Meeting new challenges

Further system reforms will enable China to overcome middle-income trap and push forward social progress

President Xi Jinping and Premier Li Keqiang represent a new generation of leaders, determined to continue and accelerate China's economic progress and social progress. They are smart, committed and articulate.

The preceding decade was one of stupendous economic performance: growth approaching and sometimes exceeding 10 percent, poverty receding, a growing middle class projected to grow from 230 million to 630 million people in a decade, and an national economy that is the second-largest in the world. Resilience in the post-crisis period has been impressive, and crucial to the broader pattern of resilience and partial de-coupling in the developing countries. China is an economic powerhouse, the dominant force for growth in the global economy at this point. The dream, expressed frequently by the incoming President, is to become an advanced, creative, innovative, and equitable economy and society.

Few doubt that this is possible. But there are major, surmountable challenges to achieving this goal. The growth and progress of the last decade were enabled by a combination of growing engagement with the global economy and major structural and system reforms put in place in the 1990s. There is a widespread understanding that the existing growth pattern needs to change in multiple dimensions, in order for progress to continue. Major system reform is needed to support the altered growth dynamics of a rising middle-income country.

China is in the middle-income transition in which growth takes average incomes from $4,000 to $10,000 per year. Most developing countries, even high growth ones, slow down and get stuck at this stage, although there are exceptions (the economies of Japan and the Republic of Korea). There are many reasons for this. Labor intensive sectors in the tradable sector lose their comparative advantage to other, earlier stage, countries and must be let go and replaced by functions and sectors with higher added value. Entry and exit of firms and innovation are important parts of the shift in productivity and dynamic efficiency.

In China's case, the demand side is equally important. Because of its scale, China cannot rely on external demand as a buffer against transitional shortfalls in domestic aggregate demand. Growth must be driven increasingly by domestic consumption and high return domestic investment. That means household incomes have to rise and the financial and investment systems need to change to enable demand and to screen out inefficient investment.

Some of the reforms for the new leaders will be expanding the scope of market determined outcomes and redefining the key elements of policy needed to move in that direction. Equally high on the agenda will be elements of the social agenda. And they are related. As the scope of the market expands, the natural turbulence of structural change and competition require the support of social security systems. Much useful experimentation and learning in a number of northern European countries will help with the design of social security programs that enhance rather than impede growth. Social security must not depend on protecting specific jobs and companies, whether they are State-owned or not.

Maximizing the economic potential of the growing internal domestic market will require removal of barriers and preferences, many of local origin, and enhancing the mobility of people and labor. The status of migrants (those with rural registration living in cities) will have to be upgraded to full citizenship. This in turn means that urbanization must work.

China's population is now just over 50 percent urban. The massive investment in urbanization under the leadership of the new premier will drive growth, enhance mobility and is required to make the pattern of urbanization orderly and efficient. Also needed are enabling reforms of the fiscal and financial systems to support such investment.

But urbanization by itself is not sufficient. It is crucial that it be driven by expanding employment opportunities in the urban sector rather than declining options in the rural and traditional sectors. Such opportunities require structural change, growing household incomes and the rapid expansion of a range of service sectors. It is easy to see that the elements of the changing growth pattern and supporting policy are closely linked and complementary.

The State has a massive (by Western standards) balance sheet. Assets include reserves that amount to almost half the GDP, land, dominant ownership of the State-owned enterprises and more. Public debt is less than 50 percent of GDP. This has enabled China to maintain macro stability even when imbalances emerge and to sustain high levels of public sector investment to support growth. It was a key element in weathering the 1997-98 Asia crisis and again in 2008-09.

Chinese leaders and policymakers are unlikely to follow the Western model of smaller balance sheets and large unfunded liabilities. But that leads to the major challenge of the effective management of public assets. There are ways to manage these assets that impede or promote the expansion of competition, market efficiency and dynamism. There will be debate within China about the benefits and costs of alternative models and more generally about the details that will define the evolving role of the State.

Finally, meritocracy has deep historical roots in China. And generally citizens accept market outcomes if the competition is fair, and the elements of social insurance and security are adequate. Both require development. Recent rising anger and social tension is linked to the perception that there are insiders and outsiders and that economic outcomes depend more on relationships than superior competitive performance. An important priority for China's new leadership therefore, are actions that signal to the people that there will be a determined assault on this pattern and a commitment to a meritocratic egalitarian society.

Over the next few months, all of China and much of the rest of the world will be watching as the system reforms emerge. A huge amount is at stake, within China and in the rest of the global economy. The mood is optimistic. It has been a good start.

The author is a Nobel laureate, a member of the Advisory Board of the Institute for New Economic Thinking and academic council chairman of the Fung Global Institute.