Clinton Administration's point man for Asia, ''The Chinese are undermining their credibility'' for living up to agreements. The risk for the global economy is that Beijing seems to be reneging on guarantees that Hong Kong can retain its position as China's capitalist gateway to the world. The tiny colony is a major financial center of Asia, and its trade volume is the tenth largest in the world. This role supposedly was protected by an imaginative treaty called the Joint Declaration, signed by Britain and China in 1984. Its essence: China pledged that when the British departed, Hong Kong would be run largely by its own people under the concept of ''one country, two systems.'' Hong Kong settled back into what it has always done best -- making millionaires. As 1997 receded as an issue, Beijing began watering down its promises and secretly pressing for immediate influence over Hong Kong. The British went along for a while. Then last year Prime Minister John Major finally got fed up. He picked Chris Patten, a political ally and former chairman of the Conservative Party, to be Hong Kong's governor and instructed him to stop negotiating behind closed doors. Just months after his arrival last summer, Patten began openly proposing a faster pace of democracy for Hong Kong, in part by allowing more participation by Hong Kong Chinese in the selection of members of the local legislature. Beijing responded with a stream of abuse reminiscent of its old Maoist madness, even suggesting that its treaty with Britain could be ''scattered to the wind.'' Through leaks to the Chinese-language press in Hong Kong, China even raised the possibility -- considered remote -- of grabbing control of the territory before 1997. Hong Kong's economy is still booming; it should grow about 6% this year, and corporate profits are strong. There has been no big sell-off on the Hong Kong stock market -- one of the world's top performers in recent years -- but the political uncertainty has made traders jittery. Merrill Lynch has advised investors to diversify away from Hong Kong until the political dispute between Britain and China eases. And though the Hong Kong government has $29 billion in foreign exchange reserves -- the 12th-largest hoard in the world -- and virtually no debt, Standard & Poor's is reviewing its credit rating, which is much higher than China's. For those and other reasons, Beijing has found allies in an unexpected place: among the Hong Kong Chinese who have made millions -- and sometimes billions -- as free-wheeling capitalists. The Business and Professionals Federation, whose membership includes many of the colony's biggest businesses, wants the governor to withdraw his pro-democracy proposals. Says Vincent Lo, 44, a big real estate developer and current chairman of the group: ''China will not sit back and do nothing. It is not acceptable, in our view, that Hong Kong has to be the victim of a major confrontation with China.'' Confides a multimillionaire Hong Kong Chinese investment banker, fearful of being identified by name: ''You can vote with your feet, or stay here and get along with our new masters.'' Americans, who outnumber the British in their own colony, are fretting too. Gareth C.C. Chang, regional president of McDonnell Douglas and until January president of the American Chamber of Commerce in Hong Kong, worries that a prolonged disagreement could shake the confidence of people who invest in Hong Kong or in China. China's rough tactics in Hong Kong may also endanger its already shaky most-favored-nation trade status with the U.S., which will expire in June unless Congress renews it. President Clinton is already getting ! pressure from human rights groups, and China's behavior doesn't help. HONG KONG'S economic importance to China can't be overstated. Two-thirds of foreign investment in China comes from Hong Kong Chinese. In neighboring Guangdong province, more than 25,000 Hong Kong-backed factories employ three million workers, and Hong Kong's currency circulates freely. Forty percent of China's trade passes through Hong Kong. Says William Purves, group chairman of the Hongkong Bank: ''China needs a thriving capitalist force to continue in Hong Kong.'' At the same time, Hong Kong's prosperity depends more than ever on its Chinese comrades, who have invested a roughly estimated $16 billion in everything from night clubs to 22.5% of Cathay Pacific, the colony's main airline. Citic Pacific Ltd., a Beijing investment group controlled by the Chinese government, has just raised some $943 million through a private placement of shares -- the largest in the history of the Hong Kong stock exchange. And next year the state-owned Bank of China will start issuing Hong Kong currency notes, fully backed by foreign exchange deposits with the Hong Kong government. Nonetheless, Hong Kong has become a political soccer ball in a larger contest for global power. China wants capitalist rewards for its economy while preserving the Communist regime. The Chinese economy is expanding at a 12% annual rate, and the country's aging leaders think of prosperity as an insurance policy for staying in power. Beijing's ugly outburst over Hong Kong is ''a calculated move,'' says one Sinologist, which amounts to a broader warning to the West. The last thing Beijing wants in any part of China is democracy, a determination leaders showed by gunning down students in Tiananmen Square in June 1989. Chinese leaders see the world through lenses fogged with paranoia. In their wacky geopolitical view, Hong Kong -- despite its usefulness -- is an irritant. Beijing has never quite forgiven Britain for seizing the colony in 1840 in the first place. Says an American businessman who knows China, its language, and its officials well: ''Hong Kong is the scapegoat for what Chinese leaders perceive as Western injustice.'' BRITAIN'S new, firmer stance toward China is instructive for anyone trying to negotiate a business deal with Beijing. The British long tried being amenable in hopes of persuading China to abide by its Hong Kong commitments -- and got nowhere. After signing the agreement, the Chinese added a new wrinkle they called convergence: The British should do nothing in Hong Kong that would differ from what China envisioned for 1997. The Chinese demanded consultations to achieve convergence, but what they really meant was