Cuba: The second revolution?

It's the sort of glitz you would expect to see in Hollywood, not Communist Cuba. Drop-dead gorgeous, 6ft-tall women, stitched into the skimpiest of red dresses, work their way around the gala dinner to which 1,500 men and woman have come from around the world, paying $500 a head a ticket to attend. And what a spectacle it is: stunning opera singers caress a selection of tasteful arias, lithe dancers spin to Cuban rhythms, while Jim Belushi, the American actor and comedian, keeps guests on their toes as Master of Ceremonies.

What you won't have seen in Hollywood, though, is a room so big filled with cigar smoke so thick that it hangs like a mushroom cloud, making it hard to breathe, if not see. Yet the cigar-girls in red are tempting guests to smoke still more, giving away the latest hand-rolled vitolas to sample between the four-course meal. Welcome to the gala dinner, the finale of the week-long 14th Habanos Cigar Festival held in Havana – and a festival that the visiting cigar aficionados acclaim as the most glittering ever.

It's my first visit to the cigar Oscars, so I can't compare. But what's for sure is the glitz is not just for show: tobacco is big bucks. Seated on the top table next to the stage is a young Western woman, puffing away on the fattest cigar imaginable. She is Alison Cooper, chief executive of Imperial Tobacco, the world's fourth-biggest tobacco company, and she is sitting alongside Ricardo Alarcon, president of Cuba's National Assembly and one of the most powerful men in the country. Also present is trade minister Rodriguez Malmierca. Cooper is here to do business; Imperial is a joint venture partner with kHabanos, Cuba's state premium-cigar company, and Cuban cigars are a significant part of its sales. Tobacco is worth more than $400m a year to Cuba in exports, and the industry is a huge employer.

Seated not far from Cooper is another British woman, 40-year-old Jemma Freeman, managing director of Hunters & Frankau, which imports most of the four million Havana cigars smoked in the UK each year. Jemma is also there to collect the "Habanos Man" of the year award, cementing a relationship between the Freeman family and the Cubans that goes back to the 1930s. Why so many women? Freeman laughs. "Serendipity, I think. But women have always been involved in the cigar industry; the Cohiba cigars smoked by Fidel Castro were made only by women and most of the hand-rollers are women," she says, puffing away.

A third British woman makes her way through the tables, chatting quietly to Cuba's political elite as well as the foreign buyers. Dianna Melrose, the British Ambassador to Cuba, has been our woman in Havana for four years. The ambassador spends much of her time promoting trade between the countries – small but growing now that Cuba is opening up to more foreign joint ventures. UK companies want to work with the Cubans, she says, on projects ranging from the tourist resorts and golf courses planned along the island's white-sand beaches to oil specialists hoping for a piece of the action in the oil reserves being discovered in Cuban waters in the Gulf of Mexico.

But cigars, adds Melrose, are special, playing a deep part in Cuban nationalism: "No one in the world makes cigars like the Cubans – they dominate the luxury market and generate important export revenue." That's why this festival is so crucial, and why there are so many busloads of well-heeled Russian, Indian and Chinese cigar tourists on Havana's streets on the hunt for the perfect Montecristo Sublimes or a Cohiba Behike 56, which sell for £40 each in their home country. Luckily for Cuba, sales to these new markets are booming.

There are buyers from Europe, too – I'm with a party of cigar aficionados from Boisdale, the UK jazz restaurant group run by Scottish entrepreneur Ranald Macdonald. Boisdale is one of the biggest sellers of Cuban cigars in the UK and Macdonald claims that sales are up despite the smoking ban – but that's not the case elsewhere. Western Europe still makes up about half of all Cuba's exports but they are in decline – sales to Spain, once its biggest partner, plunged 20 per cent last year, which is not something the industry – or Cuba – can afford.

Cuba is one of the last countries in the world that declares itself Communist; locals call it tropical socialism. However, crippling finances have forced the Castro regime to embark on a series of reforms to revive the economy. The changes started in earnest when Fidel's brother, Raul, took over as president after his brother's illness in 2008. But they were small steps. Then, in April last year, the Communist Party Congress sped up the reforms with another 313 guidelines for relaxing the economy, giving people the right to become self-employed in 188 different trades.

For the first time since the revolution in 1959, when Fidel, Raul and the Argentine guerilla fighter Che Guevara toppled the US-backed dictator Fulgencio Batista, Cubans are free again to own small businesses and farm their own land. Even more revolutionary, they are allowed to buy and sell their own homes; till now, they could only swap them. They can set up cafés, beauticians, gyms, hairdressers, run their own taxis and be plumbers, albeit with state licences.

Nearly a million Cubans are now working out of "state hands" and there are plans to cut more free; some say Raul is dismantling the state as radically as Lady Thatcher did in the UK. By 2015, the plan is to have a third of the workforce working in the "non-state" and co-operative sector. Yet Cubans are not permitted to refer to what's happening as a transfer to the private sector; Raul, always said to be the purer Marxist of the two brothers, may be a reformer but he defends the changes to create a "sustainable socialism". He said recently: "Many Cubans confuse socialism with freebies and subsidies, and equality with egalitarian

ism." The regime has made it plain, too, that state planning remains the main policy, and that the accumulation of big wealth into private hands will never be allowed.

