Well, it finally happened: the dollar crashed below the 7 yuan mark today, hitting its lowest level against the Chinese currency since 1994.

China’s central bank, which determines exchange rate targets, set the new benchmark at 6.99 yuan to the dollar just before markets opened this morning and held it there throughout the day.

The yuan, also known as the renminbi, or “people’s currency,” has gained 4.5% against the dollar so far this year. That follows last year’s gain of 7%. Since 2005, when China abandoned its fixed dollar peg in favor of a more flexible policy allowing for gradual adjustment to market pressure, the yuan has gained more than 18% against the buck. A glance at a Bloomberg screen shows currency traders are betting the yuan will climb 11% higher over the next 12 months.

This is bad news for schlubs like me who get paid in greenbacks but spend in renminbi. Where three years ago, I could trade a single George Washington for eight Chairman Maos, now George fetches just seven of the Great Helmsman – and even those don’t seem to buy as much here as they did.

What the strong yuan means for the rest of the world is less clear. If you believe New York Sen. Charles Schumer – and the multitude of other lawmakers who’ve singled out China’s “unfair” currency policies as the source of the U.S. trade deficit – then the yuan’s advance should slow the pace of U.S. companies shifting production offshore, and stem the tide of lost U.S. manufacturing jobs. Most economists say the renminbi will have to climb a whole lot higher against the dollar to make much of a dent on the overall U.S. trade balance. The usual argument is that the yuan’s rise is more likely to prove a boon for workers in Mexico, Malaysia or Vietnam than for workers in the United States.

Nor is it easy to guess what a stronger currency will mean for China. Fear of trade friction isn’t the primary reason China’s policymakers let the yuan rise. Their larger concern is inflation, lately running at about 9%. In theory, a stronger currency helps curb inflation by lowering the cost of imported commodities like oil, soy beans and grain. But as I’ve noted in earlier posts, China’s inflation problem is mostly about higher food prices, particularly for pork, and so perhaps the sort of thing that can’t easily be fixed by tweaking exchange rates.

Data revisions announced today by China’s National Bureau of Statistics stoked fears that the economy is overheating. The new figures indicate that the world’s fastest growing economy has been growing even faster than anyone thought. The NBS said China’s GDP grew by 11.6% in 2006 (revised up from 11.1%), and 11.9% in 2007 (revised up from 11.4%). The changes prompted many China watchers to raise their growth forecasts for this year and next – and suggest that it will take a lot more than gradual currency appreciation to slow this economy down.

This year’s Olympic torch relay was meant by organizers as a kind of worldwide marketing tour, carefully scripted to showcase China’s emergence as a modern global power. But a funny thing happened on the way to the coliseum. Somehow, the beacon of hope has morphed into a “flame of shame” — and its “journey of harmony” has been transformed by demonstrations in city after city into a gauntlet of humiliation.

Trouble started at the flame-lighting ceremony in Greece, where a human rights activist posing as a reporter interrupted a speech by the president of China’s Olympic committee, unfurling a black banner depicting the Olympic rings as handcuffs.

On Sunday, torchbearers in London were harassed by thousands of demonstrators decrying human rights abuses in Tibet. Worse mayhem waited across The English Channel, where, on Monday, tens of thousands of protesters took to the streets of Paris, blocking the flame’s progress at nearly every turn. In the melee, the torch was extinguished no fewer than four times. The crowds forced organizers to abandon plans to parade the flame past the French capital’s grand monuments. Hapless VIP torchbearers traversed the final leg of the route in a bus guarded by helicopters and police trucks. Elsewhere, pro-Tibet activists clashed with thousands of Chinese students carrying banners and flag. Activists unfurled a pro-Tibet banner from the Eiffel Tower.

Chinese officials backed out of an Olympic reception that was to be held at Paris’ City Hall; politicians from the Green Party had draped a Tibetan flag across the front of the building. Mayor Bertrand Delanoe blamed China for the cancellation: “Chinese officials decided they would not [attend] because they were offended by Parisian citizens expressing their support for human rights. It is Beijing’s responsibility.”

In San Francisco, where the flame will arrive on Wednesday, police arrested activists for stretching a giant “Free Tibet” banner across the Golden Gate Bridge, and were bracing for large demonstrations. The flame is certain to draw opposition in Istanbul from Muslims dismayed by China’s treatment of the Muslim Uighur minority in the Xinjiang region. Authorities in New Delhi, where the flame is due April 19, have shortened the relay route to 3 kilometers instead of 9 kilometers as originally planned.

Needless to say, this isn’t the reaction Beijing expected. The Independent’s John Lichfield equated demonstrations along the torch relay route to protests in the aftermath of the 1989 crackdown in Tiananmen Square. “Beijing must be regretting its decision to stage the longest and most complex torch relay in the history of the Olympics.… Instead of a celebration of China’s emergence as a world power, the journey of the flame has turned into a trail of shame: the most intensive, international protests against Beijing’s human rights violations since the student massacres in Tienanmen [sic] Square in 1989.”

