Two types of spirals are working on the Chinese economy. The first is the overcapacity-deflation spiral－the falling producer price index because of overcapacity leading to the declining profitability of enterprises. In response, enterprises have to deleverage and reduce investment, which in turn leads to more overcapacity and a further fall in the PPI, although this will help stabilize prices in the future.

The second type is the debt-deflation spiral: the falling PPI leads to rising real debt, which in turn leads to the declining profitability of enterprises. In response, companies have to deleverage and reduce investment, which in turn leads to the same results as above.

Faced with the possibility of a growth rate below 6.5 percent, the government should provide a stimulus package to break the two spirals, while continuing to push for reforms and economic restructuring. Of course, a stimulus package, comprising mainly infrastructure investment and provision of public goods and services, should be financed by the issuance of government bonds rather than credit expansion.

Although breaking the debt-deflation spiral will be difficult, China's economic fundamentals are sound thanks to its high savings rate and relatively strong fiscal position. As long as the government can implement a good policy mix, the economy will rebound and return to a slower but still inspiring growth path.

Needless to say, a stimulus package will only create some breathing space for China. The real key to sustainable growth is to give entrepreneurship full play. To achieve this, the government has drawn up a comprehensive plan for reforming the ownership, financial and innovation-support systems.

No one can say for sure that the above plans will fully succeed, but there is no need to be too pessimistic about China's economic prospects. China will push ahead, as it has done time and again over the past more than three decades.

The author is former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.

Courtesy: chinausfocus.com