But it may be too late. Many of the self-employed running the restaurants and bars, and others dealing on the fringes of the black market, are already making good money. It's this young, highly educated and wealthier elite who are increasingly frustrated by the petty restrictions on their daily lives; they have mobile phones, but only just. For months, imported mobile phones were left stored in warehouses because the regime couldn't decide whether the public should be allowed to have them. Finally, Raul gave the go-ahead. They can have email accounts at work but are not allowed private ones. Satellite television is banned, which is perhaps why watching forbidden US TV hits such as Desperate Housewives has become an obsession for many Cubans. But satellite dishes exist – friends share with each other, and hide them in water tanks if they suspect they are being watched.

It is the paladares – derived from the Spanish for "the palate" – which are the most visible of the reforms. These are the restaurants run out of people's homes that sprang up in the early 1990s to feed relatives and friends during the terrible hardships when the Russians pulled out after the collapse of the Soviet Union. This was when Fidel Castro declared a national emergency known as the "Special Period in Peacetime", after the Soviet Union withdrew aid and credit, and dropped the oil-for-sugar swap that was worth $3bn a year to Cuba. Fidel also opened up the country for the first time to foreign investment and tourism; small businesses were able to operate with a licence and the dollar was legalised– a policy then reversed again. This is also when Castro started doing business with the Canadian tycoon Ian Delaney, now retired from the mining colossus Sherritt International. Cuba has a third of the world's nickel reserves and Delaney helped out by investing in the country's nickel and cobalt mines and providing jobs. He's still known as Castro's "favourite capitalist".

Cubans still talk of this "periodo especial" with bitterness, when food was in such short supply that Cubans lost on average 20lb in weight and the economy shrank by a third. One Cuban tells me about friends who ate orange leaves sprinkled with sugar for breakfast: "Yet this is a country where if you throw a pip in the ground, it will become a tree within months. The ground is so fertile we could grow everything ourselves. But we import food from around the world – even pineapples from the Philippines. It's madness."

One of Fidel's costliest mistakes was to switch investment out of agriculture to a forced industrialisation, a policy that destroyed the farming industry. Two-thirds of all food is now imported, much of it from the US despite the trade embargo, as there are two exemptions to the sanctions. Ironically, that means the US is Cuba's fifth-biggest trading partner.

Food is basic: rice, black beans, chicken and roast pork are the mainstay diet and people still queue for subsidised rations at corner shops. But the restaurants get by, and are now allowed to buy from private suppliers. One of the most popular paladares is the Doña Eutimia in Old Havana's beautiful Cathedral Square. It's run by Leticia Abad, seats about 20, and used to be the workshop of her late husband, a famous sculptor; the beautiful metal-wrought doors are his legacy. The restaurant is named after an elderly black woman, Eutimia, who lived locally and cooked food for the Cuban artists working by the square. Today, Abad runs it with her family and Abiel San Miguel – the paladares can now employ non-family members for the first time – who proudly shows me the restaurant's listing in Condé Nast Traveller magazine. How does he find the changes? "Good but slow," he says, cautiously.

Next door to Eutimia is an artists' workshop, run in co-operative style. Since the early 1990s, Cuba's musicians and artists have been treated with special care. Artists such as the late Wifredo Lam and Alexis "Kacho" Leyva have been allowed to travel overseas, sell and show their work abroad, sign contracts with foreign distributors – even in the US – and keep some of the revenue from sales. Some live part-time in Madrid and other capitals but they can travel freely, unlike most Cubans who have to go through a laborious process to get exit visas. As with the restaurants, individuals are also opening their homes as art galleries so they may invite overseas buyers to see their work privately. Yet publicly there is little to see of such a thriving cultural life; Alberto Korda's gripping Che Guevara photograph still dominates the hotel foyers and shops.

In the West, there is much talk of Cuba's second revolution; that the reforms, coupled with the newly discovered oil, will put the country on a path to a free-market economy and, then, capitalism. But that's not what most Cubans think. One, who prefers to remain anonymous, says the changes are only about keeping the current regime in power: "This is about lifting the boot off our neck just enough to let us breathe a little more." Another says it's impossible to know, and that anyone who tells you otherwise is lying.

Economic reforms may be gathering pace but political ones are slower. While Raul Castro has signed the UN human rights convention – something his brother refused to do – and around 100 political prisoners have been released, dissidents were rounded up ahead of Pope Benedict XVI's visit to Cuba last month. Calls for more political freedom are regularly crushed – although young students who have been openly demanding more political freedom are being tolerated, for now. The mood feels tense. Most people don't talk in public about the regime; if they do, they stroke their chins to indicate the bearded Fidel. But at home, the only talk is of change.

