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Li Keqiang’s Bottom Line

SHANGHAI – Everyone is talking about China’s economic slowdown. Last year, Chinese GDP growth reached a 13-year low, and no upturn is in sight. But, as Premier Li Keqiang seems to recognize, this trend could actually be beneficial, spurring the structural reforms that China needs to achieve its longer-term goal of more balanced and stable GDP growth.

Recent assessments have offered a downbeat picture of the world’s second-largest economy. In its latest Global Economic Prospects report, the World Bank cut its 2013 economic growth forecast for China from 8.4% to 7.7%. Moreover, recently released central-bank data show that Chinese banks increased their lending by only about ¥667 billion ($108 billion) in May – a roughly ¥125 billion decline from the same period last year.

But simply lending more would not improve the situation. Given that outstanding loans already amount to nearly double China’s GDP – a result of the country’s massive stimulus since 2008 – new loans are largely being used to pay off old debts, rather than for investment in the real economy. Thus, the more relevant concern is that the balance of outstanding loans has not risen.

In recent years, tight monetary policy and increasingly strict controls on the real-estate sector have caused the growth rate of fixed-asset investment to fall, from more than 25% annually before 2008 to around 20% today. Furthermore, the growth rate in China’s less developed eastern regions amounts to less than half of the national average. As a result, growth of industrial value added – which contributes almost half of China’s GDP – is slowing even faster, from an average annual rate of 20% during China’s boom years to less than 10% in 2010-2012 and just 7.8% in the first quarter of this year.

The key to restoring China’s GDP growth is, therefore, returning fixed-asset investment growth to at least 25%. With a new round of stimulus, China’s excess production capacity and underused outlays (for example, built-up real-estate assets) could be mobilized immediately, restoring 9% annual GDP growth.

But the willingness of China’s new leadership to initiate another round of growth-securing stimulus depends on what rate of GDP growth Li can tolerate. With China’s leaders having offered no indication that they will change current monetary policy, some economists have estimated that Li will not act until GDP growth falls below 7%.

The reason for Li’s inaction emerged in early June, when Chinese President Xi Jinping told his American counterpart, Barack Obama, that China had deliberately revised its growth target downward, to 7.5%, in order to pursue structural reforms aimed at supporting stable and sustained economic development. Given that China was moving toward such reforms before the 2008 global economic crisis prompted former Premier Wen Jiabao to launch his ¥4 trillion stimulus plan, Xi’s statement suggests that the new government will seek to restore the economy’s pre-2008 fundamentals.

In 2005, China was experiencing currency appreciation, which, as other fast-growing economies in East Asia have demonstrated, can stimulate the government and businesses to pursue structural reforms and industrial upgrading. But the subsequent increase in official fixed-asset investment – which rose by 32% in 2009 alone – delayed structural reforms, while over-capacity and a real-estate bubble became even larger and more deeply entrenched problems.

The government must now dispel the remaining vestiges of the stimulus-fueled over-investment of 2008-2010, however painful it may be. This means allowing the economy to continue to slow, while maintaining relatively tight macroeconomic policies that force local governments and the business sector to find new sources of growth.

The combination of external shocks and internal pressure from rising wages can serve as a powerful incentive for governments and businesses to pursue structural reforms. For example, firms in China’s export-dependent coastal regions have been burdened by renminbi appreciation since 2004. When the economic slowdown hastened the relocation of many manufacturers to inland provinces or neighboring countries, those in the coastal regions began to call for increased openness, deeper structural reforms, and industrial upgrading.

The view that Li will tolerate slower growth only above a particular threshold is based on the belief that GDP growth below 8% would hurt economic development more than it helped, and lead to social instability. And, indeed, if unemployment pressure had become as acute today as it was in the 1990’s, the prolonged economic slowdown would undoubtedly have precipitated government intervention.

But, over the last decade, structural changes to China’s economy have caused unemployment pressure to decline significantly – a trend that can be corroborated by across-the-board wage increases. Now, the setting is very favorable to build the stronger, more stable economy that Li wants – and that China needs.