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The gray dust of construction clinging to his shoes, Lloyd Chao leads a visitor through one of the cavernous sound stages in the new Shaw Studios production complex, perched on a windy hillside in Hong Kong. In its heyday Shaw Bros. churned out hundreds of films for Chinese-language audiences around the world, leading an industry that, by the mid-1980s, made a city of 6 million the world's third biggest movie producer. That's when Shaw began to phase out film production in favor of TV. Though other studios filled the gap for a while, Hong Kong, which had made 234 movies in 1993, produced only 64 last year. That makes the very existence of Shaw's high-tech cinematic playground, which is scheduled to fully open in half a year, a surprise in itself. But to Chao, a Hong Kong native who joined the project 10 months ago, Shaw Studios is a $180 million vote of confidence that the industry still has life. "The Hong Kong film industry is going to come back, but in a different way," he says. "It just has to evolve."

Evolve is something much of the industry has failed to do. Piracy, video and aggressive foreign competition eroded the market for the city's movies, while its once kinetic style grew stale. Yet even as Hong Kong struggles through creative and financial doldrums, Chinese-language cinema is poised to take off—as the increasingly mainland-oriented Hong Kong International Film Festival will demonstrate when it opens this week. Chinese films like Hero and House of Flying Daggers have earned world-class box office, while the gradual liberalization of the mainland market means the demand for Chinese-language movies is only going to grow. If Hong Kong's smartest producers can leverage the city's international financial networks, China experience and stable of stars, then it could defend its position as the beating heart of Chinese cinema. "There are tremendous challenges and tremendous opportunities," says Nansun Shi, one of Hong Kong's most respected producers. "We're at a crossroads and we need to get this right, in a very short time."

Since the postwar years, Hong Kong had a virtual monopoly on producing entertainment for the entire Chinese-speaking world. All that changed in 1997. The Asian financial crisis dried up film financing and permanently damaged the city's vital Asian markets; those of some countries, like Indonesia's, have never recovered. The introduction of VCDs and DVDs, legitimate and not, ate into box office. Fewer Asians were willing to shell out $7 to watch a Hong Kong film with sub-Hollywood production values when they could cheaply get their fix at home. With box office disappearing, the only sure money in moviemaking came from video rights, which meant an increasing number of films were made with a VCD expressly in mind—not a formula for cinematic greatness. "Videos are like drugs to us," says Peter Chan, a director and head of independent film company Applause Pictures. "You can't get off them, because it's the only way to make money off a film, but it's killing theatrical."

Faced with shrinking revenue and investment, the Hong Kong film industry responded as threatened industries often do—it forgot how it became successful in the first place. Gone was the freewheeling spirit that fueled the creativity of the '80s and produced international icons like Jackie Chan. There were exceptions, but too many Hong Kong filmmakers began to churn out timid, formulaic comedies with the same old stars. Audiences flocked instead to the high-budget Hollywood event movies that are increasingly pitched at international audiences, and to films from Asian nations like South Korea, where young directors weaned on John Woo are making the kinds of dynamic movies Hong Kong used to produce. "The export value of Hong Kong film is deteriorating," says Peter Tsi, executive director of the city's film festival. "It's a little bit pathetic that if we're talking about Hong Kong stars, we're still talking about Andy Lau." But few new talents have surfaced. (The Actor in Focus at this year's festival: Andy Lau.)

While Hong Kong-made cinema was forgetting how to make money, mainland movies were striking box-office gold. Hero and Crouching Tiger, Hidden Dragon and House of Flying Daggers all proved that there's undoubted demand for good Chinese movies in Asia and beyond. But here's the hope for Hong Kong: even though each of those films were shot in the mainland with Chinese directors, they never would have been made without Hong Kong. Most of the films' stars hail from the city, and all of the movies were co-productions with Hong Kong companies that had experience in making commercial films and marketing them internationally. "China lacks all of the things Hong Kong is good at," says Shi. "We have the intellectual, legal and branding knowledge, the marketing and packaging and networking ability."

China needs Hong Kong. But—in film as in other industries—it may not need it forever. So the city has to capitalize on its status as a global financial hub immediately.

One positive sign is this week's Hong Kong-Asia Film Financing Forum, which matches promising movie projects with investors. Organizers expected 150 submissions—and received 280 from around the region. "Hong Kong can really develop its status as a film-financing center for Asia," says Raymond Yip, director of service promotion at the Hong Kong Trade Development Council, which organized the forum. One challenge will be getting Hong Kong's banking sector involved in film financing. The button-down banks have long been leery of the flamboyant film industry, but they've shown increasing interest.

Across the border, the mainland is finally beginning to offer Hong Kong what the city has always lacked: a large, domestic market for its films. New cinemas are being built in China every day; the mainland box-office market increased by 50% from 2003 to 2004 alone, to $180 million. Piracy remains a concern, but the fact that a pair of co-productions this past December—A World Without Thieves and Kung Fu Hustle—were able to clean up at the box office shows that movies can make real money in China. "This is the only film market in the world where the economy is growing, where there are more people with more disposable income every day," says Shi.

Hong Kong filmmakers know the promise China holds, but making a movie that works in the mainland and in Hong Kong is no easy task. One man who figured out how to straddle the border is Hong Kong's Stephen Chow, whose Kung Fu Hustle took in $20 million on the mainland and a record $8 million at home, and is on a pace for $100 million globally. It's tough to copy Chow's style, but his film may provide a blueprint for a changing industry. Shot in China with a cast and crew that was mostly from Hong Kong, and with Columbia Pictures on board as a co-producer, Kung Fu Hustle had the budget, the star and the story to cross borders. In a globalized film market, that's what it's going to take to be successful. "You have to know how to make an international film," says Shi.

So from being the Hollywood of the Asian film world, Hong Kong may become its New York, the place where deals are done and money is raised. The decline in movies made in and about Hong Kong is unlikely to be reversed—which has some producers wondering why Shaw Bros. is building a $180 million film studio. But Lloyd Chao believes that studio's cutting-edge facilities will be perfect for high-profile projects from around Asia, including China. "It's going to be about quality, not quantity," he says. Still, Hong Kong—and international moviegoers—will lose something when the old system dies, as Peter Chan knows. Chan, who built his name by making indie Hong Kong movies, has just shot a $10 million Mandarin musical set in Beijing and Shanghai and co-produced by the Hollywood backer of Million Dollar Baby. The film could be bigger than anything Chan has ever done, but part of him misses the way things used to be. "Hong Kong culture will inevitably be gone one day," Chan says. "That's why it's important for me to still make small Hong Kong films. If you make something, it stays on celluloid forever. Like a memory."

• Bryan Walsh | Hong Kong
• Hong Kong's once vaunted film industry has been in a slump, but help from China could turn things around