The protests create a tricky dilemma for gate-keepers of China’s domestic media. Government leaders know they must not appear indifferent to foreign slights. But at the same time, they must also dread the prospect that nationalist outrage over foreign snubs to the torch will get out of hand – a development sure to generate more embarrassing headlines in the foreign press.

In the state-run press, the solution so far has been to quote officials as “strongly condemning” the “disruption” of the torch relays in London and Paris without delving too deeply into the details of those disruptions — or attempting to explain what may have caused them. Similarly, Internet censors seem reluctant to let China-based web-users learn too much about the demonstrations online.

This weekend, as the flame arrived in London, The Financial Times reported that Beijing is looking to hire an international public relations firm to help it repair its image before the games.

Now there’s an Olympian challenge that will really be worth watching.

Hank Paulson likes a packed agenda. The US Treasury Secretary’s two-day visit to Beijing, which concluded Thursday, was a blur of meetings with Chinese officials, with talking points ranging from financial deregulation to tariffs on American-made medical equipment, currency policy and unrest in Tibet. Notably, though, Paulson doesn’t seem to have spent much time talking with China’s leaders about the one economic issue they say concerns them most: rising inflation.

In his final speech here today, which was devoted mostly to energy and the environment, Paulson touched obliquely on the subject of inflation. Noting China’s efforts to combat rising energy prices with government price caps, he warned that such measures had backfired when tried by US officials in the 1970s, resulting in heating oil shortages and rationing.

“China, by setting price controls on fuel, is facing similar consequences today,” Paulson said. “And because market forces can never be completely eliminated, price controls often lead to smuggling and corruption.”

But China’s inflation fears run deep – and extend beyond just energy. The big concern is soaring food prices, particularly for such staples as cooking oil, milk, grain, vegetables and above all pork. In February, Chinese consumer prices leapt 8.7% over the same period last year, to their highest level in 12 years. Pork prices, hit by an epidemic of the deadly “blue-eared” virus, surged in some areas by as much as 65% - prompting waves of pig-jackings.

Shortages of pork and other basic food items prompted China’s premier Wen Jiabao, with whom Paulson met Thursday, to tell China’s national parliament last month that whipping inflation is his top priority.

Such sentiments put China’s economic planners at odds with counterparts in Washington where the Federal Reserve is slashing interest rates and pumping credit into beleaguered banks. But perhaps it’s the US that’s out of step. As my colleague Peter Gumbel has observed, policymakers in Europe remain far more concerned about inflation than the threat of a liquidity squeeze. (See Peter’s excellent survey of the view from Europe here.)

The story is the same elsewhere in Asia. On Wednesday, the Manila-based Asia Development bank warned that, throughout the region, inflation has reached its highest level in a decade. Ifzal Ali, the ADB’s chief economist, said the widespread use of government price controls suggests real inflation is probably a lot worse than the official figures suggest.

The World Bank recently estimated that 33 countries around the world “face potential social unrest because of the acute hike in food and energy prices.” Jim Adams, World Bank vice president for the East Asia and Pacific, argues that in East Asia, where the burden of higher food and fuel prices falls so heavily on the poor, inflation poses a far greater risk to stability than fallout from the subprime debt crisis. “While the subprime crisis will have its impacts — possibly on some countries more than others — the more immediate concern is that in virtually every East Asian country, inflation is climbing to uncomfortable levels,” Adams says.

Shortages and high food prices have generated social tension around the world in recent months, triggering food riots in Guinea, Mauritania, Mexico, Morocco, Senegal, Uzbekistan and Yemen, reports The New York Times’ Keith Bradsher. Rising food prices may even have contributed to riots in Lhasa.

The Washington Post’s David Ignatius, in a recent column, contends global inflation looms as the new danger to the U.S. economy. Inflationary pressures are “most worryingly in food prices, but also in prices for commodities, raw materials and products that require petroleum energy, which includes almost everything,” Ignatius writes.

Many economists dismiss the fuss about global inflation as overdone. Should investors worry that China is in the early stages of a tumultuous price spiral comparable to bouts of inflation it suffered in the 1990s? “Even the most superficial look at detailed figures leads to a fairly emphatic ‘no,’” declares UBS economist John Anderson in a recent note to clients. “The evidence suggests the current spike in prices will be temporary, fading away by the second half of 2008.”

Anderson contends that, unlike the 1990s, when inflationary pressures were broadly based, the current price spike is almost entirely limited to food items, which make up less than a third of urban household expenditure. When food is excluded, China’s core inflation rate drops to 1.6%.

Officials at China’s top planning agency, the National Development and Reform Commission, may be coming around to that point of view. Today, as Paulson decried the futility of price controls, the NDRC relaxed controls on dairy and cooking oil, suggesting that it believes that, in at least some sectors, inflationary pressures have peaked.

