In early March, members of the National People’s Congress (NPC) convened for the annual legislative session, at which the body approves the policy program of the Chinese Communist Party (CCP) government. Outlining the regime’s priorities for the coming year, Prime Minister Li Keqiang focused on just two themes: China’s transition to a new phase of economic development, in which the “new normal” will include real GDP growth that is significantly slower than the double-digit average in the decade to 2011, and the urgent need to repair the environmental damage produced by two decades of breakneck economic growth.

In keeping with the first of those themes, Prime Minister Li announced a growth target for 2015 of 7%, a figure that is consistent with the government’s goals of doubling GDP by 2020 and producing the estimated 10 million new jobs required each year to absorb new entrants to the labor pool. Toward that end, Li indicated that the government will ease restrictions on foreign participation in specified manufacturing and services industries, although he provided no details. As for the environment, he mentioned several proposals, including an increased focus on conservation, tighter enforcement of environmental regulations, and increased investment in renewable energy sources.

Li stressed that slower growth is a natural outgrowth of economic development. The subdued tone of the prime minister’s speech was an implicit acknowledgment that the process of establishing the “new normal” will not be painless, but Li was careful to avoid sounding alarmist. However, the prime minister’s assurances notwithstanding, there is cause for concern, and the risk of a hard landing—i.e., a deceleration of real GDP growth to 5% or less—cannot be ignored.

China’s total debt burden (public and private) has nearly doubled since the onset of the global financial crisis in late 2008, and stood at an estimated 282% of GDP as of early 2015. Despite the explosion of credit, the pace of real GDP growth has been slowing steadily since 2010. Policymakers have attempted to take some of the air out of the bubble, but have struggled to find a proper balance, resulting in unpredictable shifts in lending policy.

With growth continuing to slow and property values falling, the risk of a sharp increase in bad loans is rising. That has significant negative implications for the government’s strategy of guiding an economic transition from an export-driven model to one that relies more heavily on domestic consumption and the expansion of the services sector.

The specter of deflation prompted the People’s Bank of China (PBOC) to cut its benchmark interest rate for a second time in three months in early March, along with an easing of reserve requirements for banks. However, the inflationary impact of monetary loosening is likely to be limited, as a crackdown on so-called “shadow banking” figures to more than offset any increase in lending generated by the reduction of interest rates. In any case, the lion’s share of lending by the official banking sector is directed to larger, mainly state-owned, enterprises—the least efficient pathway for monetary stimulus—and a growing portion of new borrowing is being used to service existing debt.

Against that backdrop, investors are beginning to wager that China will engineer a faster depreciation of the yuan vis-à-vis the US dollar, in a bid to stave off deflation and offset the negative impact of rising domestic labor costs and the appreciation of the local currency against the euro and the yen on export competitiveness. In January 2015 alone, foreign exchange deposits surged to more than $80 billion, compared to a total of somewhat more than $130 billion for the entire year in 2014, signaling anticipation of an adjustment to currency policy.

The PBOC insists that it will continue to prop up the yuan as necessary to maintain the dollar peg and ensure no more than a gradual depreciation against the dollar, arguing that the economic harm caused by a significant weakening of the local currency—which would hurt banks, drive down property prices, increase the debt burden of businesses with sizeable foreign-denominated debt, and, quite possibly, trigger a destructive currency war—would outweigh any benefit. With monetary officials in the US signaling that they have no immediate plans to initiate aggressive tightening, pressure for a devaluation of the yuan does not figure to become unbearable, particularly given the ample foreign exchange reserves available to the PBOC.

However, the ability of policymakers in Beijing to manage the economic situation hinges on ensuring that local government officials are not acting in ways that run counter to the central government’s strategy. Toward that end, Beijing has cracked down on local government borrowing from the shadow banking sector, which has contributed to an accumulated debt estimated at some $3 trillion. But with falling property prices dampening the attractiveness of land purchases—an important source of income for local administrations in recent years—the new restrictions, if strictly enforced, would amount to a massive tightening of fiscal policy at a time when the economy is already slowing.

Prime Minister Li has offered repeated assurances that the central government will take care to ensure that deleveraging does not result in a hard landing. The danger is that in their effort to fine-tune the economy, officials could miscalculate, resulting in wild swings in policy that could throw the entire system out of balance. In that regard, the recent shifts in lending policy do not inspire confidence. Given the fragility of the current situation in China, the room for error is fairly narrow, and the damage in the event of a serious mistake would be significant.

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