How China's best business school is rewiring the nation's economy.

(FORTUNE Magazine) – As students in his competitiveness class settle into their seats, the professor lets fly an opening query: "Who can tell me why Estonia was so successful in making the transition to a market economy?" There's an awkward silence, then a hand pops up in front. "Because they moved so quickly to let in foreign trade?" The professor rubs his jaw. "Okaaaay ... but why would the Estonians do a crazy thing like that?" Another hand. "They knew they needed competition." The professor's mouth twists into a frown. "Okaaaay ... but wouldn't that risk control by foreigners?" When a student suggests Estonia derived a geographical advantage from its location "at the gateway to the Baltic," the professor rolls his eyes. "You think living in the shadow of Russia is a good thing?" Another's contention that Estonia benefited from a strong work ethic elicits outright scorn. "The Estonians lived in a centrally planned economy for 30 years," he says. "And we all know that in a centrally planned economy, no one is hard-working."

It's a bravura performance in the Socratic tradition--just what you'd expect at Harvard Business School. But this isn't Harvard. It's half a world away, on the Beijing campus of Tsinghua University. The professor, Li Mingzhi, has modeled his lectures on a course developed by Harvard guru Michael Porter, with help from Porter himself. What's surprising about Li's classroom is not that his methods diverge so starkly from the stuffy lectures and rote memorization that remain the norm elsewhere in China, or that the discussion takes place in English, or even that the instructor feels free to take potshots at central planning in a country where (unlike Estonia) Communists are still in charge. What's most remarkable is that Li's course at Tsinghua, alma mater of President Hu Jintao, is part of a larger effort to rewire the minds of China's future leaders.

The goal: creating a new breed of managers--not just smart technocrats loyal to the party but true Western-style executives and entrepreneurs versed in the logic of modern markets and equipped with the skills to compete in a freewheeling global economy. Hatching such creatures is no small trick, especially in a country that until 1992 was all but closed to foreign trade. So Tsinghua is reaching out to the West for help, forging partnerships with America's best business schools; inviting prominent businessmen like former Goldman Sachs co-president John Thornton to teach courses; and soliciting cash and advice from such multinational giants as BP, Wal-Mart, and McKinsey. At the same time, the school is wooing foreign specialists--many of them Chinese nationals trained abroad--with the promise of academic freedom and increasingly competitive salaries.

For an experiment of such national import, Tsinghua University is the obvious laboratory. It is sometimes described as "China's MIT," but that understates its heft. In prestige and influence no other Chinese school comes close. Its graduates hold four of the nine spots on the politburo's standing committee, hundreds of seats in the party's central committee, and thousands of senior posts in provincial and municipal governments and at China's state-owned firms. The vast majority of these officials trained as engineers in the 1950s, only to be banished to the countryside in the 1960s during the Cultural Revolution, then rehabilitated after Mao's death. During the past decade, as reforms set in motion by Mao's successor, Deng Xiaoping, gathered pace, an influential core of Tsinghua graduates has argued that China needs a different kind of leadership.

At the vanguard of Tsinghua's management revolution: former Premier Zhu Rongji, himself a Tsinghua engineer. In 1984, while serving as deputy of China's state economic-planning committee, Zhu carved out the university's department of management and information systems and relaunched it as the Tsinghua School of Economics and Management. Zhu served as dean and occasionally delivered lectures. Students competed fiercely for admission but found the curriculum less than stimulating. "The courses were useless," says Wang Chaoyong, a venture capitalist in Beijing and one of the 31 members in the first class of the school's master's program. "The professors had been trained in Russia. The reading was Mao Zedong Thought and Das Kapital." Many struggled to fathom markets on their own. Fang Xinghai, a founding-class member who is now deputy CEO of the Shanghai Stock Exchange, recalls stumbling upon a translation of Milton Friedman's Free to Choose in the library. "I thought, 'Wow, this is the best book I've ever read.'" In those early years, Tsinghua's management school was "mostly a training program for party cadres," concedes Zhao Chunjun, the current dean. "China was still a planned economy, so we didn't see much need to worry about demand or profits or accounting. The main task was maximizing production."

When Deng embraced trade and competition in the early 1990s, the school scrambled to adapt--and discovered an old friend, American philanthropist Houghton Freeman, waiting to assist. Freeman was born in Beijing in the 1920s, when his father was a philosophy professor at Tsinghua. The elder Freeman later moved to Shanghai, where he co-founded a small insurance firm that grew into AIG. Houghton followed his father into the business but was forced to flee Shanghai in 1949 after the Communist victory. He moved to Tokyo, where he launched AIG's Japan business, then returned to the U.S., rising to vice chairman of the company. By the mid-1990s he had retired and was looking for ways to use some of his family fortune to improve U.S.-China relations. In 1995, Freeman helped fund an exchange program to send Tsinghua management professors to study at Wharton and later gave $5 million to create the school's first endowed professorship.

