Inside The New China
Part communist, part capitalist--and full speed ahead.

(FORTUNE Magazine) – WHEN THE NOON BELL RINGS ON THE Shenzhen campus of Chinese telecommunications equipment giant Huawei Technologies, an army of engineers falls out from the gleaming office towers. Like terra-cotta warriors sprung to life, they march past manicured lawns and soaring palms to the newly built cafeteria. The menu is distinctly local: pigs' feet with peanuts, dried bean curd with chives. But forget the Mao-era stereotypes about work units and "iron rice bowls." At Huawei employees pay for their own meals. Even management of the cafeteria is put up for bidding from outside vendors. In today's China, jokes Huawei executive vice president William Xu, "nobody gets a free lunch."

Back at their workstations, Huawei's troops are hatching plans to eat the lunch of global competitors, among them Cisco, Lucent Technologies, Siemens, and Alcatel. Founded in 1988 by a former People's Liberation Army sergeant, Huawei has come a long way from its start as a distributor of switchboards made in Hong Kong. Today the company employs 22,000 people, dominates China's market for high-speed switches and routers, and is muscling in overseas. Last year Huawei edged out half-a-dozen rivals, including Alcatel and Siemens, for rights to build a third-generation wireless-phone network in the United Arab Emirates, and it has signaled its U.S. ambitions by striking an alliance with 3Com, a Cisco rival. Huawei's sales this year are expected to top $5 billion, twice what they were in 2002, with $2 billion coming from outside China. Within three or four years, says Xu, foreign sales will account for more than 70% of Huawei's revenue.

Huawei's global prowess is just one of many signs that the world's most populous nation is coming into its own. After the communists seized power in 1949, Mao Zedong declared that China had "stood up." But as Chinese today like to point out, it wasn't until the diminutive, chain-smoking Deng Xiaoping opened the country to the forces of market competition after Mao's death that China was able to run. In the quarter-century since that second revolution, China has emerged as one of the most powerful--and unpredictable--forces in the global economy. It has sucked in hundreds of billions of dollars from multinationals eager to tap its vast pool of cheap labor and secure positions in its burgeoning market. It has become the world's manufacturing hub (half of the planet's clothes and a third of its mobile phones are made in China), driving down the prices of toys sold at Wal-Mart and laptops shipped by Dell. It has surpassed Japan as the country that has the largest trade surplus with the U.S. and trails only Japan as the largest holder of U.S. Treasury bills.

China is pulling in imports from Asian neighbors--machinery from Japan, steel from South Korea, palm oil from Thailand--and its appetite for raw materials of all sorts, from peanuts to pig iron, has sparked an unprecedented boom in world commodity markets. It has become the world's largest consumer of copper, aluminum, and cement, and last year overtook Japan as the world's second-largest importer of oil. China is the world's No. 1 market for mobile phones and the No. 2 market for personal computers; many analysts believe it will become the world's second-largest auto market by the end of the decade. No wonder consultants at McKinsey's Shanghai office report visits from CEOs of more than 40 major multinationals so far this year. For FORTUNE 500 executives, says Ian Davis, McKinsey's worldwide managing director, China is "absolutely center stage right now."

Analysts disagree about whether China's economy can sustain this torrid pace. Last year's GDP growth rate, 9.8%, fanned fears that China was overheating. In May, Beijing moved to cool things down, ordering local governments to curb public-works spending and banks to rein in lending. Other threats to expansion loom. By Western accounting standards, not one major Chinese bank is solvent. The country's stock exchanges are dens of thieves, planning is incoherent and often contradictory, and corruption is rampant. Once the most egalitarian of societies, China now has one of the world's widest gaps between rich and poor.

CLSA Asia economist Jim Walker urges the long view. China, he predicts, will grow faster this year than last, despite banking woes and government attempts to hit the brakes, and may well keep barreling forward at its current speed for years. "Capitalism in China is only ten years old," Walker says. "We're at the early stages of one of the greatest industrial revolutions in world history." Analysts at Goldman Sachs have projected that China's economy (2003 GDP: $1.4 trillion) will overtake Japan's by 2015 and America's by 2039. Perhaps. But econometric models can't compute all the variables in the China equation. It is, after all, an experiment without precedent in economic history. No other communist nation has managed the transition to the global marketplace with greater aplomb. Then again, no country has ever attempted to do it in quite this way.

