In a sooner-than-expected turn of events, the Chinese economy has shaken off the economic downturn, experiencing only a few fi nancial bumps as it moves toward prosperous times. But uncertainties still loom large, as rapid growth no longer seems to be the country’s main concern—economic rebalancing for greater sustainability has since taken top priority. In its latestChina Quarterly Updatereleased in March, the World Bank pointed to the Chinese economy’s prospects and offered suggestions for structural reforms. Edited excerpts follow:

Massive investment-led stimulus was key to driving the economy last year, but real estate investment has since taken prominence, while household consumption remains steady. After weakening in early 2009, labor market conditions improved, and employment and wage growth have held up well through the early months of 2010. Income and consumption were further supported by falling consumer prices throughout 2009 and government measures, such as lower consumption taxes for small cars and subsidies for household electrical appliance purchases in rural areas.

Overall, exports declined in 2009, even as China gained a larger global market share.With a steady fl ow of imports, external trade was a major drag on growth in 2009, leading to a sharp decline in the external current account surplus. In a heated real estate market,surging property prices triggered policy measures to expand affordable housing supply and curb speculation. In fl ation is on course to be a signi fi cant burden in 2010, after remaining negative in 2009. But, with global price pressures likely to be subdued amidst large spare capacity internationally, China’s in fl ation is unlikely to reach high rates in 2010.

RESIDENTIAL SPENDING SPREE: Newly built houses for survivors of the May 12, 2008 earthquake in Shifang of Sichuan Province, one of the hardest hit cities in the province,await occupants. China has stimulated the economy with massive infrastructureinvestment, including reconstruction in the quake-hit province

Macroeconomic risks include a property bubble and stress on local government fi nances. Since late 2008, local governments have ramped up infrastructure spending while simultaneously being pressured to spend more on health, education and social security,for which they are in large part responsible.With monetary conditions likely to become tighter and land revenues possibly slowing down or even declining, local government fi nances may become strained.

At the heart of concerns are local government investment platforms established to finance infrastructure construction and urban development. Problems may emerge if the infrastructure projects do not generate enough growth or revenues to pay the operating and interest costs, in addition to repaying loans.

Given China’s solid macroeconomic position, the local fi nancial problems are unlikely to cause systemic stress. But the fl ow of new lending to the platforms needs to be maintained and local government revenues need to become less dependent on land transaction revenues. As a country with a surplus,China has room in deciding how to deal with such problems, since the government debt is largely held domestically.

The 2010 budget rightly implies a broadly neutral fi scal stance. Given the remaining uncertainty about the world economy, fl exibility in its implementation is important.Inflation expectations can be contained by a tighter monetary stance and a stronger exchange rate, while monetary policy also has a key role to play in containing asset price in fl ation risks.

With regard to the property market, stability calls for an appropriate macro stance and improving the functioning of markets.Meanwhile, concerns about the affordability of housing for lower income people would be best addressed by a long-term government support framework.

The government has attached importance to structural reforms. In the coming years,two key challenges stand out. The first is playing the basis for continued rapid development. This requires bold efforts to reform and open up the economy, undertake needed public investments and create new sustainable sources of demand and supply. The second challenge is sustaining recent progress in moving towards a “harmonious society.”Specific challenges include creating conditions to generate employment and improve“primary income distribution,” in the quality of and access to public services, in expanded social security and other means to reduce vulnerability, and in efforts to create a less resource-intensive and more environmentally friendly form of growth.

Meeting these challenges will require a range of reforms and policy adjustments,most of which already featured prominently in the speeches and policy documents presented at the recent session of the National People’s Congress. Implementing them ef-fectively will be the key to success. These reforms aim to achieve the following five inter-related objectives:

First, further progress in rebalancing the economy must be made. Speeding the shift from a model led by exports, investment and industry to one led by domestic demand,consumption and service sectors, has become more critical than ever.

Second, efficiency gains in all sectors and spheres of activity should be enhanced.While recent growth of Total Factor Productivity (TFP)has by no means been low, the main driver of China’s GDP growth has been physical capital accumulation.However, if rapid growth is to be maintained,TFP will have to play an increased role.Reforms to the pricing of capital, energy,and other natural resources will also lead to more efficient use of resources. Financial sector reform can also improve the ef fi ciency of capital. Further policies to support innovation can help China’s export enterprises move up the value chain.

Third, a more spatial transformation of economic activity and employment must be pursued. While the core of this agenda is about moving to a more permanent and successful form of urbanization, it also includes the shift of economic activities—for example,from coastal toward inland areas. Further urbanization is inevitable as China continues to develop. It can also be a positive source of sustained consumption growth, and creating demand for major investments in productive activities, infrastructure and housing. The resulting agglomeration effects can further raise productivity, especially if backed by investments to connect urban centers.

Fourth, further changes are necessary to the role of the state concerning the economy.In sectors like the financial sector and the broader service sector, it is necessary to expand the role of the market, with the state shifting from the use of direct controls or dominant ownership stakes toward a greater focus on incentives, appropriate regulation and other indirect means of governance. But in some other areas, the direct role of the state could be enhanced. These include the provision of health and education services and various dimensions of reducing vulnerability.

Fifth, China’s interaction with the rest of the world must be taken into account. As China’s role in the global economy increases,including through increased outward investment, its development and policies will have increasing impacts on global markets and other countries, which needs to be factored into policymaking. Meanwhile, working in concert with other countries, China will be involved in tackling a range of issues on global and regional public goods, including matters concerning the environment.