However, economic activity, including industrial production, has shown signs of a pick-up in recent weeks. The recent acceleration, which is likely to continue into the next two quarters, reflects robust consumption, a recovery of external demand, and new growth supporting measures, including infrastructure investments and tax incentives for small and medium-sized enterprises.

The China Economic Update, a regular assessment of China’s economy, identifies several risks to this gradual adjustment. First, a disorderly deleveraging of local government debt could trigger a sharp slowdown in investment growth. Second, an abrupt change in the cost of, or access to, capital for such sectors as real estate could significantly reduce economic activity. Finally, the recovery in exports may not materialize if growth in advanced countries weakens.

The Update notes that the policy responses to these medium-term risks should center on fiscal and financial sector reforms, which were part of the government’s reform agenda outlined in November 2013. These include effectively managing and supervising rapid credit growth, especially in the shadow banking system, and gradually reducing the local government debt that has been accumulated through off-budget and quasi-fiscal activities.

“The proposed reform measures are structural in nature,” observes Karlis Smits, Senior Economist and main author of the Update. “In the medium term, these policy measures will improve the quality of China’s growth – making it more balanced, inclusive and sustainable and lay the foundation for sound economic development.”

While these reforms may reduce growth in the short run, policies that promote competition, lower entry barriers to protected sectors and reduce administrative burden on businesses will help dampen the impact, and create a more market-oriented economy.

Download the complete World Bank’s June 2014 China Economic Update here

Key Findings:

China’s economic growth is gradually slowing as the structural transformation of the economy continues.

Output grew by 7.7 percent in 2013, matching its 2012 growth rate and exceeding the government’s 7.5 percent indicative target.

 Stable growth partly reflected the effects of mid-2013 growth support measures.

 Nevertheless, recent growth rates have been significantly below the levels observed over the past decade as drivers of economic growth continued to shift from manufacturing to services on the supply side, and from investment to consumption on the demand side, and as measures to rein in the rapid accumulation of credit came into force.

 The impact of decelerating growth on labor markets has been so far relatively small due to the structural shifts of economic activity toward labor-intensive service sectors.

 The rebalancing is not smooth, and quarterly growth is volatile.

 In part this volatility reflects tensions between structural trends and near-term demand management measures taken by the government.

 China’s growth will continue to moderate over the medium term, and the structural shifts will become more evident.

 Growth in China is expected to decrease marginally to 7.6 percent in 2014 and 7.5 percent in 2015, from 7.7 percent in 2013.

 Fiscal and financial sector reforms are needed to address financial stability risks in the medium run.

 The first task involves effectively managing the process of rapid credit growth, including less well-regulated shadow banking system.

 The second: gradual and orderly deleveraging of large stock of local government debt accumulated through off-budget and quasi-fiscal platforms.

 A sustainable resolution of these issues would require reforms in the financial sector and in fiscal policy. Both of these reforms could potentially be disruptive to growth in the short run.

 Therefore, reforms likely to support growth in the short term, such as promoting competition, eliminating entry barriers in select sectors, and reducing administrative burden on businesses, should be implemented in parallel.

Source: World Bank