Last week, the World Bank and the Development Research Center of the State Council, an official Chinese think tank, jointly released “China 2030,” a new paper calling for sweeping economic reforms aimed at preventing China’s growth from stalling. Perhaps most significantly, the report calls for China to dramatically reduce the role of the state in its economy. Many China watchers believe the recommendations have the ear of the country’s next generation of leaders, including Vice President Xi Jinping, who is expected to become the new head of the Communist Party later this year.

The World Bank report has generated plenty of attention, and rightly so: its recommendations could fundamentally reshape the Chinese economy. But with delegates gathering in Hong Kong in a few days to attend the CFA Institute Asia Pacific Investment Conference, where China will figure prominently into the agenda, now is an opportune time to reflect on the subtle yet important political and economic changes that are already under way in China. All offer important clues to four key questions about the country’s future:

• How will China play on the world economic stage?
• How will China play on its own internal economic stage?
• How will China play on the world political stage?
• How will Chinese citizens be impacted over the next 10 years?

China on the World Economic Stage

Investors can be certain that serious change is afoot when political alliances once considered impossible become a priority. Consider China’s relationship with Japan. The two Sino-Japanese wars of the late 19th and mid-20th centuries created such enmity between the two countries that China refused to deepen economic ties with Japan for generations. Yet last year that frosty economic relationship appeared to thaw. In December, China surprised many observers by announcing a deal with Japan to allow the purchase of Chinese debt — its first ever such deal with a large foreign government. Then, in early February, news surfaced that China had substantially increased its presence in Japan’s debt markets last year, with total transactions amounting to ¥58.151 trillion.

This cooperation has intensified. On 28 October 2011, European Financial Stability Fund CEO Klaus Regling traveled east to enlist the financial support of the Chinese to help increase the size of Europe’s bailout mechanism. Regling was told that China would not support the EFSF until Europeans did more to help themselves. Even so, last month China and Japan announced that they would coordinate their responses to European sovereign debt aid requests from the International Monetary Fund.

As if China’s emerging role in Japanese and European economic affairs wasn’t enough evidence of a major rumble, the Asian giant is also trying to make the renminbi a global currency, while simultaneously purchasing fewer U.S. dollar-based securities. While this goal has been apparent for several years, there are increasing signs of progress. Consider, for example, the financial community’s growing interest in renminbi bond safeguards. When global investors begin to focus on the technicalities of bond safeguards instead of existential questions about the existence of the market itself, it’s fair to conclude that China is making progress in establishing its currency as a global reserve.

China on Its Internal Economic Stage

In the wake of the 2008 global financial crisis, the Chinese government pumped trillions of yuan into its economy to insulate it from outside economic shocks. Consequently, China’s property values have soared due to profligate lending. Reports suggest that Chinese efforts to calm spasmodic real estate lending have only led to an increase in its shadow banking sector, which is fueled by both the banks and informal lenders. Despite prohibitions, banks in China are notorious off-balance-sheet lenders and thus undermine official efforts to cool the overheated economy. In addition, government efforts to constrain lending by increasing reserve requirements are often more than mitigated by the sheer size of informal lending in China.

Exactly how big is China’s shadow lending sector? The country officially estimates the size at 3.38 trillion yuan, although unofficial estimates are much higher. As a result, despite stringent central enforcement by the Chinese government, the economy must contend with large inflationary and potentially bubble-bursting pressures. Last fall, further evidence of the consequences was starkly illustrated by reports of entirely empty Chinese “ghost” cities, which sent shivers through global markets. Reports that Chinese businesses are using copper as an alternative real-estate financing vehicle paint a similar picture. Many Chinese firms have stockpiled copper and use it as collateral when borrowing through unofficial lending channels.

Still, there are encouraging signs of economic progress in China. One key example is that the central government is for the first time allowing Chinese municipalities to issue their own debt. Still further evidence of liberalization comes in the form of the Chinese government’s interest in developing a non-investment-grade bond market. And the release of the China 2030 report itself suggests that the country is beginning to embrace more transparency with regard to its challenges and opportunities.

China on the World Political Stage

China’s leader-in-waiting, Xi Jinping, captured the attention of the global press corps with his recent visit to the United States. He seemed to want to project a softer image of China, even going so far as to visit old friends in Iowa — a U.S. state that is far from the country’s economic and political capitals of New York City and Washington, D.C.

Despite this grand photo opportunity, China nearly simultaneously thwarted the United States at the United Nations on policy measures related to both Iran and Syria, refusing to support the position of its U.S. and European counterparts. The takeaway here is not necessarily that China’s political direction is discordant with the West, but rather that the country’s desire to be more assertive on the global stage won’t always align. (Contrast this behavior at the U.N. with China’s change of course on the European sovereign debt crisis and its new willingness to partner with Japan to help the E.U. solve its economic problems.)

China in 10 Years

Over the next decade, China’s social contract with its people could be ripe for change. In the preceding 20 years, China has pursued “growth at any cost.” This policy has favored output and full employment over profitability. Why? Because the current social contract between the Chinese government and its people is one based on full employment in exchange for limited political choice.

Inevitably, though, economic growth that favors output and full employment over profitability will lead to markets where the integrity of price signals fail. To stave off the resulting economic turmoil, the authorities will need to liberalize the economy so that the central focus becomes profitability. The profit motive, in turn, implies job losses and higher unemployment. And that, in turn, raises the question of how the political system may change so that it is more responsive to the people’s needs. (Interestingly, the “China 2030” report is somewhat vague on the future role of the Chinese Communist Party, as the Wall Street Journal recently reported in this article.)

Examined separately and with too narrow a mental framework, these developments may seem less consequential. But when considered as a whole, this mosaic of change suggests that China is attempting to fulfill its greater promise — one in which it will take an increasingly active role in global economic and political affairs as it transitions from a centrally managed, developing economy into a potentially more transparent, developed economy. The choices its leadership makes, the challenges that lie ahead, and the economic and financial reverberations that will be felt are sure to challenge investors and China-watchers alike for years to come.

Originally published on CFA Institute’s  Enterprising Investor.