The road ahead is not easy, but measures are needed to avoid the risk of lost opportunities

From shadow banking to lavish public spending, the message of the new leadership headed by President Xi Jinping and Premier Li Keqiang in its first year has been clear: the days of excessive spending and damaging liquidity are over.

By the time the Third Plenum of the 18th Communist Party of China Central Committee was held in November, the leadership had already shifted its focus to tripartite reforms, that seek to foster the role of efficient markets, competitive companies and a smaller but more effective public sector.

The core reform sectors include finance, taxation, state assets, social welfare, land, foreign investment, innovation and governance. The reform blueprint seeks to relax control over market access, establish a basic social security package and allow the sale of collectively owned rural land.

And the old household registration system (hukou), which continues to discourage migration, will be phased out gradually in the course of the massive urbanization drive.

Along with economic and financial reforms, Premier Li played a vital role in the launch of Shanghai's free trade zone, which unleashed a new free trade zone initiatives in other big Chinese cities and provinces. These initiatives are moving parallel to increasing financial deregulation and the internationalization of the renminbi.

To reduce bureaucratism and implement reforms, Li pushed the central government to delegate administrative approval powers to lower levels of governments, by drastically reducing approval in the administrative approval system.

But the reforms promise no free lunches. When Li wrote his prize-winning dissertation in 1994, he argued that structural change fuels productivity growth. Until the new leadership took over, China coped with economic challenges by accelerating and leveraging economic development, which degrade the quality of growth. That is no longer an option.

That message was brought home last June, when China's inter-bank rates soared but the People's Bank of China did not intervene. In the past, the authorities had usually resorted to new injections of liquidity. Now it has declined. A deja vu ensued in December. Initially, observers called the outcome a cash crunch, which fails to capture what really happened. The People's Bank of China and China's new leadership were not behind the curve. Rather, it was made clear that the new administration prefers to act, rather than react, to expected corrections.

That is not an ideal result because it means higher borrowing costs. But it is certainly preferable to the alternative - unsustainable liquidity creation and the rising probability of a debt default.

One of the most important policy achievements of the new leadership has gone by almost unnoticed. After the global financial crisis, China avoided the worst thanks to a 4 trillion yuan ($653 billion, 478 billion euros) stimulus package.

But the stimulus also unleashed huge liquidity, which led to speculation, particularly in the property market, and burdened certain provinces with excessive local debt.

China's total credit, in the mean time, increased from 75 percent to 200 percent as a proportion of GDP.

If Xi and Li deleverage the volatile property markets and unsustainable local debt too quickly, they risk a severe European-style recession. If they leave the outcome to the markets, the property markets will overheat and the local debt will eventually cause debt defaults in the provinces - something that the US experienced in 2008 and 2009. Worse, the coupling of speculative property markets and soaring local debt could drive China to a lost decade, which since 2009 has led some observers to forecast China's hard landing.

In a delicate balancing act, the new leadership has sought to prevent the concurrent deleveraging of the property markets and local governments. As the two have been decoupled, hard landing forecasts have given way to predictions of soft landing or long landing in the medium term.

In the coming months, Xi and Li must cope with the tapering of the US' quantitative easing policy, which began with reductions in bond purchases in December and will eventually mean higher interest rates in the West. In the past three to four months, it has caused hot money outflows from and deflation and depreciation effects in weaker emerging economies. It is in this volatile international environment that Xi and Li will try to curb fiscal deficit and stabilize the real estate market, even while financing urbanization and the impending hukou reform.

The risks and the rewards are particularly prominent in the financial and banking sector, and the new leadership hopes to foster stability in the banking system and financial intermediation regulation, along with interest rate liberalization and capital account opening.

If the policies of Xi and Li prove successful, China will continue to have potential for 6 to 7 percent growth in the coming years. In the Xi-Li era, adversities can no longer be faced with new stimulus packages, excessive leverage and deferred reforms, but with no stimulus, deleveraging and structural reforms - though with fiscal support.

It is tough medicine, but vital to deter the kind of liquidity traps that have led to a record slow recovery in the US, a probable lost decade in Europe and two lost decades in Japan.

The author is research director of US-based International Business at India China and America Institute and visiting fellow at Shanghai Institutes for International Studies and Singapore-based EU Center. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 02/28/2014 page13)