China’s economy has followed a remarkable course in recent years: from record-breaking powerhouse to major global risk, at least in the eyes of some. Indeed, with GDP growth this year almost certain not to reach the authorities’ 7% target, the world is now watching closely for signs of crisis and a much sharper slowdown. How did China get here, and can it put its economic growth back on track?

China’s growth has been unsustainable for a while. A stimulus package of less-than-prudent fixed-asset investment, adopted in response to the 2008 global financial crisis, sustained 9% GDP growth for two years. But, after 2011, stimulus turned to macroeconomic tightening, causing investment growth to plummet from a nominal rate of over 30% to about 10% recently. This prevents full utilization of production capacity and resources, and explains why GDP growth above 7% is simply not possible.

Excess capacity and falling growth are mutually reinforcing. Not only does excess capacity have a negative impact on growth; perhaps more important, sharply declining growth also contributes to massive redundancy in some industries (especially resources and the heavy and chemical industries).

The question is why growth continues to slow. One popular line of thinking focuses on long-term structural factors, such as demographic transition. But, so far, few studies have indicated that structural factors are adequate to explain the extent of the decline in China’s potential growth rate over the last couple of years.

A more convincing answer lies in China’s monetary-policy stance. Since assuming office in 2013, Premier Li Keqiang’s government has chosen not to loosen the previous government’s rigorous macro policies, instead hoping that the resulting pressure on existing industries might help to stimulate the authorities’ sought-after structural shift toward household consumption and services. Economists welcomed this ostensibly reasonable approach, which would slow the expansion of credit that had enabled a massive debt build-up in 2008-2010. China’s lower growth trajectory was dubbed the"new normal" .

But, for this approach to work, GDP growth would have had to remain steady, rather than decline sharply. And that is not what has happened. Indeed, although structural adjustment continues in China, the economy is facing an increasingly serious contraction in demand and continued deflation. The consumer price index (CPI) has remained below 2%, and the producer price index (PPI) has been negative, for 44 months.

In a country with a huge amount of liquidity – M2 (a common measure of the money supply) amounts to double China’s GDP – and still-rising borrowing costs, this makes little sense. The problem is that the government has maintained a PPI-adjusted benchmark interest rate that exceeds 11%. Interest rates reach a ludicrous 20% in the shadow banking sector, and run even higher for some private lending.

The result is excessively high financing costs, which have made it impossible for firms in many manufacturing industries to maintain marginal profitability. Moreover, the closure of local-government financing platforms, together with the credit ceiling imposed by the central government, has caused local capital spending on investment in infrastructure to drop to a historic low. And tightening financial constraints have weakened growth in the real-estate sector considerably. With local governments and companies struggling to make interest payments, they are forced into a vicious cycle, borrowing from the shadow banking sector to meet their obligations, thereby raising the risk-free interest rate further.

If excessively high real interest rates are undermining the domestic demand that China needs to reverse the economic slowdown, one naturally wonders why the government does not take steps to lower them. The apparent answer is the government’s overriding commitment to shifting the economy away from investment- and export-led growth.

But it is doubtful that China can achieve the consumption-driven rebalancing that it seeks. After all, no high-performing East Asian economy has achieved such a rebalancing in the past, and China has a similar growth model.

Given this, China’s current deflation should motivate its policymakers to pursue monetary easing, reducing real interest rates to a much lower level, even zero. Such a move – for which China has plenty of room – would not only enable the reduction of existing debt burdens; perhaps more important, it would also allow for the rollover of debt as the economy accelerates.

Indeed, because most bank loans in China – unlike, say, in Europe – are now locked up in infrastructure and other physical assets, boosting demand is preferable to deleveraging. The key is to lower interest rates enough to mitigate the financial risks of high leverage and enable the restructuring of local-government debts. Lower borrowing costs would also boost China’s capital market, which is critical to provide equity financing to innovative small and medium-size businesses.

Of course, China needs to continue debt write-offs and swaps, and it must remain on the path of gradual structural reform. But policymakers must recognize the damage being done by excessively high real interest rates. Monetary loosening is vital to prevent growth from slowing further, and thus to ensure economic stability at home and maintain the momentum of recovery worldwide.

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