Stephen Wood's got a soft spot for this little country. For a quality budget destination, with plenty of intermediate skiing and affordable designer hotels, look no further

You are probably not in the habit of arriving at hotels blindfold, and I am not recommending it; nevertheless, to enter the Sporthotel Hermitage with no knowledge of its location would be an interesting experience. Because nothing about its interior tells you that this is a ski-resort hotel. No gingham swags, no scatter cushions; no old skiing paraphernalia nor posters. True, there are Alpine-style, varnished pine beams above the vast reception area, but otherwise it is all earth-tone surfaces (stone slabs imported from Brazil, oxidised steel panels) and muted leathers. In daylight, the view out of the back window to the ski slopes of the Valira valley gives the game away; but at night you might imagine that you were entering a very cool hotel in Chicago or Denver.

The location is actually Andorra, the late-20th-century beginner-skiing, cheap-lager winter sports destination. This Pyrenean principality has a bargain-basement appeal that came close to propelling it past Italy into third place (after France and Austria) among British skiers' favourite destinations. So why would such a place have a property like the Sporthotel Hermitage? Because Andorra is going posh.

In the week before Christmas, there wasn't much point in skiing in Andorra: snow was in short supply, and much of it was being husbanded for the busy Christmas period ahead. But it was a good time to visit the new hotel - which opened that week, quietly, with just a few guests - and to talk to locals about the changes Andorra is going through.

A tiny, 450sq km nation squeezed between Spain and France, Andorra is a historical curiosity - and a modern one, too. For 700 years it was a feudal society governed jointly by Spanish bishops and French aristocrats; and even after the adoption of a democratic constitution in 1993, Andorran legislation still technically required the approval of the Bishop of La Seu d'Urgell and the President of France. Although it now seems far more Spanish - or, rather, Catalan - than French, it maintains its dual nationality, and, as a result, Andorrans have a choice that Lady Thatcher never offered us, of national postal services. There are both French and Spanish mailboxes in the principality (local lore has it that the former are faster for international mail).

Too small to play any significant part in European history, Andorra even managed to stay neutral during the Spanish Civil War and the Second World War, a decade in which smuggling established itself as the primary economic activity. After the war, in the sort of manoeuvre which psychologists call "paradoxical intervention", dealing in contraband was effectively recognised as a legitimate business: Andorra became a duty-free trading zone, and a virtually tax-free area, too. The effect, over time, was to make a handful of hill-farming families very rich, and to transform the native Andorrans (who number about 25,000) from peasants into high-earners. A mark of how heated the economy became is that a few years ago a development site there sold for the same price per hectare as land in central Paris, according to a local estate agent.

It was one farming family, the Viladomats, who invented the Andorran ski business in 1957. Its scion, Francesc, took a long-term lease on slopes around the village of Pas de la Casa, and installed lifts to create the first commercial ski area. Four decades later, the village was a booming resort-town with 11,000 guest beds, and surrounding mountainsides had also been turned over to skiing by other former farmers who realised that Francesc Viladomat wasn't crazy after all.

Although French and Spanish skiers were closer to hand, and more numerous, Andorra turned into a British fiefdom thanks to low package-holidays prices, an après-ski scene fuelled by duty-free booze, and ski schools in which the proportion of native English-speaking instructors sometimes reached 50 per cent. Andorra's ski terrain is only about 2,888 hectares, one-third the size of the Trois Vallées in France. Yet its share of the UK market grew year after year for more than a decade, and by 2003/4 more Britons were skiing there than in Switzerland, the US and Canada combined.

That season was a turning point. It isn't easy to generate collective endeavour among self-made mountain men working in a fast-growing business in a newly rich economy; nevertheless, in 2003 the owners of the Pas de la Casa ski area (primarily the Viladomat family) and the Credit Andorra bank (majority shareholder in the adjoining Soldeu-El Tarter area) agreed to create a common domain called Grandvalira with a single lift-pass.

