Is debt China's Achilles heel? The corporate sector's gross debt in China's bank-dominated financial system is estimated at around 100 percent of GDP. The majority of investment in the commercial sphere, however, continues to be financed by retained earnings rather than debt, leaving the corporate sector's leverage manageable. That is not true for property developers and some of the bank lending to them may go sour. From 2008 to 2010, local government debt rose at an unsustainable pace as a result of borrowing by local government investment platforms to finance infrastructure, which lifted total government debt to around two thirds of GDP. That episode did not last very long, though, and such lending has since been reined in.

Even after the recent maturity restructuring, some bank lending to local government investment platforms is likely to go bad, with the burden split between the banks and the Central Government. As part of the credit binge, household debt, largely from mortgages, rose rapidly during the 2008-10 period, although at one third of GDP it remains modest. With much of the debt held within the broader public sector, a fiscally healthy Central Government and low foreign debt amidst still substantial current account surpluses, China's debt problems are unlikely to become systemic at the macro level.

The key motivations for changing China's growth pattern lie largely outside of the narrow financial-economic realm. But that does not make them less important. The investment- and industry-heavy pattern of growth has led to several imbalances. Since the late 1990s, in a policy setting too favorable to industry and capital, flourishing industrial firms ploughed back increasingly large profits into new capacity, while wage increases lagged productivity growth. With profits rising, the wage bill and household income declined as a share of GDP. Combined with low deposit rates and a rising household saving rate—in no small part due to rising income inequality accentuated by this growth pattern—this reduced the role of consumption and made external surpluses swell. External surpluses have come down recently, but that could be temporary in the absence of rebalancing. This growth pattern was also very tough on the environment and led to intense use of natural resources and energy.

Seeking rebalance

China needs to rebalance the pattern of growth away from industry and investment toward services and consumption.

Such a shift would mean more labor-intensive growth, with more urban employment creation. By boosting the share of wages and household income in GDP, this would increase the role of consumption in a way that is economically sustainable and would lower the external surplus. Such rebalancing would also make growth less intensive in energy and resources and less detrimental to the environment.

As to how to rebalance, many observers emphasize financial sector reform and exchange rate appreciation. These are important measures. They would, however, need to be part of a comprehensive set of reforms to channel new resources to new sectors, rather than traditional ones, and to support more full migration to the cities, with migrants able to behave and spend like full-blown urban citizens to foster more labor-intensive, services-oriented and consumption-based growth there.

The key reforms include removing the subsidies to industry by raising prices of inputs such as land, energy, water, electricity and the environment; increasing private-sector participation and removing entry barriers in several service industries; improving access to finance for small and medium-sized enterprises and service-sector firms; continuing state-owned enterprise dividend reform and actually channeling the revenues to the Ministry of Finance; liberalizing the hukou, or household registration system, and reforming the inter-governmental fiscal system to give local governments the means and incentives to fund public services and affordable housing for migrants; and pursuing land reform to increase the mobility of migrants and, by facilitating land consolidation and mechanization, boost per-capita incomes and consumption in the countryside.

There is nothing obviously dramatic about the easing of trend growth and, from a financial-economic perspective, China's economy is on a sounder footing than often believed. To successfully rebalance the growth pattern, however, requires a major reform push in many areas, including ones where change would be difficult to pursue.

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