In June, China's producer price index (PPI), a gauge of inflation at the wholesale level, declined 2.1 percent year on year, according to the National Bureau of Statistics. This is the fourth consecutive month the PPI has taken a hit, indicating that price decreases caused by shrinking demand are reaching a level of severity.

In fact, the world economy is facing the contradiction between insufficient effective demand and overcapacity. If we loosen monetary policy or expand investment, overcapacity will be intensified. For the real economy, short-term stimulus can hardly solve the long-term structural problems.

The reasons for the overall decline of global manufacturing include:

First, both the United States and EU are mired in debt, causing less demand. Most enterprises have a cautious attitude toward purchasing raw materials, leading to sluggish demand and companies' reluctance for re-stocking.

Second, the imbalance between demand and supply has yet to be solved. De-leveraging is a must after each crisis. The subprime mortgage crisis ended up with de-leveraging of residents while the euro zone sovereign debt crisis caused de-leveraging of government departments. De-leveraging is changing the structure of global demand. After the financial crisis, weak consumption demand has substantially restricted the recovery of developed countries. The balance sheet of families in developed countries took a heavy blow and their consumption demand has thus nose-dived. De-leveraging of family assets has affected the debt-based consumption pattern in developed countries.

The supply shortage caused by the financial crisis can hardly be filled. The United States, Japan and Europe are now trapped in insufficient demand worth $1 trillion. The whole world expects emerging economies in Asia to take the baton and Chinese domestic consumption to be the major force in the global economic recovery, but the increase in China can hardly make up the shrink of U.S. consumption. In China, household consumption only accounts for about 35 percent of the GDP. Individual consumption in the United States totaled $10 trillion, while that in China only stood at $1.6 trillion. In the long run, if all governments continue to stimulate investment by lowering the interest rate, the world economy will inevitably face a crisis caused by shrinking demand and overcapacity.

For China, overcapacity has been a lingering problem throughout its economic development. Severe overcapacity appeared in 1996-99 and in 2005. Different from the previous two rounds, the overcapacity we are facing now is a general surplus in heavy industry.

Early in 2006, the State Council listed 10 sectors with excess capacity. By 2009, the number had almost doubled to 19. Right now, China's manufacturing sector has 28 percent excess capacity on average. Severe overcapacity has appeared in not only traditional sectors, such as steel, cement, auto making and textile, but also some emerging industries, such as wind power facilities and polysilicon.

To tackle excess capacity, policies should never focus on loosening monetary policy or expanding investment, but on eliminating outdated capacity, improving overall competitiveness and forging a solid foundation for next-round development. Meanwhile, we should sustain the market demand to ensure that advanced capacity can survive.

Most importantly, China should alter its dependence on investment. Otherwise, during the process of de-leveraging of global demand, excess capacity will be a bigger challenge and threat than the slowdown of economic growth.

This is an edited excerpt of an article by Zhang Monan, an associate researcher with the State Information Center, published in National Business Daily