by Yao Yang, Project Syndicate

If everything goes right for China, it will surpass the United States as the world’s largest economy, in current dollar terms (and more quickly in real terms), by 2021. Its per capita income will reach that of today’s lower tier of high-income countries. But, despite its forward momentum, the Chinese economy faces looming risks in the coming decade.

The immediate risk is continuing stagnation, or recession, in Europe. In the last decade, export growth has accounted for roughly one-third of China’s overall economic growth, and about one-third of Chinese exports went to the European Union. If the situation in Europe continues to deteriorate, China’s growth will be dragged down.

Over-tightening of domestic macroeconomic policies, especially those aimed at the real-estate market, could heighten the risk of a slowdown, with house prices currently falling across China, owing to stringent government measures. Indeed, the situation is much like that of the 1997 Asian financial crisis. In the several years before that crisis hit, China had been combating inflation, and appeared to be headed for a soft landing. But the combination of crisis and austerity condemned China to several years of deflation and considerably slower growth.

Today, as China looks to the medium term, the government must face the problems created by its pervasive role in the economy. A new World Bank report singles out lack of reform of state-owned enterprises as the most important impediment to the country’s economic growth. But that is only a symptom of a deeper problem: the government’s dominant role in economic affairs.

In addition to controlling 25-30% of GDP directly, the government also takes a lion’s share of financial resources. In recent years, more than one-third of total bank lending has gone to infrastructure, most of which has been built by government entities. Indeed, recognizing its over-investment in infrastructure, the government recently abandoned several high-speed rail projects that were already under construction. But government over-investment is also evident in numerous industrial parks and high-tech zones.

China’s investment frenzy reminds many people of Japan in the 1980’s, when high-speed rail links were extended to Japan’s remotest corners. Most rely on government subsidies to this day. And, while the subsidies may improve the quality of life for ordinary people in some respects, they also detract from it by suppressing domestic consumption.

Infrastructure investment will inevitably run up against the law of diminishing marginal returns, but consumption growth does not have a limit. Suppressing consumption thus suffocates future growth, and the share of household consumption in GDP has declined from 67% in the mid-1990’s to below 50% in recent years, with most of the decline reflecting the distortions created by government policies.

China’s government is production-oriented by nature. The upside is that this has helped to maintain high GDP growth rates. But the downside is equally pronounced. One negative consequence is the persistent deepening of income inequality. The Gini coefficient of per capita income has surpassed 50 (with 100 representing maximal inequality), putting China in the upper quartile of inequality worldwide.

The problem may not be inequality per se, but its consequences, one of which is the bifurcation of human capital. The return on education is increasing in China, but access to education is becoming increasingly divided socially and geographically. While education is improving in urban areas, children in the countryside are facing a decline in educational quality, because better teachers find their way to the cities. Moreover, given the income disparities between cities and rural areas, their education is more expensive than it is for urban families.

As a result, a majority of rural kids will enter the workforce without a university diploma. Among China’s 140 million migrant workers, 80% have only nine years or less of formal education – far short of what high-income countries require.

Despite officials’ seeming desire to reduce income inequality, China’s government is aggravating it, by – among other things – subsidizing producers, favoring capital-intensive industries, and maintaining a highly inefficient financial sector. But there are also promising signs of an economic uptick. The government has just announced new rules for household registration, known as hukou. Except in large cities, people can now freely choose their hukou after three years of residency. This will greatly help migrants by ensuring equal access to education for their children.

To change completely the government’s distorting behavior, however, requires more drastic political changes. The hukou reform is a good start, as it will strengthen migrants’ political rights in local communities. Given their large numbers, their political participation may force local governments to become more responsive to ordinary people’s needs. And government responsiveness at lower levels, one may hope, might eventually trickle up to the top.

Article originally published by Project Syndicate as China’s Growing Growth Risks