But Stephen Roach, Asia chairman at Morgan Stanley, insists the inflation threat is real. “I’ve seen this movie before,” he writes in this piece in the Wall Street Journal. “It takes me back to the early 1970s” when Fed chairman Aurthur Burns dismissed the significance of rising food and energy prices as external shocks, and focused instead on core inflation with disastrous consequences. Roach’s conclusion: “China cannot afford to ignore the lessons of America’s most painful policy blunder on the inflation front.”

This week, U.S. Treasury Secretary Henry Paulson is in China to discuss economic issues in an ongoing dialogue aimed at improving trade relations between the two countries.

When Paulson arrived in Beijing this morning he was welcomed by an old friend. Wang Qishan, chosen last month to lead China in its high-level “strategic economic dialogue” with the United States, has known Paulson for years.

The two met in mid-1990s when Paulson worked for Goldman Sachs and Wang headed China’s first investment bank. Later, as deputy governor of China’s southern Guangdong province, Wang turned to Paulson - by then Goldman’s chairman – for help in averting a credit crisis after two Guangdong investment funds defaulted on loans from foreign banks.

In Wang’s next job, as mayor of Beijing, he helped Paulson structure the deal that won Goldman entry into China’s domestic banking market. They speak different languages, but share a similar temperament: Both are confident trouble-shooters, schooled in the ways of money and power and the complex mechanics of their different - but increasingly inter-dependent - nations.

In remarks to reporters before their meeting this morning at The Great Hall of the People, Wang needled Paulson about the U.S. sub-prime mortgage crisis. Noting that he had seen the Treasury Secretary on television Monday rolling out a plan to overhaul the U.S. financial system, Wang observed dryly: “You looked a bit worn out.”

The fact that, with that crisis still simmering, Paulson would fly half way around the world to meet with Wang, highlights the growing significance of U.S.–China economic relations.

Wang has worries of his own. While Fed chairman Ben Bernanke is cutting rates to shore up lenders, China’s central bank is moving in the other direction in a bid to rein in inflation. And with the U.S. economy slowing in a presidential election year, Wang must fend off criticism of China’s soaring trade surpluses and a currency many decry as undervalued against the dollar. In Beijing, officials from the two nations are haggling over those issues as well as product safety, market access and a long-range plan for bilateral cooperation on matters of energy and the environment.

After meetings with Wang, Paulson met with Foreign Minister Yang Jiechi and was granted a brief audience with Chinese president Hu Jintao. He told foreign reporters afterward that in those meetings, he raised the delicate topic of unrest in Tibet. “As you might imagine, I expressed our concern about the violence and urged a peaceful resolution through dialogue,” Paulson said. But Paulson was cagey about what he said to Hu: “I made the point, I felt, in a very appropriate way to the appropriate people.”

Paulson is scheduled to meet Thursday with China’s premier, Wen Jiabao and Commerce Minister Chen Deming. Treasury officials cautioned that they expect no major policy breakthroughs in this week’s discussions, the third round of a bilateral dialogue launched in 2006.

But Paulson is sure to have better rapport with Wang than he did with Madame Wu Yi, who used the last dialogue in Beijing to scold a delegation of U.S. lawmakers and administration officials for their ignorance of Chinese history.

Wang, 59, was promoted last month to the post of vice premier for finance and economics. He has considerably more experience than Wu on financial matters - and more clout. He’s also thought to have more enthusiasm than Wu for market-oriented reform. His appointment has been hailed by Western businessmen in China, who grouse that the reform process has faltered over the past two years.

The next round of the Strategic Economic Dialogue is scheduled to take place in Washington in June. For now, it’s hard to say what, if anything, these encounters have accomplished – or speculate their fate after the Bush administration comes to an end.

At the very least, though, it’s reassuring that top financial officials from these two economies aren’t just talking, but know what they’re talking about - and how to talk to each other. If a U.S.-China financial crisis sends phones jangling at 3 am (whether it’s Washington or Beijing time) knowing Paulson and Wang will be at opposite ends of the line should help the rest of us sleep a little easier.

The Olympic flame arrived in Beijing today, where it was received by luminaries from China’s Communist Party at a welcoming ceremony in Tiananmen Square. Amid tight security, China’s president Hu Jintao lit the Olympic torch from a cauldron in the middle of the Square, then handed it to China’s Olympic champion hurdler Liu Xiang. Thus the torch began a month-long, 85,000-mile “Journey of Harmony” that will span five continents.

Before leaving Beijing, the flame will be divided in two, with one passing through 19 foreign cities before landing in Hong Kong in early May, and the other transported to the slops of the Himalyas where it will eventually be carried to the summit of Mt. Everest. The two torches are to be reunited in Lhasa, the Tibetan capital, and then tour China’s mainland, returning to Beijing August 8 to open the summer games.

The opening date for the games was deemed by Chinese authorities to be enormously auspicious, falling as it does on the eighth day of the eighth month of the century’s eighth year. (In Chinese culture, the number eight has long been associated with wealth and good fortune.)

