BEIJING – 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 the continuing 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 EU. 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.

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 the lack of reform in 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 to 30 per cent of the 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, recognising 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.

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 per cent in the mid 1990's to below 50 per cent 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.

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

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.

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.

Yao Yang is the Director of the China Center for Economic Research at Peking University.