It's taken me a long time to really get how relationships work in China. I'm not an expert, but here is my street-level view, roughly hewn from countless embarrassing fauxes pas, baijiu drenched business dinners and the careful explanations of my ever patient Chinese friends.
The hardest thing for us to understand is that Chinese relationships are unequal - one person is senior and the other junior.
This is usually decided by who is older, but can be influenced by other factors such as job seniority. For example, most of my employees are younger than me, so I'm clearly senior when I talk to them and I call them by their first names prefixed by Xiao (little), eg: Little Ou, Little Jiang and so on. I insist they call me by my name as I don't like being called 'boss'. However, they sometimes feel uncomfortable doing so and slip back into calling me Shi Zong (Managing Director Shi) or Laoban (Boss). Once I accidentally addressed one using a senior (though very familiar) form of address 'Ge' (big brother). He immediately coloured from head to toe in embarrassment and entreated me not to call him that!
On the other hand, another employee is older than me by almost 10 years, so here age trumps seniority. Despite the fact that she does what I tell her (more or less!), I always use the friendlier senior forms of address such as Hong Jie (Big sister Hong). These make her feel more comfortable than if I used her name. Age isn't always the most important though - I have a friend who is actually slightly younger than me. He is a very successful businessman and so doesn't at all object to being called 'Big Brother'... but then again, he isn't known for his modesty - I'm sure someone less prepossessing would insist I use their name!
When two people meet each other for the first time, they will first establish who is the senior. Whilst baffling for clueless foreigners, this is essential, as it's very difficult to address someone appropriately unless you know whether they are senior or junior to you.
I think that the need to establish seniority is an important reason why asking details such as age or salary in China is much more socially acceptable than in the west. Directly asking is still impolite however, and the better educated are far more likely to establish these details indirectly. For example: asking when you graduated from university, or what kind of car you drive. Asking questions to establish wealth is often perceived as materialism by westerners but is usually just an attempt to work out how to address you!
Establishing which way the relationship works is obviously important in more formal situations or when you're not familiar with the person you're talking to, but can also apply to close friends. My girlfriend is two years younger than me and so frequently 'Ge's me. This does not mean that Chinese girls are demure, it's just a speech habit. I found this one particularly hard to get used to, because 'Ge' also means literally big brother. It sounds kind of incestuous to western ears... But it would be strange for me to 'Jie' her, because I'm older.
The thing that makes all this especially tricky for the language learner is that the best way to learn is by copying what people say to you. But if you do that with forms of address you're likely to make embarassing mistakes - what people say to you is not always appropriate to say back to them! This is important culturally as well as linguistically. As two people get to know each other, the relationship will begin to relax and they will use more familiar forms of address. It's at this point that you will put your foot in it big time. These mistakes may not matter so much when dealing with the under 30s, or to those who are used to speaking with foreigners, but when dealing with the older generation ignore them at your peril.
Mistake 1 - too familiar too soon
As the junior partner in a relationship, don't try to switch to familiar forms of address too early, it's rude and it will make your new friend bristle if they're not used to dealing with foreigners. It's up to you as the junior partner to be friendly by being respectful to the senior partner, expressing your concern for their wellbeing, addressing them appropriately (a common way, though obsequeous sounding to western ears is to address the other person in the 3rd person! Has Mr Chen eaten yet? How has Mr Chen's business been lately?).
Mistake 2 - doing what is asked of you
Mr Chen will likely respond to your polite treatment by telling you off! 'Eh, don't be so polite, it's really not necessary!'. 'Just call me Old Chen, OK?'. Don't believe him! Make an effort to keep on addressing him politely till he really insists. This is not being cold, it's being friendly and expressing that you respect Mr Chen. I have often fallen into this trap and immediately switched to a familiar address only to have the cold shoulder turned on me. If on the other hand, Mr Chen continues to be very formal towards you, it may be because he doesn't like you, because he's just a very formal guy, the situation is very formal, or possibly... because he feels that you (being a stranger having travelled thousands of miles from overseas) is actually the senior partner in the relationship, and is waiting for you to break the ice. This is a tough nut of a situation and is tricky to crack... but generally only occurs when you're out in the countryside and run into someone who has literally never seen a foreigner before.
Mistake 3 - reciprocating formality
If you are the senior partner in the relationship, your new friend (let's call him Guanyao) will be polite to you as described above. Addressing you in the third person is NOT making fun of you! The usual mistake for the foreigner is again to reciprocate and be polite right back. WRONG! This will be interpreted as coldness. Copy Mr Chen above and insist that he call you by your given name, tell him off when he's too polite. He will probably initially resist, but will eventually come around.
Of course, China is opening up, and in most big cities young people will happily talk to you on your terms according to western cultural rules, and this will almost always be true if you're talking in English. I have a couple of friends who, although they speak good Mandarin, will always talk in English at business meetings. Perhaps they're hoping that not letting on to their language skills will mean they can overhear some useful titbits, but I think the main reason is that switching into Chinese leads to a maze of pitfalls of the type I've been talking about.
I prefer to jump in and learn the hard way...

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