Increasingly, though, the day risks being overshadowed by expressions of concern over China’s treatment of its Tibetan minority and criticisms of China’s record on human rights. French President Sarkozy has hinted that he might boycott the opening ceremony. The European Union has called on China to hold talks with the Dalai Lama to lessen tension in Tibet, where protests by monks and other Tibetans have smoldered for the last three weeks. Pro-Tibetan advocacy groups are reportedly planning to disrupt the torch’s harmony tour with protests all along the way.

Beijing’s response thus far suggests that leaders are far more worried about looking soft on separatism at home than they are about damage to China’s reputation overseas. China has banned foreign journalists from traveling independently to Tibet. Party leaders have railed against “conspiracies” led by the Dalai Lama and his evil “clique.” Web sites seethe with indignant commentary decrying the biases of foreign media.

The controversy bodes ill for China’s bid to be taken seriously by the rest of the world as a peaceful, modern global power. It’s also a marketing headache for multi-national corporations — including General Electric (GE), McDonalds (MCD), Visa (V), UPS and torch relay sponsors Coca-Cola (KO), Lenovo and Samsung Electronics — who’ve paid millions for rights to sponsor the games.

Should sponsors rethink their involvement with the Beijing games? A coalition of 153 pro-Tibet organizations has written to Coke CEO Neville Isdell, urging the company to demand the torch relay exclude all Tibetan areas. In public statements, Coke has expressed concern for the situation in Tibet. So far, however, none of the games’ corporate sponsors has said it plans to change its media strategies.

In an essay on The Huffington Post, Tom Doctoroff, Greater China CEO for J Walter Thompson, suggests foreign firms fool enough to request that China alter the torch relay will be, well, playing with fire. Even the smallest slight against the games, Doctoroff warns, risks triggering a visceral backlash among potential Chinese customers. Why? Because in China, “individual identities are smothered, burdened by layers of suppressed expression [and therefore] linked to national pride…. In this context, Brand China – i.e. nationalism – is seized en masse as the ultimate identity surrogate. The Olympics reflect not only the nation’s potential but also ‘my own greatness.’”

A boycott of the 2008 games, Doctoroff concludes, would be “culturally tone-deaf” and a rejection of “the aspirations of 1.3 billion Chinese souls.” That’s an awful lot of aspiration. In Beijing, perhaps more so than in any previous Olympic games, there’s a lot more gold at stake than just the medals.

PS For a darker take on the torch and the symbolism of the Beijing games, see this column by the Financial Times’ Gideon Rachman.

Once you’ve lived in China for a while, it’s easy to get jaded about superlatives. World’s biggest this, world’s tallest that, world’s fastest the other. Whatever.

But even the Dragon Chaser’s cynical jaw dropped a bit the other day as he disembarked from his favorite Chinese carrier (DragonAir, natch!) into the enormity of Beijing Capital Airport’s new Terminal Three.

Designed by British architect Norman Foster in the shape of (what else?) a giant dragon, T-3 seems meant to inspire in foreign visitors to the Beijing Olympics the sense of awe once felt by emissaries to the Forbidden City. Pillars of imperial red supporting a soaring gold roof canopy drive home the message. Lest anyone still miss the point, the structure is adorned with replicas of some of China’s best known art treasures, including China’s most famous scroll painting and carvings imitating the famed (surprise!) Nine-Dragon Screen.

This photo, snapped hastily along my Long March from the gate to Immigration, doesn’t begin to convey the scale. (For a better idea, check out this report on CNN by ITN correspondent John Ray.)

With 14 million square feet of floor space, T-3 is not only the world’s largest air terminal (big enough, according to Sir Norman, to house all five terminals at Heathrow combined) but the world’s largest building period.

Built for $3.6 billion in just four years, Foster’s glass and steel dragon stretches nearly two miles in length. Triangular skylights in the rooftop evoke dragon scales. The structure boasts a capacity of 76 million passengers, who will be whisked to their gates by a high-speed commuter train. Their bags will travel along 40 miles of conveyor belts capable of handling 20,000 pieces of luggage an hours.

In stark contrast to Beijing’s dowdy two original terminals, which seemed designed to encourage you to rush to your boarding gate as quickly as possible, T-3 tempts passengers to tarry with 64 restaurants and 84 shops. And of course the facility has been built to accommodate the new Airbus A380 superjumbo.

Dragon chasing gets a little more civilized every day.

Ask the mayor or local party boss in boomtowns along China’s southern coastline to describe their biggest challenge and odds are they won’t answer “product safety” or “pollution.” What I’ve found over the years is that most cite chunjie, China’s lunar new year, as their No. 1 administrative headache. The mayor of Dongguan, the manufacturing hub an hour’s drive north of the Hong Kong border, once told me that migrant factory workers account for perhaps 70% of his city’s 11 million residents. When the New Year holiday rolls around, he lamented, millions of workers swarm from plant gates to the city’s train station at once, all clamoring for passage to their home provinces. Chinese New Year may be the world’s biggest movement of mankind. Government transit officials estimate that during this year’s lunar holiday, which runs from Feb. 6 to Feb 12, China’s 1.3 billion people will make a record 2.17 million journeys.

