In recent discussions that I have had with decision makers and economists working on People’s Republic of China (PRC), the question on the incoming leadership’s approach to economic reforms inevitably comes up. Is the transition to new leadership a good opportunity to rethink economic policies?

The PRC’s economy faces three principal challenges: avoiding the middle-income trap, strengthening the role of the private sector and narrowing the income gap.

The middle-income trap. For over 30 years, growth has been based on low-cost labor and exports, but this model has now reached its limits. Wages have risen sharply, and PRC can no longer compete with low-income countries. However, due to its relatively low level of technology and innovation, the PRC cannot yet compete with developed economies.

To avoid the trap, the PRC must rapidly raise the value-addition of its production. This requires increased investment in human capital, research and development (R&D) and information and communication technology (ICT).

Education and innovation provide the key. The PRC has increased spending on education, which is expected to reach 4 percent of GDP this year. However, this is still lower than in other middle-income countries. Developed economies spend between 5 and 7 percent.

The government is also stepping up innovation. Spending on R&D has been increased significantly. However, much of this is carried out by state research institutions or enterprises, and the link with manufacturing is weak. The PRC has some innovative enterprises, but the majority continues to focus on production rather than innovation.

Importance of strengthening the private sector. This is vital to avoiding the middle-income trap. Without a creative private sector, economic innovation will not take place.

Many economists agree that this is also the time to review the role of state-owned enterprises (SOEs). State monopolies still dominate key areas of the economy. Following an initial rationalization of SOEs in the 1990s, reforms have slowed.

Financial markets are also in need of urgent reform. State-owned banks lend mainly to local governments and large SOEs. Small and medium-sized enterprises (SMEs) generate a large share of GDP, provide jobs, and have a stronger track record for innovation than SOEs. However, they have difficulty obtaining financing and have to borrow on the costly informal markets.

A stronger service sector would reduce the carbon footprint of the PRC’s rapidly expanding cities and help to absorb rural-urban migrants. Bold reforms are needed including opening the sector up to foreign direct investment.

Narrowing the income gap. The gap between the rich and the poor has increased sharply. If not addressed, inequality will undermine the shift to consumption-driven growth, constrain development in poorer regions, and generate social tension.

Fiscal reform and increasing social expenditure provide the solution. Policy makers should broaden the tax base, increase the progressivity of taxation and better align revenue and expenditure responsibilities at the local government level.

Social spending will help raise living standards. Current social spending is only 38 percent of revenue compared to 52 percent in countries at a similar income level. The PRC has the fiscal space to achieve universal social security coverage and provide equal access to social benefits in urban and rural areas.

The challenges are significant, and the global slowdown highlights their urgency. The leadership change is the right time to rethink economic policies and reforms.