Following the 18th National Congress of the Communist Party of China, the new leadership is formulating its economic priorities and policies. The Central Economic Work Conference, an annual policymaking forum, will convene in the coming days. The leadership change provides the conference with an opportunity to take a broad look at the economic challenges facing China and to rethink the policies needed to address them.

A sluggish global economy will continue to provide a challenging backdrop, and efforts need to be stepped up where reforms have slowed. Observers remain skeptical about how quickly some announced policies will be implemented. This is particularly true of plans to reform State monopolies and relax migration controls. These are essential to spur economic efficiency as labor costs rise and the competitiveness of the economy declines.

In the past year, government policymaking has focused on how to implement the reforms set out in the 12th Five-Year Plan (2011-15). Tax policies have been introduced to develop a modern service industry. A plan has been prepared to restructure the country's industrial base. The government has also raised the income tax threshold and plans to increase minimum wage levels to improve living standards and boost consumption.

The Central Economic Work Conference presents a unique opportunity for economic policymakers to reflect on how to make growth more inclusive and sustainable. They face three principal challenges: avoiding the middle-income trap, strengthening the role of the private sector and narrowing the income gap.

China is currently facing the middle-income trap. For more than 30 years, growth has been based on low-cost labor and exports, but this model has now reached its limits. Wages and other production costs have risen sharply, and China can no longer compete with low-income countries. However, because of its relatively low level of technology and innovation, it cannot compete with developed economies either.

Numerous middle-income countries, including Malaysia, the Philippines and Thailand, have got caught in the trap. To avoid the same fate, China 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), and a strong and vibrant private sector. As production becomes more sophisticated, the technical and vocational skills of the workforce are increasingly important. China currently suffers from skill shortages in several sectors, and a rapidly aging population will reduce rather than increase labor market flexibility.

Education and innovation provide the key. China has increased spending on education, which is expected to reach 4 percent of GDP this year. However, this is still lower than in many other middle-income countries. Developed economies spend between 5 and 7 percent of their GDP on education. Besides, China also needs to move from rote learning to student-centered learning.

China has pockets of excellence, such as Shanghai, whose students have received top international ranking. The challenge is to provide this high standard of education throughout the country. China also needs to improve the quality of its universities.

The government is keenly aware of the need to step up innovation. Spending on R&D is currently 1.8 percent of GDP, and it is set to increase to 2.2 percent by 2015. However, much of this is carried out by State research institutions or enterprises, and the link with manufacturing is weak. China has some innovative enterprises, particularly in ICT and consumer electronics, but the majority continues to focus on production rather than innovation.