This year those journeys will be complicated by some of the worst weather conditions on record. Blizzards, ice storms and sleet battered wide swaths of southern and central China in recent days, grounding planes, disrupting train service and crippling electric power grids. In the coastal city of Nanjing, the heavens dumped more than a foot of snow over the weekend. In Beijing, bad weather stranded more than 400,000 travelers, prompting the city government to dispatch military police to Beijing station to keep the peace. In Guangdong, the provincial governor urged migrant workers to abandon plans for returning home. Chinese premier Wen Jiabao rushed to snow-bound Hunan province, north of Guangdong, to demonstrate the government’s concern. State television showed him standing in the Changsha railway station shouting through a bullhorn to stranded travelers, promising it would “not be long” before electric power and rail service would be restored and they could get back home.

Weather woes, combined with fears of a global economic slump, have taken a heavy toll on China’s stock market. The benchmark Shanghai Composite Index fell 7% on Monday, with shares of energy firms, steel producers, airlines and insurers all hard hit.

Thankfully, for the next few days I’m hunkered down in Hong Kong, where temperatures - and stock prices - have fallen less precipitously than on the mainland. Even so, the mood here is suddenly chilly. A couple of weeks ago, I managed to cadge a ticket to Jimmy Buffett’s sold-out charity concert at the Hong Kong Football Club. It was Buffett’s first performance in Hong Kong and he put on an amazing show. At 61, Buffett radiates the sunny, carefree enthusiasm of an 18-year-old. He played barefoot most of the night. His voice is better than ever. A mob of Margarita-guzzling investment bankers in Hawaiian shirts (the official costume of Parrotheads the world over) crowded the stage. Together with Buffett and his Coral Reefer Band, they belted out old favorites about rum, romance, and rootless expatriates in tropical ports. But this month’s nasty market turn has lent Buffett’s repertoire new resonance. In the Year of the Rat, I fear, we may all find ourselves on a very slow boat to China – with fins to the left, fins to the right. And unless the global financial storm blows over quickly, quite a few of those singing along with Buffett the other night could be in for some changes in latitudes and changes in attitudes.

PS Thanks to former Hong Kong Foreign Correspondents Club president Tom Crampton, who helped organize the concert, I was able to join Jimmy and entourage for dinner the nights before and after the show. I was pleasantly surprised to discover that, for all his carefree demeanor, Buffett is an astute entrepreneur with some very sharp ideas about branding and marketing. (Each year, he told me, he lectures students at the Berklee College of Music to impress upon them the importance of being your own manager and the idea that paying attention to the bottom line is they key to being a successful artist.) For what it’s worth, this Buffett struck me as no less business savvy as than other famous Buffett — and similarly generous. As Tom notes on his blog, ThomasCrampton.com, the performance, which sold out almost before it was announced, raised $60,000. Buffett didn’t keep a cent. Proceeds went entirely for needy kids in Hong Kong. Buffett paid his own travel expenses and even donated the tequila.

As the U.S. holiday shopping season kicked off last week, I hopped a plane for Zhejiang province to visit “Yiwu Little Commodities City,” a sprawling wholesale complex that has been dubbed The Great Mall of China.

Yiwu isn’t the best place to hunt for Christmas bargains (unless your gift list is really, really long). It’s geared to wholesalers, not ordinary shoppers. Ceilings are low and the shops are small. There’s no food court, no multiplex, no line of children waiting to be photographed with Santa. Merchants don’t offer free gift-wrapping; they deal in bulk. When they ask if you want a container, they mean the kind that gets loaded onto ships by 100 foot gantry cranes.

But I came to Yiwu in search of something else: China’s future. Over the past couple of months, I’ve been hearing about Yiwu and the dynamism of Zhejiang’s entrepreneurs from some of the savviest China watchers I know. Jack Ma, founder of China’s leading on-line commerce site, touts the fact that his business model is built around small proprietors like those hawking their wares at Yiwu as the reason Alibaba’s stock deserves to trade at an earnings multiple five times Google’s. (You can read my profile of Alibaba in the current issue of Fortune or on the website here.)

Take a photo tour of the Yiwu mall

Last month, a few days after Alibaba’s IPO in Hong Kong, Fang Xingdong, founder of China’s leading blogsite, launched Yiwu2.com, an e-commerce venture dedicated to partnering with Yiwu’s wholesale vendors. Fang, who grew up in Yiwu and remembers when his hometown was small enough that he and his high school classmates could jog around its outer perimeter in half an hour, marvels at the speed with which Yiwu has embraced the global economy. “Give Yiwu ten years,” he vows. “You’ll see dozens world class enterprises.”

Zhejiang’s small proprietors also are lionized in “Capitalism with Chinese Characteristics,” a new book by Sloan School management professor Yasheng Huang. Huang argues it’s no accident that Zhejiang, where the local economy is dominated by indigenous private ventures rather than state-owned giants or foreign multinationals, has emerged as China’s richest province. He hails the freewheeling entrepreneurial culture of rural boomtowns like Yiwu as the most plausible alternative to China’s current development model, which he decries as “an oligarchic version of the state-led capitalism prevailing in Latin America.”