A similar partnership with MIT's Sloan School has also proved fruitful. More than a third of Tsinghua's 120 faculty members have cycled through Cambridge, Mass., to work with MIT counterparts in developing courses for students in Beijing. Sloan faculty make frequent forays to Tsinghua and have helped the school launch an international MBA program, offered in English and open to overseas and Chinese students. Tsinghua has also formed an alliance with Harvard to design an executive training program for mid-career businessmen that now instructs 5,000 executives a year. Goldman Sachs CEO Hank Paulson helped broker Tsinghua's partnership with Harvard. He and Thornton were the driving force behind the creation of the school's international advisory board, a blue-chip panel whose members include Paulson, BP's John Browne, Nokia's Jorma Ollila, Wal-Mart's Lee Scott, and Sony's Nobuyuki Idei. The group, for which Zhu serves as honorary chair, meets once a year. Members are expected to contribute money and time. Wal-Mart has put up $1 million to finance a center to study retailing. BP has given $3 million to fund the creation of a think tank for economic policy.

This web of alliances with Western experts is a throwback to Tsinghua's past. Founded in 1911, the final year of imperial rule, the university owes its birth to Teddy Roosevelt. In 1907 he called on Congress to redirect part of the crushing indemnities imposed on the Qing dynasty for supporting attacks on Westerners during the 1900 Boxer Rebellion and use them to fund a Western-style academy. The idea was that China's best and brightest could be groomed in Beijing for further enlightenment at American universities and then take over for Qing mandarins. The Qing surrendered an imperial garden north of the Forbidden City for the school's campus. By the late 1930s Tsinghua had blossomed into a full-fledged university, complete with a red-brick rotunda, rolling green lawns, and a faculty boasting more Ivy League Ph.D.'s than many U.S. universities.

Mao's acolytes reshaped Tsinghua along Soviet lines. Students and faculty were required to study Russian. The focus was on science and engineering. Disciplines like art, literature, and the social sciences were jettisoned, as were most of the American-trained professors. Tsinghua's president at the time, Jiang Nanxiang, saw the school as an instrument of politics. He pushed out accomplished scientists to make way for trusted allies.

By the eve of Mao's Cultural Revolution in 1966, it had become hazardous to advocate training of any sort. Jiang himself was purged after ultra-leftists denounced him as "capitalist roader." Tsinghua was the scene of some of the Cultural Revolution's bloodiest battles. Between 1966 and 1968 warring Red Guard factions roamed the campus with clubs, homemade spears, and Molotov cocktails. Hundreds were injured and scores killed before Mao finally quelled the violence. Faculty and students were sent to the countryside, where most languished until Deng's return in 1976. Among the castoffs was a bright hydraulic engineer named Hu Jintao, who had won Jiang's favor and party membership as an undergraduate. Hu spent the early years of his exile as a construction worker in Gansu, a dusty southwestern backwater, where he was discovered by another powerful Tsinghua patron, provincial party boss Song Ping. In the 1980s, Song helped Hu reconnect with Jiang, by then restored to a post as Communist Party school vice chairman. Jiang brought Hu back to Beijing and helped him resume his swift ascent.

A plaque at the entrance to a hall in the center of campus laments the humiliation of the Boxer indemnities. Inside, black-and-white photos depict smoke billowing from a science building during the Cultural Revolution. But talk to the current crop of Tsinghua students, and debates about foreign imperialists or ideological battles seem worlds away. Zhang Zhe, a junior in the School of Economics and Management's undergraduate program, extols a textbook by Harvard economist and former Bush advisor N. Gregory Mankiw. "I especially like his explanation of how rational people think on the margin," says Zhang. Senior Zhang You talks enthusiastically about his internship last summer with the Financial Times in Hong Kong and a recent visit to the Tokyo trading floor of Goldman Sachs. The Tokyo trip helped persuade him to sign on with Goldman. He starts as a derivatives trader with the firm in Hong Kong in July. "I'm good with numbers," he says, "and I love the idea of taking risks."

"Good with numbers" could be the Tsinghua motto. Undergraduates "have phenomenal technical skills--definitely on a par with the students I teach at MIT," says Wang Jiang, a Sloan School economist who works at Tsinghua four weeks each semester. "These kids can show you four different ways to develop the Black-Scholes equations. You can throw almost anything at them, and they just pick it up."

MBA students are required to take a course called China's Socialist Economy: Practice and Theory, which covers trade, currency, and other economic issues in much the same way they would be studied at Harvard, though with examples more relevant to China. Often the textbooks are in English--the same ones that can be found on U.S. campuses. But broader analytical skills are harder to parse. Critics say the school's curriculum gives short shrift to management strategy and government policy, and that many subjects remain taboo. Students debate the merits of moves by Dell or General Electric, but China cases are few and nearly always tales of success. Dean Zhao jokes that short of advocating China be ruled by Taiwanese nationalists, "in our classrooms we can discuss anything." Still, it's hard to imagine full-throated debate about official corruption, private property rights, or how to slash payrolls.