The cigar festival is said to be the best time to see Havana; the Cubans, naturally warm and gregarious, are more cheerful than ever because bars such as Floridita and La Bodeguita, home of the mojito and made famous by Ernest Hemingway, are busier than ever and the taxis fuller. There's also music everywhere; in every café, street corner and town square there are live bands where old and young dance so comfortably together. But even so you sense a sadness, an impatience that they can't be trusted with more freedom. "The freedom to think for ourselves, that's what we want," says one. The streets, which are impeccably clean, are also run down; the beautiful Art Deco and glorious baroque houses and hotels are dilapidated. Everything needs painting, cracks in buildings need mending, potholes need filling.

Daily life is frugal, but Cuba does boast one of the highest living standards in Latin America: they have one of the highest literacy rates in the world and schools and colleges are free. So is healthcare, and Cubans enjoy one of the highest longevity rates in the world, despite nearly everyone smoking cigars or cigarettes. It's rather shocking to the re-trained eye, but at the Corona cigar factory that I visit in Havana, where most of the workers are women, they smoke while preparing the leaves and rolling the tobacco. One, a young woman in her early forties who has been working six days a week in the factory for 20 years, explains that they are given five cigars a day as part of their wages. Earning about 420 Cuban pesos a month – around £10 – they are paid above the average monthly wage.

Smoking may be ubiquitous, but Cuba also has one of the most advanced biomedical and pharmaceutical industries in the world. Big investments in healthcare by Castro in the 1960s have paid off. Joint research with the Chinese on new monoclonal antibodies and vaccines for treating lung cancer is cutting edge, and clinical trials are now taking place in China. A revolutionary new diabetes drug has also just been developed which European doctors are keen to acquire. Indeed, biotech and medical services are the country's biggest export – more than 30,000 Cuban doctors and sports instructors work in Venezuela as part of a deal between the nations to swap doctors for oil.

With the Soviets gone, Cuba's biggest trading partners today are China and Venezuela; China's giant blue-and-white Yutong buses are everywhere, taking the one million or more tourists to the beach resorts and other beauty spots, some of which the Cubans are not allowed to visit. It's a two-way trade; China's bus-makers are taking Cubans back to China to teach them about mechanics, because they've learned so many tricks from having to mend the Dodge and Chevrolet cars that they have been driving since the 1950s. Trade with Venezuela is crucial, too. The Venezuelan president, Hugo Chavez, is visiting the country again regularly for cancer treatment. But the big question now is whether Chavez will be either well enough, or able to win his own elections later this year.

What next? Ambassador Melrose is cautious: "There are significant economic reforms under way that are creating new economic freedoms for Cuban people and leading inexorably towards a more market-based economy. I believe Raul when he says these changes are irreversible. He is the key figure driving the reforms. But there are lots of factors that will shape Cuba's future, including the impact of a significant oil find in the Gulf, the elections in Venezuela and the US, global food and commodity prices and, importantly, future succession to a younger leadership."

The Castros have not yet picked a successor; Fidel is 85 and Raul is 80, while most of the politicians around them are in their seventies. At January's Communist conference, Raul admitted young blood should be brought in, but no one has said how. Two politicians, Carlos Lage and Felipe Pérez Roque, who were seen as reformers and potential heirs, were caught criticising the regime and quietly disappeared from political life. What Cubans fear most is that hardliners might take over if Raul dies, taking the country back a few decades or even plunging it into civil war as the young and frustrated take action to introduce a social democracy.

But they also fear a power vacuum, one in which the 1.2 million Cubans living in exile on their own doorstep in Florida might move swiftly to take control with US backing. Many are said to be planning to claim back land they argue was taken from them after the revolution. Others fear that if Cuba implodes, it could become a centre for the organised terrorism and drug-trafficking which bedevil its Latin American neighbours. "The last thing we want is for the organised-crime and mafia people to come in and take control. Compared with our neighbours, our crime rates are relatively low and we don't have such extremes between wealth and poverty, " says one retired businessman. This is also why so many moderate Cubans argue that if the US is serious about wanting to encourage Cuba on the path towards a managed social democracy, or a form of state-controlled market economy as China and Vietnam are doing, then it must abolish the embargo.

A more sympathetic approach by US President Obama if he wins the coming elections would strengthen their case for reforming the economy, and speed up social change; there are many wealthy, articulate US-Cubans who want to see an orderly shift in power. They are hopeful that Obama will put lifting sanctions to the top of the agenda if he wins again, as there appears to be majority support in Congress for ending the embargo which has done such damage.

Indeed, it is the US sanctions which give the Castro regime its justification for being "at war", as it provides Raul with a narrative to defend the one-party state by showing the US as the implacable enemy. At the same time, it gives the regime a perfect excuse to justify to the Cuban public the country's economic failure, as they claim sanctions have cost the country $70bn in revenues since the revolution.

On a clear day it is possible to see across from Cuba to Florida, a stretch of water of 90 miles or so. It's when you are up in the beautiful hills, overlooking Havana and across the Gulf from Hemingway's old farmhouse, the Finca Vigia, that you realise just how absurd the stand-off is between two countries so close, yet so far. Nestling under the trees is Hemingway's recently restored boat, the black-and-red painted Pilar. It's the boat he used to cross between Key West and the island which he adored and which he was supposedly forced to leave because of US political pressure. The boat trips should start again.