The sheer scale of Yiwu’s wholesale complex is overwhelming. Created shortly after China opened to foreign trade and investment in the 1980s, the facility has expanded over the years to encompass more than 50,000 shops. The city’s international trade area, launched in 2001, is composed of five different marketing pavilions laid out in an S-curve meant to resemble the shape of a dragon. All told, the facility boasts 14 million square feet of shop space – the equivalent of five Malls of America.

It’s a good bet that at least a few of the things likely to wind up under your tree – or on it – this year were ordered by someone who found them first at Yiwu. Merchants represented there include the world’s largest producers of Christmas ornaments, Christmas lights, tinsel, artificial Christmas trees and dancing Santas. In villages and townships around Yiwu, thousands of small factories – many run by families barely a generation removed from working the fields – churn out a dizzying array of low-cost merchandise for overseas markets. In Yongkong, they make scooters and motorcycles. Shangyu is renowned for its plastic umbrellas. In Yiwu, locals take pride in the fact that their city produces more socks than any other city in the world. Lug-wrenches, Day-Glo party hats, electric can-openers, faux alligator handbags, remote-controlled helicopters, silk brassieres, smiley-face beach towels, topless garden statues. You name it: odds are someone at Yiwu sells it.

Peter Hessler, writing for National Geographic, figures that if you spent one minute at each shop and shopped eight hours each day, it would take you at least two months to work your way around Yiwu’s international trade area. My guess is it would take more time than that. I spent about eight hours over two days wandering Yiwu’s corridors and saw only a fraction of the place. I came away exhilarated and exhausted — but also a bit more skeptical of the Zhejiang model’s long-term promise.

There’s no doubting the vitality of the local economy. I emerged from my stay at the Yiwu Da Jiudian to discover a shiny red Ferrari parked in the front drive. At Yuanda Car Town, a luxury auto dealership on the highway to Hangzhou, the sales manager cheerfully informed me that he has sold three Bentleys (priced at over $400,000 each) this year and more than 100 Porsche Cayenne SUVs. In his study of China’s economy, MIT’s Huang finds that Zhejiang outperforms other Chinese provinces by every significant measure of prosperity. Its residents enjoy higher incomes and longer life spans than counterparts elsewhere. They also are more likely to own computers, televisions and mobile phones.

Nor would I question Zhejiang merchants’ ability to compete on price: a visit to Yiwu makes shopping at Sam’s Club seem like breakfast at Tiffanys. And yet I found little at Yiwu to suggest Zhejaing’s small producers are making the shift from quantity to quality. At Tongli Measuring Tapes, sales manager Wang Shaoli offers her top-of-the-line model to large-lot buyers for as little as 30 cents per unit. She told me her factory does brisk business in exports to Malaysia, Indonesia and Thailand, but doesn’t have many U.S. customers. “American buyers are too demanding,” she complained. “They want expensive materials and too many special features.”

I heard variations of that lament from scores of Yiwu proprietors, whether the product was tea kettles, bicycle helmets or umbrellas. City officials say vendors represented in Yiwu’s wholesale complex shipped the equivalent of 500,000 containers of merchandise to overseas markets last year. But only about 80,000 of those containers went to the United States, while about 165,000 went to the Middle East. Nearly all the merchants I spoke with – even the umbrella makers — cited the Middle East as their top export market.

Yiwu has a thriving Muslim community, with thousands of residents from countries like Pakistan, Afghanistan, Iraq and Iran. In the evenings, the call to prayer wafts from a downtown mosque over “Exotic Street,” where women in long white headscarves serve kabobs at Abdullah’s or the Baghdad Restaurant.

Merchants told me they rely heavily on Middle East middle men for tips on product design and the tastes of consumers in faraway lands. (In my brief visit, I wasn’t able to able to sort out the origins of Yiwu’s Middle Eastern connection, but this article in the China Economic Review suggests some interesting leads.)

It’s dangerous to generalize about the economy of an entire province on the basis of an overnight field trip. But my visit to Yiwu left me questioning whether Zhejiang’s vaunted entrepreneurs have what it takes to climb the global value chain. Part of the trouble, clearly, is that China’s financial system – rigged in favor of state-owned giants and foreign multinationals — deprives small, homegrown companies of the capital they need to invest in new technologies and marketing and move beyond commodities to unique, high-value brands.

But I wonder, too, whether there are cultural obstacles. “For many Chinese entrepreneurs, the problem isn’t just money, it’s a mindset,” says Xiang Bing, dean of Beijing’s Cheung Kong Graduate School of Business. Fledgling Chinese enterprises, he complains, typically lack the sophistication to figure out first-hand what consumers want in developed markets, but would rather stay small and compete on cost than share control with investors or professional managers beyond their immediate family.