HUAWEI'S HOMETOWN of Shenzhen is the cradle of the new China. It was little more than a fishing village when Deng emerged from exile in the late 1970s. But its location--at the mouth of the Pearl River on China's southern coast, just across the border from Hong Kong--made it the obvious choice for the first of Deng's special economic zones, where foreign trade and investment could flourish. Three decades of isolation, central planning, and political upheaval had laid waste to China's economy. It was stagnating, while Japan and Asia's "tiger economies" were booming. Deng's solution: revive Chinese communism by injecting it with limited doses of capitalism. The remedy proved more potent than anyone dreamed. Investment poured in from Hong Kong. Trucks filled with toys, textiles, and consumer electronics rumbled back the other way. Within a decade Shenzhen was a boomtown with a forest of shiny office towers and its first McDonald's.

But the experiment was nearly scuttled. The 1989 crackdown in Tiananmen Square put Deng and his allies on the defensive. Conservative rivals, decrying the collapse of communist regimes in Eastern Europe, clamored for retreat from economic reform. Deng made no significant public appearances for more than a year, fueling speculation about his health and his grip on power. Then, in January 1992, he popped up in Shenzhen. He visited a botanical garden and rubbed the smooth bark of a jade tree said to bring fortune to those who touched it. He admired Shenzhen's metropolitan sprawl from the revolving restaurant atop the new trade center. And he toured factory after factory, uttering aphorisms like "Development is the hard truth" and hailing freewheeling Shenzhen as a model for the rest of the nation. As political theater goes, it was tame stuff--a far cry from Mao's heroic swims in the Yangtze. But Deng's message got through. After a few weeks of silence, the state media fell in step and other government leaders were parroting Deng's assertion that socialism's only salvation lay in markets and material gain. In short order Beijing announced plans for a dozen new special economic zones. Foreign investment flooded in. Xu, then in his first year at Huawei, remembers the shift in sentiment. "Deng's statements set a tone," he recalls. "He made it clear to everyone that there would be further opening. For years after, we had annual growth of more than 100%."

IN HINDSIGHT, Deng's southern tour was an event comparable to the collapse of the Berlin Wall--the moment that one-fifth of humanity made its great and irrevocable leap into the global economy. By Deng's death in 1997, China's course was set. "For Deng's successors, undoing the economic reforms or ending the interdependence with the outside world is not a real option," China scholars David Goodman and Gerald Segal wrote that same year. "The clock of reform cannot be turned back."

Today Shenzhen pays tribute to Deng with an imposing bronze statue. The city's population has ballooned to eight million, outstripping Hong Kong's, and its economy is growing by double digits. Average annual income, about $3,000, is the highest of any mainland city. Nearly everyone in Shenzhen seems to come from someplace else--like 25-year-old Chen Chao, an electrical engineer who arrived three years ago from Hebei province. "The village I grew up in," Chen recalls, "didn't even have electricity until I was 7."

The reforms Deng set in motion have buoyed living standards far beyond Shenzhen, helping lift 250 million people out of poverty since 1978, according to the World Bank. "This is modern China's great triumph," says World Bank economist Deepak Bhattasali. "It is an achievement unprecedented in human history."

