By: Paul Vandenberg and Juzhong Zhuang

The Chinese economy grew by 7.4 percent in 2014 and is expected to expand by 7.0 percent this year. These are impressive growth rates for any country but lower than what has been achieved in the past. For three solid decades, since the beginning of market reforms in the late 1970s, the economy expanded by an annual average of almost 10 percent.

Rapid growth has transformed China from a small, closed economy into a large open one and the second-largest in the world. It has lifted millions out of poverty, created urban jobs for hundreds of millions of rural migrants, and helped to shift the global balance of economic power eastward.

Slower growth may provide space and opportunity for a more balanced, steadier pace of expansion, a view espoused by the Chinese leadership for much of the past decade. The government has set a target to double the size of GDP, in constant prices, in 2010–2020. A key question is how to ensure that this target is achieved.

Nature of the middle-income transition

These questions are important because the PRC is only partway through the middle-income phase of development. With gross national income (GNI) per capita at about US$6,500 in 2013, it remains years away from the high-income threshold of just over $12,600 and the cachet of being an advanced economy. Furthermore, the health of the Chinese economy also matters for the global economy.

Our new edited book, Managing the Middle-Income Transition: Challenges Facing the People’s Republic of China provides an analysis of the country’s rapid progress in the middle-income phase and the obstacles that might impede further expansion. Middle-income countries, notably those at the upper-middle stages, are known to experience falling growth rates, although there is little consensus on the causes. It may be the result of a general law of economics that scarce factors of production generate high returns, but returns then fall as factors become less scarce.

This may occur at the middle-income stage as the capital stock increases. A slowdown, and indeed a trap, may also result from the specific relationship between value added and wages. An economy may lose competitiveness in low-value goods and services, due to increasing wages, while being unable to gain competitiveness in high-value activities. Japan and the other East Asian economies that progressed past the middle-income stage did move up the value chain in goods and services production.

Wages up, so is productivity

The PRC has seen a very rapid rise in wages in recent years, especially in the main manufacturing provinces along the coast. The country is moving to its Lewis turning point—and in some areas may have reached it—in which the supply of surplus labor from the countryside to the cities is being depleted. This has put pressure on wages and encouraged firms to increase automation, move production inland, or consider low-wage sites in other countries. Further increases in output, which drives economic growth, will therefore need to come from gains in productivity and from the production of higher value goods and services.

Productivity  has risen rapidly and steadily although it remains considerably behind the US and other advanced economies. Catch-up is taking place, therefore, but more is needed. It is encouraging that domestic firms are taking on the competition in such areas as mobile phones, tablets, laptops, solar panels, and commuter trains and are trying to make inroads in cars. The Chinese firm Xiaomi is now the third-largest smartphone maker in the world, behind Apple and Samsung, although it commands only 5 percent of the global market and has sold few phones beyond its borders. Lenovo, another Chinese firm, is the global leader in the production of laptops. A shift from the simple assembly of Apple iPads and iPhones at factories in southern PRC to the design, production, and marketing of products by domestic firms is a welcome sign. The PRC is also the world’s largest producer and market for automobiles, even if foreign firms and joint ventures make up a large part of production and exports of Chinese cars remain limited.

Infrastructure, property, shadow banking

Growth has been driven not only by manufacturing and services but also investment in infrastructure, construction, and natural resources production. Governments at different levels and including state-owned enterprises have played a major role in these sectors. Local governments have poured vast sums into expanding residential infrastructure and creating attractive development zones. This has led to the buildup of local government debt through special vehicles that use land as collateral.

These vehicles constitute part of a shadow banking system that is not regulated by the financial authorities and that poses a risk in the event of falling property prices. Local government investment may temper and contribute less to growth in the coming years, although the national government has plans to expand large infrastructure projects (road, rail, and ports).

Inequality and the environmental challenge

Inequality is another challenge. The gap between rich and poor rose dramatically over two decades, although it has leveled off in recent years. Inequality constrains domestic demand, as low-income households have little to spend, and it retards the development of a consuming middle class. It also reduces the potential for these households to invest in healthcare and education to build human capital. Further, inequality could create social tensions that would scare investors.

Finally, the lack of adequate regulation of heavy industry has resulted in environmental damage and contributed to climate change. Pollution in major cities is not only a health hazard but causes production disruptions. Coal is a main energy source but also a key polluter. The cost of cleaning up major industrial areas, including the water supply, and of evolving a greener production model can slow growth. On the positive side, the PRC has a unique opportunity to engage in production in green industries, such as renewable energy generation and electric automobiles, which could provide new sources of growth for the economy.

The future

The PRC can manage the middle-income transition by moving up the value chain, attracting and developing high-quality investment, and creating a more central role for the market in the allocation of resources. Higher wages will generate pressures for improved productivity. They will also contribute to increased domestic consumption by an expanding middle class, which will be important if global demand remains subdued.

These developments, combined with prudent financial sector management and harmonious social relations, should enable the PRC to pass beyond the middle-income stage.

Paul Vandenberg is a senior economist at the Asian Development Bank Institute in Tokyo and Juzhong Zhuang is deputy chief economist of ADB’s Economics and Research Department. See more at the ADBI blog, Asian Pathways, where this originaly appeared