“The Zhejiang model deserves a lot of credit,” says Xiang. “But it’s time for Chinese businesses to get beyond this small commodities way of thinking.”

In the meantime, Yiwu’s small commodities complex keeps getting bigger. Developers have begun construction on a new phase of the facility that will add another 29 million square feet, more than doubling its current size.

I don’t know about you, but I’m getting pretty tired of the ubiquitous media references to PetroChina as “the world’s biggest company,” “twice as valuable as Exxon Mobil,” the first company in history to achieve a $1 trillion market capitalization, etc, etc. The impetus for all this hyperbole, of course, is PetroChina’s Nov. 5 debut on the Shanghai stock exchange. On its first day of mainland trading, the company, China’s largest oil and gas distributor, raised nearly $9 billion by selling 2.2% of its total shares to mainland investors, with the price closing at $6.52, about three times the morning’s IPO price of $2.24.

As the Financial Times Lex Column put it: “There is big and there is humungous. On Friday, the world’s biggest company by market capitalization was worth just below $500 billion. By Monday, the new holder of the crown boasted a market capitalization of more than twice that. Benchmarked against almost anything, PetroChina’s value is huge. It is worth more than Exxon Mobil and General Electric combined, roughly equivalent to the entire Brazilian economy and worth substantially more than the combined economic output of the five founding members of the Organization of Petroleum Exporting Countries.”

Though they make for great copy, comparisons of this sort are completely spurious. The only way to generate a market cap anywhere near $1 trillion for PetroChina is to multiply its Nov. 5 closing price by total shares. But valuing the company in that fashion makes little sense for many reasons. Even after the Shanghai offering, PetroChina had listed only 13% of total shares; the remaining 87% are held by China National Petroleum Corp., a holding company that is wholly owned by the Chinese government. The 2.2% listed on the Shanghai exchange trade at a huge premium to PetroChina shares traded in Hong Kong or New York. Notably, on Nov. 5, PetroChina’s Hong Kong shares fell 8.2% to close at $2.32, close to the company’s IPO price on the mainland. Using the Hong Kong share price to calculate PetroChina’s value would put total market cap at around $425 billion – less than that of Exxon (XOM) or GE (GE).

Using the mainland share price to calculate PetroChina’s value is unrepresentative because China’s stock markets aren’t really markets in the true sense. Investors aren’t allowed to invest in shares outside China, have only limited choices for investments on the domestic exchanges and have few attractive options for putting their savings to use beyond the equity market. The result is an enormous, and in many ways artificial, demand inside China for the shares of well-known state-owned firms.

Valuing PetroChina using the price of shares traded in Hong Kong is a better, but still flawed alternative. In recent months, Hong Kong shares have been turbocharged by rumors — since squelched by comments from premier Wen Jiabao — that Beijing would loosen capital restrictions to allow mainland investors to purchase shares of companies traded in Hong Kong. By more conventional benchmarks, PetroChina does not outshine its global peers. PetroChina’s petroleum reserves are roughly comparable to those of Exxon, but the Chinese company generates half as much income as Exxon on four times the revenue and has a price/earnings ratio of about 50 to Exxon’s 15.

I am reminded of Warren Buffett’s comment during the dot com bubble that if he taught at Harvard Business School, the final exam for his class would ask students to compute the market value of an Internet company. Anyone who presumed to answer the question would be automatically flunked. The same treatment should be accorded any analyst presuming to divine the value of China’s state-owned behemoths on the basis of their mainland share prices. No surprise, then, that days before mainland investors piled into PetroChina shares offered in Shanghai, the Sage of Omaha unloaded his entire stake in PetroChina – reportedly for a price seven times what he paid for it in 2003.

Indian and Chinese companies have embarked on a global spending spree in recent years. Emboldened by booming growth at home, soaring profits and sky-high valuations of their shares, firms from Asia’s two rising giants have plunked down billions for foreign assets ranging from telecoms to tea.

As of Oct 19, Indian companies had announced foreign acquisitions worth more than $22 billion in 2007, according to Thompson Financial. That’s $1 billion shy of the same period last year, but more than five times the value of outbound Indian M&A deals in 2005. Overseas acquisitions by Chinese firms in that interval topped $12 billion – and that was before the announcement last week of two big new deals by CITIC, a leading Chinese securities firm, and Industrial and Commercial Bank of China (SEHK:1398), China’s largest bank, that were together worth $6.5 billion.

The rising tide of overseas purchases suggests companies from the two Asian giants are transcending their reputations as low-cost exporters and fast emerging as global players in their own right. This year’s roster of big-ticket purchases is certainly impressive: In India, Hindalco Industries (BSE:500440), part of the Aditya Birla group, bought Novelis, a Canadian aluminum company, for $3.6 billion. Suzlon Energy (BSE:532667), India’s largest wind power company, nabbed REpower, a leading German engineering firm, for $1.7 billion. United Breweries, India’s largest beer and spirits conglomerate, snapped up Whyte & Mackay, the world’s fourth-largest distiller of Scotch whisky, for $1 billion. Wipro (NYSE:WIT), one of India’s software giants, pocketed New Jersey-based Infocrossing (NASDAQ:IFOX) for $600 million. (We’ll learn more about what’s behind the surge in Indian acquisitions Tuesday in a panel discussion I’m chairing here in Delhi at the Fortune Global Forum.)

