While China’s growth is continuing to stabilise, a trend that began to appear from last year, it seems the new government is not pursuing fast growth as its top priority. This is the right call. While China faces a number of challenges, stable and inclusive growth will follow if the government focuses on five key reforms: restructuring economic and social imbalances, securing China’s energy supply, reforming the financial sector, reducing inequality and fighting corruption.

China encountered many internal and external challenges in 2012 following the world financial crisis and the European debt crisis. Externally, export growth and foreign capital inflows slowed due to a sharp contraction in bilateral trade between China and its largest trading partners, including the EU, the United States and Japan. Despite Chinese government efforts to diversify international trade, the volume of trade grew by only 6.2 per cent, compared to 22.5 per cent growth in 2011.

Internally, asset bubbles (especially high house and land prices), increased labour costs and currency appreciation reduced China’s international competitiveness. Numerous small- and medium-sized enterprises specialising in export processing in Guangdong and Zhejiang were closed down or downsized due to rising production costs and weak foreign demand.

But there are signs that these asset bubbles are ballooning more slowly than before. The growth rate in the value of China’s fixed-asset investments was 3.4 percentage points lower than in 2011, mainly due to a real-estate market slowdown. Property still accounted for about 22 per cent of the country’s total fixed asset investment, and fixed assets investments in the central and western regions grew significantly faster than in the eastern or coastal region. The large discrepancies suggest that China’s less-advanced inland provinces are catching up to their prosperous neighbours on the coast.

China also changed its export structure, giving priority to general exports, which are increasing much faster than processed exports. General exports tend to have a larger proportion of domestic-made components and hence can generate more value than processed exports. This shift implies that China has been forced to accelerate its trade reform, focusing more on value-added and technology-intensive manufacturing than processing in response to the external shock caused by the world financial crisis.

Despite rising labour costs and an economic slowdown, China remains attractive to foreign investors. But after increasing its financial strength in recent years, China’s outward direct investment (ODI) in non-financial sectors is increasing rapidly. In 2012, it was up by 28.6 per cent, reaching US$77.2 billion, placing China among the world’s five largest foreign investors. As China’s ability to invest in other countries grows, it is expected that its ODI will rise to US$150 billion by 2015. This implies that China’s ODI will soon surpass its investment inflow and the country will become a net foreign investor.

China is also starting to build its consumer base. In 2012, retail sales reached RMB21 trillion, up by 12.1 per cent in real terms from a year earlier. According to the National Bureau of Statistics, consumption is expected to contribute over half of China’s growth in 2013, overtaking investment to become the economy’s key driver. If this pattern holds, China will gradually transform itself from an investment-driven to a consumption-led economy.

Last year could be marked as a turning point for the country. The complicated internal and external environment China faced in 2012 forced the government to slow down and think carefully about its development path. Looking ahead, China will face a number of challenges.

First, it must restructure its unbalanced economic and social development. There are six important structural imbalances in the Chinese economy and society. First, the share of manufacturing is too high, accounting for about 45 per cent of GDP; second, heavy industry, particularly the most polluting industrial sub-sectors, is too dominant in the industrial sector; third, China has depended too much on exports and investment for growth, while domestic consumption has contributed substantially less to growth than in any other industrialised or emerging economy; fourth, the persistent regional divide between the coastal and inland areas means there are effectively two Chinas; fifth, there is a persistent urban–rural divide in terms of per capita income, education, healthcare and employment; and, sixth, all this means rural poverty remains a serious problem. Although China improved its position in all these areas in 2012, the imbalances remain. They are stubbornly difficult problems to solve and the government will take years to get the balance right.

Second, China must secure its energy supply. In 2012, China consumed 3.6 billion tonnes of coal equivalents and 5 trillion kilowatt hours (kWh) of electricity. Rising energy demand has caused various social and economic problems, and China’s heavy coal use leads to pollution that exposes its population to potentially devastating health problems.

Third, China must reform its financial sector. In 2012, the total profits of all Chinese banks reached RMB1.24 trillion, up by RMB194 billion from a year earlier. Together, they now contribute nearly one-third of total global profits. But there are troubles hidden below. The number of non-performing loans Chinese banks hold is increasing. Expanded infrastructure construction over the past few years prompted local governments to borrow a great deal of money. If local governments start defaulting on their debt and surging property loans go bad, the proportion of non-performing loans could be as high as 20–30 per cent. More effective policies need to be implemented to break up the monopoly position of a small number of major banks and to further improve the efficiency and transparency of the whole banking system.

Fourth, the government must reduce income inequality. During the 18th Chinese Communist Party (CCP) National Congress, the new leadership re-emphasised the government’s mission to develop an ‘all-round well-off’ society by 2020. In order to achieve its goal, the leadership proposed that by 2020 China would double its GDP and per capita income from 2010 levels — the first time that China has linked personal income to GDP growth. According to the National Bureau of Statistics, the Gini coefficient was 0.474 in 2012, making China one of the world’s most unequal societies. China needs to reduce inequality not just to make people happier but to make the country more stable, socially and politically. There were over 200,000 mass demonstrations in the country in 2012, compared with 78,000 one decade earlier.

Finally, corruption is a serious issue embedded deeply within China’s political system and society. In 2012, Wang Qishan, China’s new Secretary of the Central Commission for Discipline and Inspection, was chosen to lead the country’s anti-corruption campaign. But despite the majority of Chinese welcoming this move, many remain unconvinced that the government can indeed eliminate corruption.

Shujie Yao is Professor of Economics and Chinese Sustainable Development at the University of Nottingham.

This article appeared in the most recent issue of the East Asia Forum Quarterly, ‘Leading China where?’