Everyone is talking about China's economic slowdown. Last year, GDP growth reached a 13-year low, and no upturn is in sight. But, as Premier Li Keqiang seems to recognise, this could be beneficial, spurring the structural reforms needed for more balanced and stable GDP growth.
The World Bank has cut its 2013 economic growth forecast for China from 8.4 per cent to 7.7 per cent. Moreover, recent central-bank data shows that Chinese banks increased their lending by only 667 billion yuan ($108 billion) in May - a 125 billion yuan decline from the same period last year.
But simply lending more would not improve the situation. Given that loans amount to nearly double China's GDP - a result of the stimulus since 2008 - new loans are largely being used to pay off old debts, rather than for investment. Thus, the more relevant concern is that the balance of outstanding loans has not risen.
In recent years, tight monetary policy and strict controls on the real estate sector have caused the growth rate of fixed-asset investment to fall. Furthermore, the growth rate in the less developed eastern regions is 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 per cent during boom years to just 7.8 per cent in the first quarter of this year.
The key to restoring China's GDP growth is returning fixed-asset investment growth to at least 25 per cent. With a new round of stimulus, excess production capacity and underused outlays (built-up real estate assets) could be mobilised, restoring 9 per cent annual GDP growth.
But the willingness of China's new leadership to initiate another round of stimulus depends on what rate of GDP growth Li can tolerate. The reason for Li's inaction emerged in June, when President Xi Jinping told Barack Obama that China had deliberately revised its growth target downward, to 7.5 per cent, to support stable and sustained economic development.
Xi's statement suggests the new government will seek to restore pre-2008 fundamentals. In 2005, China was experiencing currency appreciation, which can stimulate the government and businesses to pursue structural reforms and industrial upgrading. But the increase in official fixed-asset investment - which rose by 32 per cent in 2009 alone - delayed structural reforms, while overcapacity and a real estate bubble became more deeply entrenched.
The government must now dispel the remaining vestiges of the over-investment of 2008-2010, however painful it may be. This means allowing the economy to slow, while maintaining tight macro-economic policies that force local governments and business to find new sources of growth.
Over the past decade, structural changes to China's economy have caused unemployment pressure to decline. Now, the setting is favourable to build the stronger, more stable economy that Li wants - and that China needs.