In China, the ICBC deal, announced Thursday, calls for the state-owned Chinese bank to put up $5.5 billion — China’s largest overseas investment ever – for a 20% stake in Standard Bank (JSE:SBK), South Africa’s biggest lender. News of that tie-up came just days after CITIC said it would pay $1 billion for a 2% stake in troubled US investment bank Bear Stearns (NYSE:BSC).

Earlier in this year, state policy lender China Development Bank announced that it would invest $3 billion in Barclays PLC (NYSE:BCS) to support the British bank’s unsuccessful bid for control of ABN Amro (NYSE:ABN). In March, Chinese officials said the government’s newly formed sovereign investment fund would invest $3 billion for a 10% stake in Blackstone Group (NYSE:BX), the US private equity firm.

But the value of the deals tells only part of the story. The larger truth is that Indian companies are venturing into the global economy with far more confidence — and I think greater success — than counterparts from China. In an article in Fortune’s current issue (which you can read here), I note that so far there has been “no Indian equivalent of TCL, the Chinese TV manufacturer still struggling to digest its 2004 purchase of the troubled television division of France’s Thomson. Nor have Indians encountered the sort of political backlash that thwarted efforts by CNOOC (NYSE:CEO), China’s state-owned petroleum giant, to purchase U.S.-based Unocal in 2005.”

One measure of Indian acquirors’ greater self-assurance: they typically push for a majority stake that brings operational control. China’s foreign investors tend to be more comfortable with small, passive stakes that offer the chance to watch and learn while they earn. My bet is that this disparity will become increasingly obvious in years to come.

The chief defect of China’s overseas investment effort is that it’s driven by considerations of policy, not profit. Keen to burnish national prestige and recycle the huge flows of foreign currency sucked in by rising exports, Chinese leaders have explicitly ordered state-owned enterprises to step up foreign purchases as part of a national “go global” campaign. At last week’s national Communist Party congress in Beijing, president Hu Jintao promised to “accelerate the growth of Chinese multinational corporations and Chinese brand names in the world market.”

But the ability of China’s big firms to achieve such lofty goals is frustrated by the very fact that they are state controlled. US lawmakers spiked CNOOC’s takeover bid on the grounds that selling Unocal to a state-owned company jeopardized US energy security. Similar questions threaten to derail a bid by Huawei Technologies, a Chinese telecom equipment maker, to acquire 3Com (NYSE:COMS), an ailing US computer-networking firm.

But it’s not just that other governments are suspicious of state-directed corporate takeovers. Far more damaging is the way in which state control corrodes the management function at Chinese firms, virtually assuring decisions about foreign acquisition get made for the wrong reasons by the wrong sorts of people.

Over the years, I’ve interviewed executives at scores of Indian and Chinese firms. By and large, what I’ve found is that China’s big companies are run by stolid technocrats acutely aware of the fact that they serve at the pleasure of Communist planners. They tend to talk in broad, fuzzy terms about how their actions are in keeping with party goals and China’s national welfare. And they are a parochial lot: competent, usually, but new to the principles of modern management and unsure of themselves beyond the Middle Kingdom.

In India, the executive mindset is completely different. The companies are privately owned and, in many cases, have been controlled by a single family for generations. As I wrote in an article about India’s leading business dynasties in 2005 (for some reason it’s not in the CNNMoney.com archives, but there’s an abbreviated version on Kellog Business School servers here ), the scions of these families are apt to have been educated at Cambridge, Harvard or MIT, and “are equally at ease in Delhi or Davos, as adept at English as Hindi or Marathi, and thoroughly conversant in the language of modern management.”

With Indian executives, the conversation about foreign acquisitions is never about government, but how the purchase fits their larger business strategy. Those strategies may prove wrong — or simply too ambitious. But generally, I’ve come away from my meetings with Indian executives reassured that acquisition decisions are the product of a rigorous analytical process that’s focused on the bottom line.

China’s “go global” star is Lenovo (SEHK:0992), the nation’s top computer maker, which purchased IBM’s PC division for $1.75 billion in 2005. The company is still struggling to wrest market share from Dell(DELL) and Hewlett Packard (HPQ), but its financial performance is encouraging. Earlier this month, Lenovo said it earned $67 million in the quarter ended in September, up from just $5 million in the same period last year. Notably though, Lenovo has gone to great lengths since the acquisition to become a truly global company, including moving the corporate headquarters to the US and appointing Dell veteran Bill Amelio as CEO.

To date, no other Chinese company has shown itself capable of such radical adaptation. Until more do, China’s state-run dinosaurs seem far less likely than their privately owned Indian counterparts to evolve into genuinely competitive multinationals.