But maintaining that momentum won't be easy. To do so, Deng's heirs must figure out a way to generate 15 million new jobs a year, even as they keep pulling apart old socialist structures. Their surest strategy is to shift people out of the countryside, where they are unproductive, and into cities like Shenzhen, where they can be efficiently employed. Currently two-thirds of China's population, or about 800 million people, live in rural areas. The government hopes to move 400 million into cities over the next 25 years. But accommodating an exodus of such staggering magnitude implies infrastructure on a gargantuan scale. Houses, roads, schools, railways, sewage systems, power plants--to build all those things, China will need far more resources than it has. Consider: China is already the world's largest steelmaker, producing 220 million tons of the stuff last year--more than the U.S. and Japan combined. But that still wasn't enough to keep pace with domestic demand, so China imported an additional 40 million tons. China is also the world's largest coal producer, but UBS Securities analyst Joe Zhang predicts it could become a net importer of coal within the next few years. Economist David Hale warns that China's ravenous appetite for commodities will force Beijing to strengthen ties to commodity exporters in the Middle East, Africa, and Latin America, and contemplate building a navy, potentially putting it on a geopolitical collision course with the U.S. "China's economic takeoff," Hale says, "has occurred so quickly that the U.S. and other countries have not yet fully come to terms with it. All are extremely sensitive to the risk of job losses from China's export growth, but they have not devised a strategy for coping with the larger consequences."

So far, China's rise has proved more of a boon than a bane to its industrial partners. Over the past eight years cheap imports from China have saved U.S. consumers more than $600 billion, according to Morgan Stanley, and significantly lowered parts costs for U.S. manufacturers. That, in turn, has helped Alan Greenspan keep interest rates lower for longer, making it easier for America's consumers to buy houses and for its companies to invest. And the charge that China is mercantilistic, focused solely on exports, just doesn't wash. Yes, China ran a $59 billion trade surplus with the U.S. last year. But for the most part, its U.S. trade gains came at the expense of rival exporters. Moreover, the U.S. is the only country with which China runs a significant trade surplus. For most other trading partners, China buys more than it sells (see chart).

SOME CHINA OBSERVERS--and sometimes the Chinese themselves--talk as if the country is hurtling down the development path blazed by Japan and South Korea, only at greater scale and speed. Many assume that it is only a matter of time before China has its own global brands, like Sony or Samsung. But such comparisons are misleading. China's development model differs from those of its neighbors, especially in China's treatment of outsiders. Planners in Tokyo and Seoul initially shunned foreign investment and sheltered domestic firms, and they continue to do so in many ways. China, by contrast, solicited foreign investment and trade from an early stage. It took in $54 billion in foreign direct investment last year--more than Japan has attracted since the end of the U.S. occupation. Foreign capital permeates vital sectors of China's economy in a way that would be unimaginable in Japan or South Korea. Its most successful carmaker, Shanghai Automotive Industry Corp., is supported by billions of dollars of investments from two foreign partners, Volkswagen and General Motors (see "Shanghai Auto Wants to Be the World's Next Great Car Company"). Indeed, nearly all of China's major auto firms have been married off to foreign partners. Foreign giants such as Nokia, Motorola, Philips, Intel, IBM, Hewlett-Packard, and Procter & Gamble have come to China in force. Until recently China insisted that foreign investors grant local partners a majority stake when investing in China. That's still true in automaking. But the dismal performance of early ventures has prompted Beijing to loosen restrictions. In a host of important sectors--from consumer electronics to retailing--wholly owned foreign-invested enterprises are becoming the norm.

Another difference is that, unlike Japan and South Korea, which ceded ownership largely to the private sector, China's communist planners have left major enterprises firmly in the hands of the state. China's dysfunctional financial system reinforces the dominance of state-owned dinosaurs. The state-controlled banks, which allocate nearly 90% of credit, dole out funds far more readily to state behemoths than to private ventures. State firms get preferential consideration for listing on China's stock markets, lucrative tax and regulatory breaks, and first dibs on government procurement contracts.

