With the loss of its most powerful tool for economic management, Beijing must change its growth model. And it will. The fierce debate among Chinese economists and policy advisors over the past two years suggests that Beijing knows it must sharply reduce investment rates.
But doing so causes two problems. First, without the ability to increase investments at will, China's economic volatility will increase sharply. Second, if China can no longer depend on investment growth to drive high levels of economic activity, it must increasingly rely on growth in household consumption, which, at 35 percent of GDP is the lowest seen anywhere in modern history.
What can Beijing do to ensure continued rapid consumption growth? Contrary to myth, China's low consumption rate has nothing to do with the fabled Chinese propensity to save. Because China's wealth distribution is extremely unequal, the rich consume a far lower share of their income than the poor, reducing consumption overall.
More importantly, at under 50 percent of GDP, Chinese households control a very low share of the country's total income. While their wealth has grown substantially in the past few years, the economy overall has grown far more quickly, leaving them with a constantly falling share of the total.
To spur growth in household consumption, Beijing needs to redistribute wealth and spur the growth of household income. The former is always hard to do, and if economic activity slows with the reduction in investment growth rates, as it must, the latter will also be difficult.
Beijing must directly or indirectly transfer to the household sector some of the tremendous wealth accumulated by the state sector over the past three decades, for example, by privatizing companies and using the proceeds to shore up the social safety network, or granting land title to peasant farmers. Chinese households could then substantially increase consumption to compensate partially for a rapid reduction in investment. This would keep China's economy growing in a healthy way.
Beijing, in short, must bring investment rates down quickly before the country experiences debt problems. But to keep growth from collapsing it must also boost household consumption by transferring wealth from the state and the elite to the middle and lower classes. The scale of these transfers, however, will disrupt domestic politics and will require the kinds of reform in political and financial institutions that are sure to unleash substantial opposition.
The task is urgent but difficult, one that is likely to cause tremendous strain on the political system. Powerful sectors and families will resist any elimination of the distortions that have rewarded them so bountifully. But if these distortions are not eliminated, China's economy, like that of many before it, will stall, and its astonishing transformation will be a thing of the past.
The more successful China's new leaders are in managing this adjustment, the better for everyone -- not just in China but all over the world. The United States and Europe should accommodate a China that implements real structural reforms and rebalances its economy in a healthy way by tolerating some flexibility in the trade and capital accounts as Beijing as it faces its most difficult reforms yet.