Over the past decade many Americans became convinced that China’s economic rise came at their expense. The outsourcing of manufacturing jobs to take advantage of cheap Chinese labor was perceived as having contributed to stagnating middle class wages and the large bilateral trade imbalances. While the logic was always a bit tenuous, China’s cost advantages have eroded in recent years with manufacturing wages having increased by 70 percent since 2009. This has allowed the United States to claw back some production, although most of China’s lost manufacturing has gone to lower cost sites in developing Asia. Yet China’s challenge to America’s economic dominance may not be over, having simply shifted from an abundance of low-skill labor to a glut of college graduates.

Nearly 7 million students are expected to graduate from China’s institutions of higher education this year, up from less than a million in 1999 and two and a half times the number graduating in the United States. In 2004 China overtook the United States in both the number of students enrolled and the number of degrees awarded annually. And by 2020 the Chinese government expects, perhaps unrealistically, to have a total of 195 million college graduates in the labor force, compared with a total projected labor force of 167 million in the United States.

The result of this dramatic expansion of higher education has been predictable: higher unemployment and lower wage growth for Chinese graduates as supply rapidly exceeded demand. Over the latter half of the past decade, the wage premium paid to college graduates fell by 19 percentage points, while unemployment among recent graduates has risen to over 16 percent. Status-conscious graduates resist taking available but low prestige manufacturing jobs, instead holding out for office jobs in government or state-owned enterprises. Unfortunately, despite exhortations from its leadership about “innovation-driven development,” China’s economy still cannot generate enough demand for high-skill labor to absorb the surge in recent graduates.

The weakness of the graduate labor market is matched by the tightness of the labor market for those with less education. Non-college graduates are more willing to take blue-collar jobs and therefore have unemployment rates as low as 4 percent. This has led wages in manufacturing and construction to grow more rapidly than those in many high-skill industries over the past several years, with many factory jobs now paying more than entry-level office positions. The result has been the deterioration of China’s export competitiveness and partially explains the contraction of its current account surplus from over 10 percent of GDP before the financial crisis to around 2 percent now.

The bleak situation for recent graduates contrasts with robust demand for those with several years of experience. Whereas unemployment for recent graduates is over 16 percent, unemployment for graduates of all ages is only 3 percent, indicating that unemployment among older, more experienced graduates is negligible. Moreover, they can expect relatively high pay. Mid-career bank associates, for example, can expect to make between $25,000 and $50,000 a year, compared with an average annual manufacturing wage of less than $7,000.

Some students are avoiding the chokepoint of entry-level jobs by studying abroad, including 400,000 last year alone. Studying abroad not only endows students with a uniquely differentiated skill set, but it allows them to take advantage of the more plentiful supply of entry-level jobs in the countries in which they study. In the past, only 30 percent of students who went abroad for school came back to China after completing their education, but the attractive opportunities have now begun to draw experienced graduates back, including 330,000 last year.

Perhaps more worrisome, the shortage of graduate jobs in China also fuels corruption as job seekers resort to bribes to secure positions while the more privileged rely on guanxi, or personal relationships. Many students choose to study abroad because the resulting social and alumni networks are often professionally advantageous. That said, since most graduates aspire to jobs in the state sector, communist party connections play an important role. Such connections offer other benefits as well since the children of communist party officials, according to one study, are able to secure jobs with starting salaries 15 percent higher than those of their non-party affiliated peers.

Given the advantages conferred by party connections, it is not surprising that students are joining the communist party in growing numbers. Less than 1 percent of college students were communist party members in 1990, but by 2011 that figure had risen to 11 percent. According to one survey, only 20 percent of younger party members joined because they supported “the idea of communism.” The more likely explanation is that students are seeking an advantage in the job market, particularly in the cutthroat competition to become public servants, for which the acceptance rate is less than 2 percent. All this fuels perceptions that the system is unfair and adds to pressure for more political openness and reform.

China is now rapidly approaching the level of income at which most developing countries experienced a dramatic growth slowdown, the so-called middle-income trap. Countries that fall into this trap find that, thanks to rising wages, their low-value goods have become too expensive but they are not yet innovative or productive enough to compete against developed countries in high-value products like cars, sophisticated electronic components and information technology. The key question for China is whether it can join the select group that has managed to compete in these higher value sectors.

This is where the glut of graduates could become a boon: employing the massive oversupply of graduates implies a falling college wage premium that will increase the competitiveness of China’s skilled labor and the higher value sectors that rely on it. This is in fact the path that Korea, along with a few other East Asian economies, followed to move up the value chain. Korea tripled enrollment in higher education during the 1980s. By 1993 the college wage premium had fallen to 61 percent, from 125 percent in 1981, and the country was well on its way to joining the ranks of the high-income countries. More generally, comparative experience has shown that developing countries with a higher proportion of graduates are much less likely to fall into the middle-income trap.

One caveat is that the quality of China’s graduates is currently questionable. The rapid expansion of higher education has outpaced the production of qualified educators. As a result, there are approximately 3,000 undergraduates enrolled for every PhD holder in the country, and the student-professor ratio has more than doubled since the expansion began in 1997. The quality of students attending college has also deteriorated as the booming second- and third-tier universities, particularly in inland provinces, have cut admissions standards to meet enrollment goals. In the late 1990s the pass rate of the gaokao, the SAT-like examination that determines whether and where a student can go to college, was less than 40 percent; by last year the pass rate had risen to 77 percent.

However, at the same time as the quality of the average graduate has been declining, the quality of top graduates has been improving as competition to get into the best universities heats up. In the past few years both Peking and Tsinghua universities have joined the University of Hong Kong as three of the top 50 universities in the world. Graduates of these and other elite universities are globally competitive, particularly in areas like engineering and the sciences.

Although improving quality more broadly is an important objective, the key to brightening the employment prospects of graduates is to stimulate the underdeveloped service sector. Services account for just 43 percent of China’s GDP, compared to 60 percent in Korea, 70 percent in Japan and nearly 80 percent in the United States. This gap has repressed demand for graduate labor, since the service sector tends to require more skilled labor than manufacturing or construction.

Some development of the service sector will occur as the natural byproduct of China’s changing demographic structure and urbanization process. The aging of the population will increase demand for healthcare while urbanization whets the appetite for entertainment, transportation and business services. But China also needs to speed the development of the service sector by allowing more private firms to enter currently state-dominated activities, such as telecommunications, banking and education. This will generate jobs for graduates while also stimulating much needed productivity gains, thus helping China become globally competitive in tradable services and not just in the hardware.

Reforms to tackle the privileged status of state-owned enterprises would also help. State-owned enterprises are bloated, paying 70 percent higher salaries despite being markedly less productive than their private-sector counterparts. Placing state-owned enterprises on a more commercial basis will reduce the distortions that favor holding out for a state-owned enterprise job, making graduates more willing to enter the private sector. As the range of jobs graduates are willing to take expands, their unemployment rate will fall and private firms will gain greater access to skilled labor.

China’s transition to a more services-heavy economy is hardly guaranteed, and the global implications are complex. As China expands into higher value services and manufacturing it will begin to squeeze developed countries in much the same way Japan did decades ago. Japan’s rise generated significant tensions with the United States over trade and investment relations, despite historically close political ties. More recently both the United States and Japan are feeling pressures from Korea’s rise in advanced manufacturing (Hyundai), technology (Samsung), and even entertainment — Korean TV shows have become regionally popular, and pop artist PSY’s Gangnam Style music video was the first on YouTube to be viewed 1 billion times.