Reforms Vital for China to Avoid ‘Middle Income Trap’: ADB

After bottoming in the third quarter, China's economic growth is set to accelerate in 2013 and beyond, provided the country pushes through crucial reforms to escape the "middle income trap," the head of Asian Development Bank (ADB) warned.

Reforms Vital for China to Avoid ‘Middle Income Trap’: ADB
ChinaFotoPress | Getty Images

The middle-income trap is an economic situation where a developing country attains a certain income but remains stuck at that level, usually because of rising wages and falling cost competitiveness. According to the World Bank, the "middle income" range refers to per capita gross national income of between $1,000 and $12,000.

With a per capita gross national income of close to $5,000 in 2011, China risks being caught in that trap, according to Haruhiko Kuroda, president of ADB.

"Whether China can avoid the so-called middle income trap to become a high-income country closely depends on various factors including how to make real innovation, domestic kind of innovation, to further improve productivity in China," Kuroda told CNBC's "Squawk Box" on Thursday.

This means that China has to invest in technology so that it doesn't continue to lag far behind developed countries in innovation and productivity. The work that has been done so far to reduce reliance on exports and boost domestic consumption also has to continue, Kuroda said.

"Most domestic demand increase is centered around investment rather than consumption, so the next challenge is to really unleash household demand for consumption to firmly establish the second stage of rebalancing the Chinese economy," Kuroda added.

After logging an average annual growth rate of 9.9 percent from 1980 to 2011, China has seen its per capita gross national income grow to $4,930 last year from $220 in 1980, the ADB said in a report published in late October. While this is a huge improvement, the country still has a long way to go before it becomes a high-income country.

Some 18 countries globally have been "middle income" for the past 50 years, including 12 in Latin America and three in Asia—Malaysia, the Philippines, and Thailand, the ADB said. At their current pace of growth, many will remain trapped for years to come.

On the other hand, 14 economies have escaped the trap since 1965, including several in Asia. Hong Kong, Japan, South Korea and Singapore completed the transition from low to high income within 3 to 4 decades, according to the ADB.

If China wants to do the same, it needs to undertake a slew of reforms, such as investing in technology, promoting innovation by the private sector and loosening the state's control over the financial sector, ADB said.

(Read More: Changing China: the New Leaders)

In addition, China should expand its service sector, speed up urbanization, and try to reduce income inequality so that ordinary people benefit more from economic growth.

"Implementing this strategy would greatly increase the likelihood of sustained growth and reaching high-income status before 2030," the ADB said in the report. "Scenario analysis shows China has the potential to grow 8 percent annually from 2010 to 2020 and 6 percent from 2020 to 2030—if it addresses its challenges effectively."

If the reforms were implemented successfully, the country could reach the high-income bracket by 2025 and per capita income would reach $26,000 by 2030, the ADB said.

By CNBC's Jean Chua.