The Emirates Palace, an extravagant fusion of marble, gold and crystal that cost hundreds of millions of dollars, is the most obvious sign that Abu Dhabi is catching the Dubai fever. Designed as an ultra-luxurious Arabian palace, it is also Abu Dhabi's seven-star answer to the Burj al-Arab, the sail-shaped hotel tower that helped put Dubai on the map as a tourist attraction.

Awash with cash from soaring oil prices, the traditional and cautious Abu Dhabi, the largest and richest of the seven city-states making up the United Arab Emirates, is slowly adopting a more adventurous path. The interest in profligate landmarks belies a more substantive strategy aimed at diversifying the oil-based economy and preparing it for a downturn in oil prices.

"This is a unique time," says Khaldoon Khalifa al-Mubarak, head of Mubadala Development, a new government investment company. "What we've just embarked on, what will happen here will be phenomenal."

With a population of 1.5m, only a third of them nationals, Abu Dhabi accounts for 95 per cent of the UAE's oil and natural gas resources, which represent about 9 per cent of the world's proven oil reserves and about 5 per cent of natural gas reserves. In recent years, however, the guarded Abu Dhabi has been overshadowed by the more flamboyant Dubai, which has made up for its own limited oil resources by establishing itself as a re-export hub, a regional financial centre and a tourism destination.

"As Dubai developed, no one knew about Abu Dhabi," says a businessman. "This is partly why Abu Dhabi had to start its own airline [Ittihad] and is now developing a new airport." Abu Dhabi, much like Dubai, is run like a family-controlled business, where the government plays a leading role in the economy but is also a large investor in private-sector companies, blurring the lines between public and private business.

Most residents are foreigners and political dissent is limited, partly explaining why the UAE has lagged behind other Gulf states in political liberalisation. Since the 1970s, Abu Dhabi's oil surplus has been largely invested in one vehicle, the obsessively secretive Abu Dhabi Investment Authority (ADIA), which has estimated assets of $250bn (€214bn, £146bn) invested in equities across the world.

Mubadala Development was designed to take more direct stakes in companies and projects abroad, but also to develop projects at home with foreign companies. It recently bought a 5 per cent stake in Ferrari, which is helping to develop a theme park in Abu Dhabi. "You'll see us a lot more active in the future and we'll take stakes in companies that can also add long-term value to Abu Dhabi," says Mr Mubarak.

Several factors have combined to encourage Abu Dhabi to flex its financial muscle. One is the need to ensure a steady stream of jobs for a small yet fast- growing local population. The other is the advent of a younger leadership following the death last year of Sheikh Zayed bin Sultan al-Nahyan.

He was succeeded by his son Sheikh Khalifa, but the driving force behind Abu Dhabi's more energetic drive is Sheikh Mohammed, the crown prince. Under the government's plans, more than $100bn will be invested in Abu Dhabi over the next seven years. The government may have to contribute the bulk of the investments but it is also expecting to attract private sector funds and foreign direct investment.

According to Sheikha Lubna al-Qasimi, the economics and planning minister of the UAE, the government is considering new privatisations as well as regulatory changes to facilitate the entry of foreign companies into the market. Her ministry, she says, is also working on improving transparency in accounts - one of the main concerns expressed by the International Monetary Fund in a recent report.

Oil will remain the backbone of the economy, with plans to expand production capacity from the current 2.5m barrels per day to nearly 4m bpd by the end of the decade. But new industries - petrochemicals, steel and aluminium plants - are being developed.Following the setting-up of Ittihad, Abu Dhabi airport is to undergo vast expansion to prepare for what officials hope will be a fast-growing tourism industry.

Earlier this year Abu Dhabi liberalised the real estate market, allowing a free market for the first time. Previously people were given plots of land and soft loans to build, but sales were strictly controlled. Now, two government-backed companies have been set up and given land to develop.

"It was deliberate to keep a low profile in the past. We were focused on oil and gas and ADIA and both [companies] don't require any marketing. We didn't have to do anything or disclose anything because we were so rich," says Ahmad Ali al-Sayegh, chairman of Aldar, one of the new property companies. "Now we're still very rich, even richer than before, but we have a new leadership and the policy is to be efficient. Now we'll build houses better and cheaper."

Analysts say the challenge for the government will be to manage the expansion slowly and efficiently and create an economic base that complements rather than competes with Dubai, where soaring prices are raising concern among analysts. "Abu Dhabi is not a mirror of Dubai. Dubai has to work very hard for its living. Here the money flows: you just have to manage it better," says one international banker. Balancing fast modernisation with an attachment to tradition will also be tricky. "The leadership is struggling between the extreme of being completely culture-driven versus being completely modernised. But maybe there's an in-between," says Saeed Mubarak al-Hajeri, chairman of the Abu Dhabi Commercial Bank.