This is hardly the formula for spawning global giants, and it's telling that three of the four Chinese companies with the best shot at emerging as world-class companies (TCL, China's No. 1 TV manufacturer; Lenovo, the No. 1 PC maker; and Haier, the No. 1 white-goods maker) are so-called red-hat companies, where majority owners are public entities content to play a passive role. The fourth, Huawei, is employee-owned. Lenovo's chairman, Liu Chuanzhi, draws a contrast between his company, free to make its own business decisions but forced to listen to customers in order to grow, and Great Wall, a struggling state-owned rival launched with more money and assured contracts. "Eventually the government figured out that if it didn't let customers choose their own computers, Chinese industry couldn't develop. That helps us, because we can pick our own people and invest our money how we like." At most other large Chinese enterprises, however, even minor decisions about personnel, investment, and strategy require approval from government or party organizations. At a World Economic Forum meeting in Beijing in September, Li Rongrong, chairman of China's State-Owned Assets Supervision and Administration Commission, acknowledged that China's state-owned enterprises have "too many mothers-in-law" telling them what to do.

Yet for all the trappings of a centralized economy, China lacks a coherent central plan. The political system grants vast power to party satraps at the provincial and municipal level, who squeeze entrepreneurs and channel resources to value-destroying dinosaurs. The quirks of China's economy, George Gilboy argued recently in Foreign Affairs, have left it fundamentally dependent on foreign multinationals for continued growth. U.S. fears that China is emerging as a competitive threat, he wrote, "overlook important weaknesses in China's economic 'miracle' and the strategic benefits the United States is reaping from the particular way China has joined the global economy."

In many ways the incoherence of China's development model reflects Deng's personality. The disastrous results of Mao's agriculture policies left Deng suspicious of heavy-handed central planning. He saw foreign investment as a useful expedient for raising living standards, boosting China's global stature, and shoring up the party's legitimacy. But his agenda lacked a grand design. In a memorable phrase, he described the ad hoc approach as "crossing the river by feeling the stones."

Foreign firms, too, are feeling their way, with surprising surefootedness. A 2003 survey by the American Chamber of Commerce in China suggests that the Chinese operations of U.S. firms are thriving. Three-quarters of the group's 254 member companies said their operations were profitable, and nearly half said margins in China were higher than their worldwide average. Coke, which boasts more than 600 million Chinese consumers and a 55% share of China's soft drink market, says it has been profitable in China for the past nine years. Yum Brands, with 1,000 KFC stores and 120 Pizza Huts in China, dominates China's fast-food industry. Yum Brands CEO David Novak told FORTUNE earlier this year that KFC "makes almost as much money in China today as it makes in the U.S."

By contrast, Beijing's reluctance to relinquish control of large enterprises, while throwing open the economy to foreign competition, makes life tough for China's global contenders. Lenovo, formed in 1988, rose from an IBM distributor to China's top PC manufacturer in nine years. The firm still commands a 25% market share. But as executives set their sights on overseas markets, foreign rivals, including Dell, HP, and IBM, chipped away at their domestic lead. That forced Lenovo to postpone its global ambitions and focus on core markets at home. In an effort to undercut foreign competitors, the company recently unveiled a low-end model that sells for as little as $360. TCL grabbed headlines with a deal that gives it effective control over the TV-manufacturing arm of France's Thomson Electronics, making it the largest TV producer in the world. But while CEO Li Dongshen plots global strategy, he's battling to keep TCL profitable at home, where it is fending off competition at the high end from the likes of Sony, Sharp, and Philips, and at the low end from more than 20 Chinese rivals subsidized by cheap credit from provincial banks.

CHINA MARKED the centenary of Deng's birth in August with a cavalcade of films, TV documentaries, and ceremonies. Shenzhen rang in the anniversary with a concert of 200 grand pianos. But on the eve of an important September party conference, Deng emerged as a curious totem in a political tug-of-war between his two handpicked successors. Former President Jiang Zemin, who remains head of the party's powerful central military committee, has invoked Deng's memory to support his view that China's economy can grow much faster and that recent policy measures to rein in the economy are misguided. Hu Jintao, the current President, has expressed concern that rapid growth has resurrected a gaggle of old demons--inequality, inflation, crime, and greedy landlords--and instead lauded Deng for his willingness to surrender positions of formal authority. Their dispute about growth echoes disagreements that propelled Deng to Shenzhen a dozen years ago, but this time the stakes are different. Since Deng, China has felt its way too far into the river. The stones may be sharper and the current swifter, but there is no chance of turning back to shore.