One of the most popular professors is Yang Bin, who uses movies and novels to stimulate discussion in his MBA course on business ethics. In one session Yang invites comment on a 1979 novel that depicts the struggle of a hard-working cadre who is trying to revive a state-owned machinery factory but isn't any good at schmoozing local officials. Students remark about the need for managers to be well-rounded and develop networking skills. But no one challenges the logic of a system that gives party satraps so much power. In another class Yang shows scenes from a film version of Orwell's 1984, but the topic is human-resource management, not human rights.

Economics has become one of Tsinghua's most competitive undergraduate majors. Admission is ruthlessly meritocratic: The school takes fewer than 200 students a year solely on the basis of how they fare on tests that emphasize science and math. There are quotas to make sure each class includes a mix of students from China's 31 provinces. But there are no essays, no interviews, and no preferences for the children of alumni. Tsinghua doesn't require undergraduates to take many courses outside their major, so students move quickly to advanced topics. About half of each graduating class continues to master's and Ph.D. programs at the school.

Tsinghua's MBA program, established in 1991, was China's first and remains the most illustrious of the more than 100 such programs that have since been launched. Tuition, $7,300 for two years, is a substantial investment in a nation where salaries for MBA grads rarely top $20,000. The school counts 1,850 active degree candidates; nearly two-thirds study part-time, so most courses are offered at night. The list of required courses includes macroeconomics, accounting, corporate finance, marketing, and business law. Students also choose from electives, such as supply-chain management, quality control, or cybermarketing. In some instances the catalog seems to leapfrog actual development: Students receive full credit for studying derivative securities notwithstanding the fact that China lacks a futures market.

One of the school's most successful innovations is its executive MBA program, an 18-month degree program designed for senior executives. Since its establishment in 2003, the program has drawn hundreds of top managers, including CEOs and chairmen of China's largest private and state-owned firms. On the first day of classes this spring, the school parking lot was crowded with BMWs and Mercedes. Incoming students are admonished not to farm homework out to staff or bring secretaries to take notes in class. Executive MBA students pay $30,000 to attend 18 monthly, four-day instruction modules. Many commute thousands of miles to participate. Lin Qin came in search of a strategy for his fast-growing footwear factory in Fujian. "My knowledge is small," he says, "but my company keeps getting bigger." For others, the program offers a chance to network as much as to learn. "I need a clearer understanding of how people on the mainland think," says Wu Yiwen, a Hong Kong--born Singaporean educated in Canada who serves as Pepsi's managing director for greater China. Tsinghua works hard to encourage bonding. New recruits are bused an hour from Beijing, where they bunk together in spartan dormitories and engage in team-building exercises of the sort that can be found at corporate offsites in the U.S. On a freezing morning in March a dozen of Lin's classmates clutched the rope attached to his safety harness as he climbed reluctantly to the top of a 30-foot platform. The group shouted encouragement for nearly 20 minutes until he summoned the nerve to lunge for a metal trapeze.

Tsinghua's School of Economics and Management is hoping graduates will support its own great leap. To realize its vision of becoming a world-class institution, the school needs funding to supplement annual allocations from the state. Dean Zhao wants two foreign-trained professors for each domestic hire, but overseas salaries can run five to ten times the going rate for homegrown scholars. And while this may be a business school, at the end of the day it's still a state-owned enterprise, which makes huge salaries a political hot potato.

You don't have to be a Red Guard to marvel at the eagerness with which Tsinghua students chase jobs with foreign companies. Of the nearly 100 undergraduates who sought jobs this year, 36% signed with foreign-invested entities, 33% went to state-controlled enterprises, and 28% joined private Chinese firms. Only 3% went to work for the government. Students say they prize invitations from Goldman, Morgan Stanley, or McKinsey above offers from Lenovo or Huawei, not only because the pay is better but also because they expect to learn more about business and management. Zhao says it would be inappropriate for Tsinghua to meddle in the career choices of students it has instructed at length about free markets. But Fang, the Milton Friedman fan, is more critical. "I think it's sad," he says. "Chinese companies can't attract the best minds from Tsinghua. Will any of these students be President of China? Can they be the next generation's Hu Jintao?"

Perhaps not. But Fang's former classmate David Li, who earned a Ph.D. in economics from Harvard and returned to Tsinghua two years ago as Mansfield Freeman Professor of Economics, thinks maybe that's not so bad. "Back in the 1980s we were all taught to value collective thinking. We asked ourselves, 'How should we serve the country? What will we do for China when we return?' But maybe those aren't the main questions now. Maybe it's okay for students these days to ask, 'What's right for me?'"