The Chinese economy saw further signs of a slowdown and worsening deflationary pressure in 2014. Growth has leveled out at just above 7 percent, which may be high by international standards but it has raised concerns that it may not be the new normal.

China's producer price index (PPI) has been on the retreat for the past 34 months, reaching an average of minus 1.8 percent from January to November year-on-year. The drop was driven partly by a sharp fall in global oil prices. Its consumer price index was down from 3.2 percent a year ago to 1.4 percent in November. And the housing price index for 70 major cities declined from 9.6 percent in January 2014 to minus 1.3 percent in September and minus 2.6 percent in October. As a result, the confidence level of investors and companies appears to be at its lowest since 2007.

There are worries that China's growth could decline even further if reforms and macro policies do not yield the expected results on time.

In November 2014, the People's Bank of China (the central bank) responded to slowing growth by cutting interest rates for the first time since July 2012, signaling the shift of China's macro policy from controlling the property bubble, local government debts and overcapacity to stimulating growth. But the benefits of signaling a more relaxed monetary policy by the PBoC were not easily transferred to the real sectors, although in the short run, the interest rate cut might have helped the increase of the leveraged trading of bonds and stocks.

On the stock market front, the Shanghai A-Share Composite Index rose more than 40 percent to about 3,100 from July to December, with the sharpest increase being after November's interest rate cut. But the rate cut failed to lower the actual borrowing costs of small and medium-sized enterprises and non-financial companies.

The official lending rate (usually reserved for State-owned and big enterprises) is about 8 percent but the market-oriented lending rate (set mostly for private enterprises and local government projects that rely on shadow banking) is about 20 percent. The low deposit rate and the dual-lending rates reflect China's financial repression, which create strong incentives for regulatory arbitrage through shadow banking. Since the banking sector is more than three times as large as either the equity or the bond market, its inefficiency has significantly undermined China's growth.

In the past two years, China's macro authorities should have probably put more effort in preventing deflation and in providing an accommodative macro environment for positive risk-taking by innovative and productive companies. The risk-averse regulatory and policy moves reflect challenges in structural reforms and a lack of effective tools to carry out structural changes, such as deposit insurance and bankruptcy mechanisms. Consequently, even the monetary policy, usually not suitable for discriminative use towards different parts of the economy, has been employed regularly to deal with structural problems such as supporting SMEs and providing housing for low-income people through targeted releases of central bank funds.

It is important that macro regulators and policymakers do not intervene too much in structural problems and tolerate more natural market-oriented failures because they are symbiotic with success in the ecology of market competition. In other words, ghost towns and great cities, overcapacity and bottlenecks, excessive debts and excessive savings are all the new normal in a dynamic and fast-growing market economy. As China's market matures, the good parts will expand at the expense of the bad parts. What the government needs to do is to provide the right platforms for facilitating structural changes, such as deposit insurance, bankruptcy mechanisms and negative lists, which are the right micro-tools for dealing with specific structural cases.

The role of monetary authorities in an economy such as China's should be narrowed down to basically two primary macro goals:

The first would be to keep China's inflation higher than that of the US (assuming the renminbi-dollar exchange rate is relatively stable), because China's real return, real growth rate and real productivity growth are much higher than that of the US, and the prices of non-tradable goods and assets in China still have a lot of potential to catch up with those in the US. So deflation should not happen at this stage of China's development unless the money supply is too tight. China should and can avoid either deflation or hyperinflation.

The second goal of China's monetary authorities should be to stabilize the real interest rate at a low but positive level, say about 1 to 2 percent over the medium and long run. This means nominal interest rates need to be a bit higher than the inflation rate. Since the adjustment of interest rates could easily lead to volatility in securities markets, it may be easier and more important for the PBoC to target and stabilize the medium- and long-term inflation rate between 3 and 5 percent by implementing a more flexible and accommodating money supply.

The Central Economic Work Conference held from Dec 9 to 11 made stable growth the top priority for 2015. This means the growth rate for 2015 is likely to be about 7 to 7.5 percent. It also means overall macro conditions in 2015 should be more relaxed than in 2014, because a more relaxed macro environment is crucial not only for arresting the PPI deflation but also for offsetting the austerity effects of many structural and micro reforms such as the anti-corruption campaign, State-owned enterprises reform, and regulations on land use and the environment.

With the lagging effects of macro policy, China's real economy is likely to continue to grow slowly for a few months before more aggressive macro relaxation measures, such as the lowering of reserve requirement ratios for banks, are put in place. In the meantime, reforms toward financial deepening may be expedited given the authorities' strong intention to deleverage the banking sector, promote the internationalization of the renminbi, and encourage the development of the bond and securities market.

The new normal could well see the authorities trying and managing growth risks by implementing many substantial and systemic reforms at the structural and micro level as well as by promoting financial deepening.

This article first appeared on China Daily (English) on Dec 29, 2014. To view the entire article, please click here