China’s re-emergence has created enormous benefits for Chinese citizens and transformed the face of the global economy. However, the developmental model which has yielded over 10% growth for the last three decades is becoming increasingly unsustainable as country’s economy matures.

The country’s latest five-year plan, published last month, promises to create a lightweight, modern economy. But that depends on deepening social and political reforms, improving corporate oversight and efficiency, and fostering a culture of innovation. With China’s demographic and environmental situation evolving rapidly, the country can no longer afford to defer radical structural change.

China’s astonishing economic progress has huge environmental and social costs; they are now the most acute risks to future development. In 2007, the government introduced the “Green GDP” scheme, a measure of gross domestic product which accounted for environmental degradation.

Two years later the scheme was quietly dropped: the new measure showed that the economy was shrinking instead of growing once damage to the environment was included.

China’s chief comparative advantages over the past thirty years have been two-fold: low-cost, slackly regulated manufacturing and abundant cheap labour. However both are now evaporating; data suggests China is fast approaching the Lewis Turning Point, when rising income levels diminish a country’s labour cost advantage.

Neighbouring countries such as Vietnam and Bangladesh now vie for position of “China plus one” as foreign and Chinese firms move manufacturing operations out of the People’s Republic in search of cheaper labour.

China’s cost advantage in terms of a lax regulatory environment is also untenable. To avert environmental meltdown and better protect worker rights, China must radically improve idomestic corporate oversight. This in effect leaves the leadership with the choice of pursuing short-term growth at the risk of long-term environmental catastrophe.

Another increasingly agitated constituency is the country’s foreign business community. The pace of reform has slowed since China joined the World Trade Organization in 2001. Many commitments given then have not been fulfilled.

Foreign businesses in China still face political and information risks. One China-based consultant recently said that he had “not seen the foreign business community so discouraged as they are now” at any point during his twenty years in the country.

Against this backdrop, the current leadership team of Hu Jintao and Wen Jiabao will stand down in 2012, meaning China is facing the dual challenge of managing economic and political transition.

Amidst these uncertainties, China’s leaders met in Beijing last month for the Fifth Plenary Session of the 17th China Communist Party’s central committee. At it, China’s next generation of leaders stepped further into the limelight and the announcement of the 12th Five Year Plan (FYP), the government’s economic blueprint for the period from 2011 to 2015.

The plan envisages a more high-tech Chinese economy that depends less on heavy industry. Designated strategic industries should account for 8% of GDP by 2015. An extra US$600 billion will be allocated to emerging sectors such as alternative energy, green technologies, ICT, and high-end equipment and materials manufacturing. The government intends to give incentives for foreign investment and technology transfer in these areas. Chinese stocks responded positively to the announcement - especially small- and mid-caps in the targeted sectors.

But the rise was short-lived. The following day the People’s Bank of China surprised markets by raising the interest rates for the first time in three years. The increase of 0.25 percentage points, took one-year deposit rates to 2.5% and one-year lending rates to 5.56%. That triggered wider concerns that monetary policy would be tighter still as China seeks to rebalance its economy. 

Taking a longer-term view, the next five years looks like a time of critical change for the Chinese economy. In response to the global financial crisis, China flooded its system with credit: fresh loans of 1.4 trillion yuan were made in 2009.

Other stimulus measures have been taken that may create long-term risks, while efforts to tackle rising social inequality were put on hold to resuscitate the ailing economy.

There are major concerns whether China can meet the targets set out in this latest five-year plan. The Plenary Sessionheard a litany of missed environmental targets from the previous five years — although the global financial crisis may be a mitigating factor in this.

Good intentions and rhetorical assurances from Beijing have not been translated into substantive progress on enduring grass-roots issues such as corruption, regulatory abuse and predatory corporate behavior. Apart from more rational finance arrangements, the development of a modern economy in China also requires improved transparency and accountability throughout the system. That includes creating independent judicial and regulatory bodies and cementing the rule of law.

Lastly, there is the continuing of the yuan, where China finds itself in a Catch-22 situation. Keeping the yuan weak against the dollar has obvious benefits for China, particularly its exporters. But the resulting large trade surplus creates inflationary pressure that ultimately

may harm China, but weakening of the purchasing power of Chinese entities in international markets.

Similarly, promoting the export-based model may hinder the modernisation of domestic products and markets; in particular the country’s financial services sector is held back by the illiquidity of the yuan.

On the other hand, bowing to US pressure and allowing the yuan to appreciate significantly against the dollar also risks throttling short-term growth and causing deflation - and loss of face.

As such, on this and a number of other major issues, China’s leaders are facing crucial policy decisions at a time of transition and critical change. With traditional national advantages diminishing, China must find new ways to attract investment and drive economic activity.

The latest FYP identifies strategic industries in which the government will incentivise investment and push reforms. The key challenge for China’s next generation of leaders, however, will be implementing the types of wholesale structural reforms necessary to increase domestic corporate efficiency and transparency, and reducing political risk for foreign businesses, banks and investors in the process. •