This was, says Marta Rotés, director of the lift operators' association, a development she did not expect to see in her lifetime. It created a very efficient ski domain with 193km of pistes, big enough to compete with the linked areas in the French Alps and serviced by enough lifts to put Grandvalira in the world's top 10 areas for "uplift", according to the Snow24 winter-sports database. At the same time, the slopes of the remaining Andorran resorts (Pal/Arinsal and Ordino/Arcalis) were amalgamated into the Vallnord area, also with a single lift-pass.

From the millennium to the 2003/4 season, the Andorran slopes benefited from €47.2m (£35m) in investment. Combined with the advent of the two big ski domains, this had two implications. First, lift-ticket prices were raised. Second, Andorra's ski facilities were now first-class, and therefore far superior to those of other budget destinations such as Bulgaria and Serbia.

Meanwhile Josep Calbó, whose family owns former farmland at Soldeu, was pushing up standards in his Sporthotel group of properties. Alongside the four-star Sport Village hotel he began building a five-level, 4,500sq m spa with capacity for 120 clients, accessible by a tunnel under the main road from the original Sporthotel opposite. With other four-star properties having opened, and further investment on the slopes promised (eventually it amounted to €76m/£54m over three years), Andorra's image as a bargain basement was being compromised.

The process was uncoordinated, as one would expect in Andorra (although the existing, laissez-faire atmosphere may not survive a government-commissioned report on the principality's economic future, in which 13 of the 20 recommendations are concerned with tourism). But put together, and cemented by a general desire to reduce Andorra's dependence on a young and relatively impecunious clientele, the improvements in the skiing and accommodation - and the consequent price rises - had an effect: they inspired the big UK ski tour operators to start looking to Eastern Europe for alternative destinations for their most budget-conscious clients. Those tour operators had, as local tourism executives readily admit, been largely responsible for Andorra's success, delivering plane-loads of customers every week; but from 2003/4 their entry-level clients were increasingly being diverted to Bulgaria, to inferior resorts where package prices could be pitched lower than in Andorra. (The new and much-vaunted resort of Bansko still can't match Andorra's quality, and is no cheaper.)

The Andorran share of the UK market fell in 2003/4, and again in 2004/5. Last season, total ski-pass sales dropped by 26,000 days. The consensus is that there must now be a freeze on building new hotels and apartments.

In fact, the supply of guest-beds is expected to shrink. The new, pro-active government has made it clear that the blind eye turned to building-regulation infractions in the jumble of two- and three-star hotels in Pas de la Casa is about to regain its sight. There's another government initiative to improve Andorra's hotel-rating system, which currently awards four stars to hotels whose service standards barely warrant three. Improving service standards may demand a change in the principality's revolving-door policy for seasonal labour, which permits Spanish-speaking South Americans to work for five months, and then sends them home once they are fully trained.

All these factors reflect a ski destination in transition rather than decline. Quite how successful Andorra can be in moving up-market, though, is a moot point. Its slopes cannot compete with those of the Alps: they lack the soaring scenery, the altitude and the challenge of the best French ski areas. But, for intermediates who want plenty of terrain, the skiing is more than adequate. Despite the recent improvement in architectural and planning standards, the principality can seem dark and broody; and some of the restaurants are dismal. But you get what you pay for - and you can still pay very little for a week's skiing there (from £321 with Inghams for a package including hotel accommodation). And you go to a place which is culturally, politically and economically unlike anywhere else you will ski.

Now, there is the unlikely option of a five-star skiing holiday, too, at the Sporthotel Hermitage. A 130-suite property, it has a standard of design and finish which few ski-resort hotels can match; and the huge spa - on which one looks down from the top of a six-floor atrium - is most impressive. Having stayed elsewhere, in a four-star hotel which paled by comparison, I can't judge the service, nor the food in the restaurant; but the sheer sense of style was remarkable. In the first few days, the management was clearly having some problems. But assuming they are resolved, the seven-day packages offered by Inghams - from £844 - look like another bargain in Andorra.

Inghams (020 8780 4433; offers 13 properties in Soldeu. Prices quoted above are based on two sharing and include return flights to Toulouse and resort transfers. Pre-booked, six-day, whole-area ski passes cost from £148 for adults, and hire of boots and skis £58. Five days at ski school costs £85