veto power over all British decisions before 1997. Beijing has written its own Basic Law, a constitution for Hong Kong, which could dilute China's promises of an elected government, independent courts, and wide personal freedoms. Says an American business leader in Hong Kong: ''The fight with China is not about democracy or an airport but over whether Beijing will respect the rule of law.'' While Beijing has the support of some local businessmen now, it hardly has the masses. At the time of the Tiananmen massacre, Hong Kong Chinese faxed stinging messages to officials in Beijing and at one point mounted a protest march of one million people. Says a Western diplomat: ''For the first time Beijing began to see Hong Kong as a potential threat to its regime.'' To China's horror, the first popular elections in Hong Kong in 1991 swept into office the very leaders of the pro-democracy protests. The lavish new airport project on an island 21 miles northwest of central Hong Kong has become China's favorite political lever against the British, who need Beijing's support in order to get international financing and to sign contracts that extend beyond 1997. The Chinese sometimes act as if the airport is a British plot to loot the Hong Kong treasury before departing, and the $22 billion pricetag is big enough to arouse anyone's suspicions. It includes a $4.3 billion railway link, a six-lane highway with bridges, and a new tunnel under the harbor. The airport alone will cost $8.8 billion. THOUGH AMERICANS have some of the contracts, most have gone to British companies. A predominantly British consortium got a contract to build a 1.3- kilometer suspension bridge leading to the airport, even though its $992 million bid was 50% higher than that of the low bidder, Hyundai Engineering & Construction Co., which is part of Korea's biggest conglomerate. The Hong Kong government maintains that Hyundai could not supply sufficient financial guarantees. Even without Chinese approval of the airport's overall financial plan, work is moving ahead on preparing the site. That $1.16 billion contract went to a non-British team that includes Morrison Knudsen of the U.S. and a mainland Chinese company, China Harbour Engineers. In one sense Beijing has pushed its airport lever too hard. Two years ago the Chinese offered to sign an agreement approving the airport, but only if Prime Minister Major came to Beijing. Though he did not like being the first Western head of government to visit after Tiananmen, he made the trip, returning in September 1991 with a ''memo of understanding'' that plainly promised China's support for the project. But the Chinese have yet to follow through. As a result, Major is no longer listening to British Foreign Office Sinologists who recommended the trip. He dispatched Patten to get tougher with the Chinese. Patten really twisted the dragon's tail, but he did not invent the issue of democracy. After all, Britain and China had agreed to replace the colonial structure with a system that allows Hong Kong's people to run the place. Even Beijing accepts direct elections of 20 legislators (one-third of the total) in 1995. The others will be appointed by the British administration and interest groups such as the Chamber of Commerce or associations of hotel owners or manufacturers until mid-1997, when they will be appointed by China. SINCE PATTEN could not get more from Beijing, he found some loopholes in the Basic Law that China had written for Hong Kong, and he pushed right through them. Says a top Hong Kong businessman: ''Patten did to China what it does to everyone else with contracts.'' One example: Under the Basic Law, the leaders of the various interest groups each select a legislator. Rather than leaving it to a few chief executives, Patten proposes extending the vote to every worker in those industries -- which infuriated China. Many local business leaders also oppose the idea of creating what one crusty Hong Kong lawyer terms ''a dictatorship of blue-collar workers.'' Patten, however, has rallied wide support from Hong Kong citizens who believe they have been left out of decisions for too long. Says Christine Lo, 37, an appointed legislator and a director of a medium-size property development company called CIM: ''If China declines to accept the Patten proposals, it can only be because China is determined to rule Hong Kong entirely as it pleases. If that's China's attitude, we have nothing to gain by appeasement.'' The governor, in effect, has tossed the problem -- finding something China will accept -- into the laps of Hong Kong legislators. Patten stresses that his ideas are only proposals and require discussion. But China refuses to talk with the governor until he withdraws them. Beijing's many officials in Hong Kong (where their diplomatic headquarters is the New China News Agency) are talking to legislators, who are looking for a compromise. Most Hong Kong business and government leaders expect to end the impasse by summer. Beijing, in fact, has lowered the tone, though not the substance, of its rhetoric. Yet more political eruptions are bound to follow before Britain transfers sovereignty over nearly six million people, many of whom fled from communism, to China. Whatever happens, the colony will become the Hong Kong Special Administrative Region of the People's Republic. Whether it remains an open international business hub really depends on Beijing. Says Patten: ''I want to see the Chinese economic revolution succeed. That would be good for all of us.'' At best, China's regime may become more moderate in the years ahead, allowing Hong Kong to continue to be a competitive arena for everyone. The upside potential is enormous. Already the colony is the unofficial commercial capital of the Overseas Chinese. For Americans, Hong Kong will be the place to find ethnic Chinese partners to ease the way into China. At worst, though, Hong Kong could become a backwater for global business, weighed down by China's present habits of oiling business with rampant corruption. Instead of working on the basis of the best price and quality, even resilient Overseas Chinese entrepreneurs would need to buy political influence. The endless contest for power in China would make that an expensive pursuit. ''This place,'' says a wealthy Hong Kong businessman, ''may become like the Wild West.''