China's economy is expected to expand at 8.2 percent in 2012 and 8.6 percent in 2013 as domestic demand will continue to boost the world's second-largest economy amid weak external demand, the World Bank (WB) said Thursday.

"The Chinese economy is in the midst of a gradual slowdown," the WB said in its China Quarterly Update, which was released on Thursday and predicted cyclical weakness to dominate the country's short-term outlook.

The WB's projection was 0.3 percentage points lower than that forecast by the Asian Development Bank on Wednesday.

Last month, Chinese Premier Wen Jiabao lowered the government's gross domestic product (GDP) growth target to 7.5 percent this year to promote a high-quality growth in the country.

Economic outlook

The WB projected domestic demand will contribute 8.4 percentage points to China's growth in 2012 as consumption slows slightly partly due to base effects and investment growth decelerating rather sharply.

Meanwhile, as it is anticipated that world trade will remain weak, external demand will subtract some 0.3 percentage points from growth. The projected rebound remains modest as these trends are likely to weigh on 2013 as well, the WB said in its report.

Inflation looks set to rise by 3.2 percent in China in 2012, as growth slows, commodity-price impulses fade and property markets cool further, the WB added.

China's external terms of trade will likely improve as import prices dependent on commodities decelerate by more than export prices dominated by manufacturers.

The appreciation of the Chinese currency Renminbi, or the yuan, is expected to slow as long as the weak external environment continues to weigh on export volumes and prices, said the report.

The current account surplus is projected to increase slightly to 3 percent of GDP in 2012 and 3.3 percent in 2013. Terms of trade improvements offset an initially lower trade balance driven by export weakness and import robustness, according to the report.

With trade volumes recovering in 2013 and the terms of trade improving further, the surplus should also expand in 2013. Despite continued net capital inflows, foreign exchange reserves should accumulate more slowly.

While projecting a gradual slowdown, the WB warned of two significant risks for China's economic growth -- the ability of high-income countries to avert a deeper economic downturn as well as the ongoing correction in property markets domestically.

The WB said China's longer-term outlook will depend on how the country manages key structural challenges, such as a weakening of the traditional engines of growth, rising old-age dependency and a shrinking labor force.

Illustrative scenarios suggest China's growth could slow from recent rates of 10 percent to 5 percent in around 20 years' time.

Policy challenge

For the world's second-largest economy, "the policy challenge for the near term is to sustain growth through a soft landing," said the WB.

According to the report, while the prospects for a soft landing remain high, there are concerns about growth slowing too quickly in China.

"However, sufficient policy space exists to respond to downside risks," said the WB, citing targeted tax cuts, social welfare spending and other fiscal measures to support consumption as priorities.

But any policy response would need to be carefully crafted, said the WB, as previous episodes suggested fiscal stimulus would ideally be less credit-fueled, less reliant on local-government funding and less infrastructure-oriented.

Reserve requirements could be tweaked further to ease the availability of credit, with policy rate action best reserved for downside scenarios given already accommodative real rates, according to the report.

China's longer-term challenge is to continue steering its economy toward a more sustainable path that involves securing healthy per capita income growth and sustaining the ongoing shift in focus from the rate of growth toward the quality of development, the WB said.

New efforts can help China sustain its competitive advantage by progressively shifting from low cost to higher value supported by innovation, it added.