Rapid urban growth in China has been accompanied by rising social inequality and marginalization of disadvantaged social groups such as laid‐off workers of the state‐owned enterprises and rural migrants. The Chinese government has officially acknowledged the existence of ‘marginal groups’ and prioritized combating the new urban poverty as an urgent task to eliminate the root of potential social instability. This article proposes the concept of ‘poverty of transition’ from the institutional change perspective to examine how the ‘new’ urban poverty is created by the disjuncture between the old and new institutions. Specifically, the poverty of transition suggests that the main cause of the new poverty is structural, i.e. economic restructuring and the release of redundant workers previously hidden inside the workplace, and the increasing migrant population who are excluded from the formal urban institutions. A sizable underclass is now under formation in the sense that they are institutionally detached from mainstream urban society. To close the disjuncture between the marketization of labourers and the transition in welfare provisions requires more than just a policy of poverty relief; instead it requires a fundamental vision of the new ‘citizenship’ in the Chinese city.