The "Four Comprehensives" may constitute the main pillars for the next phase of the Chinese social and economic transformation. The general direction of these principles is, however, not new. It has been widely recognized that China needs ongoing reforms for more sustainable and socially inclusive growth. Otherwise, imbalances will increase, posing higher risks to the Chinese and world economy. Being principles, they are rather vague and leave much room for interpretation and adjustment. Concrete targets on the social and economic transformation have not been set. The need for reforms is urgent in many areas, and it is a challenging task to keep the balance.

Development priorities

Future GDP growth should become more sustainable and should not harm the environment. Eco-friendly growth can be supported if the service sector accounts for a higher share of the economy. The service sector is also less productive on average, implying that high employment can be realized even at lower growth rates. Products to protect the environment might become a future source of growth. In addition, more people should be able to benefit in terms of income gains and enjoy higher standards of living. Consumption should play a more important role in the economy. Increasing household demand will also reduce the vulnerability of the economy against global shocks. In contrast, the opposite has occurred in past years, with savings rates rising to record levels and a declining share of private consumption in overall production.

Institutional conditions have led to the modest expansion of private consumption. Hence, concrete reforms should change the incentives and reduce the impediments to consumption, for instance, by relaxing the hukou (household registration) system, enabling better access to bank credit and providing a higher level of social security. In particular, advances in social security are key to stabilizing domestic demand, in spite of the unfavorable demographic change.

China's growth should be primarily driven by innovation to avoid the middle-income trap over the coming years. Due to higher wage growth, China will not be able to compete with Southeast Asian economies. On the other hand, it cannot compete with industrialized economies due to a lack of innovation capacities. Hence, the private sector should play a larger role in the economy, as state-owned enterprises do not have much incentive to innovate. The expansion of small and medium-sized firms depends on many factors, such as the soundness of political and judicial institutions. Furthermore, better access to bank credit for investment projects and new firm foundation is one of the most important issues. Financial market reforms can also reduce the size of shadow banking. Due to their limited access to banks, many private firms are forced to borrow from shadow institutions at higher interest rates. This constitutes a cost disadvantage compared to state-owned enterprises and slows down the speed of innovation and economic growth. In this regard, banks have to learn that innovative private projects are often risky and might be successful, but can also fail. This is a different experience in comparison to former years, when the Chinese economy expanded by imitating already proven technologies and products from abroad.

Reform

There is no alternative to further reforms. Otherwise, there will be an increasing risk that the economy will be driven by imbalances and bubbles, for example in the housing market. Further risks stem from shadow banking, where transparency is weak. Shadow banks are involved in real estate, among other sectors, and might come across financial trouble if housing prices fall over a longer period. This can cause negative spillovers to other financial segments and finally to the real economy. The imbalances within the country led to large overcapacities in many industrial sectors. Government debt is increasing, also driven by prestigious investment projects at the provincial level. Reforms in many areas should be on the agenda, for instance, creating better framework conditions for private enterprises to support innovation-led growth and higher competition; speeding up the liberalization of financial markets, including better access to households; and promoting the internationalization of the renminbi to match China's importance to the world economy. A redistribution of tax revenues between the state level and the municipalities as well as policies toward the reduction of the urban-rural divide and to reduce regional differences within the country would also have a positive effect.

Rule of law

Application of the law, contract enforcement, and the traceability and predictability of the decisions of courts can contribute to the soundness of political and judicial institutions. At present, the qualities of these institutions do not match China's leading role in the world economy. Reforms should try to improve the current settings. According to the World Bank, the quality of regulatory standards has declined in China over the past decade. Broadly, this trend is visible for other indicators as well, such as the effectiveness of the government and the rule of law. In all these areas, Hong Kong has much higher standards, thereby improving the confidence of private investors and generating a better climate for business activities. For the main part of the country, inadequacies in institutions might create a serious obstacle to higher and sustainable growth.

Fight against corruption

Corruption can lead to a waste of resources, as firms have to pay the officials to get permission or be successful in public procurement. Measures to control corruption have improved slightly over the past decade. However, corruption among members of the Communist Party of China is not the only problem in this field. Strong personal ties between bank managers, huge state-owned enterprises, and policymakers may create further sources of inefficiency. For example, state-owned banks might get credit, even if their collateral is not sufficient. This can lead to a high share of bad loans in the balances of banks, posing further risks to financial markets and finally the government. These problems can endanger economic growth and stability. Therefore, policies should try to lower incentives for corruption. Fiscal policies should follow consistent rules both at the country and regional level.

The author is research director of the international economics at the German Institute for Economic Research

Copyedited by Kieran Pringle