China’s slowdown is the biggest short-term threat to global growth. Industrial value added fell in August, credit growth has slowed dramatically, and housing prices are falling, with sales down 20% year on year. Given stagnation in the Eurozone and Japan’s uncertain prospects, a Chinese hard landing would be a big hit to global demand.

Much attention is focused on likely GDP growth this year relative to the government’s 7.5% target. But the bigger issue is whether China can rebalance its economy over the next 2-3 years without suffering a financial crisis and/or a dramatic economic slowdown. Some factors specific to China make this outcome more likely, but success is by no means certain.

Faced with the 2008 financial crisis, China unleashed a credit boom to maintain output and employment growth. Credit soared from 150% of GDP in 2008 to 250% by mid-2014. Multiple forms of shadow bank credit supplemented rapid growth in bank loans.

The strategy worked, and China continued to create 12-13 million new urban jobs per year. But with investment rising from 40% to 47% of GDP, growth became dangerously unbalanced and heavily dependent on infrastructure construction and real estate development. Narrowly defined, these activities account for 12% of Chinese value added. In fact, recent research shows that 33% of China’s economic activity relies on the real estate sector’s continued health.

China is now struggling with a dilemma common to all advanced credit booms. The longer the boom runs, the greater the danger of wasted investment, huge bad debts and a major financial crisis. But simply constraining new credit supply and allowing bad loans to default can itself provoke crisis and recession.

This year has been one of seesawing policy responses. The discipline of default has been much discussed, but never quite applied. Despite a significant slowdown, the People’s Bank of China has resisted across-the-board cuts in interest rates or reserve requirements. But, in the second quarter of the year, Premier Li Keqiang reiterated the 7.5% growth target, which was then underpinned by several “targeted” stimulus measures – mainly new lending focused on railways, smaller banks, agriculture and small businesses. Constraints on the property market, such as limiting multiple purchases or highly leveraged investments, have been tightened and then relaxed.

At least for now, the arguments for constraint and market discipline appear to have won the debate. That may partly reflect a subtle shift in emphasis about the most crucial objective. Recent speeches by both Li and policy experts have downplayed the importance of a specific growth target, focusing instead on job creation and low unemployment.

Fortunately, demographic changes are about to make it easier to rebalance the economy and boost employment enough to avoid social tension. The Chinese working-age population is now slowly shrinking. More dramatically, the number of 15-30-year-olds will fall 25% from 2015 to 2025. The rural workforce is still above 300 million, implying that large numbers could still migrate to urban areas. But as the rural workforce ages, the pace of migration will slow.

As a result, China’s labour market will tighten more rapidly than many expect. Rising real wages will support the shift to a more consumption-driven economy, and declining worries about unemployment will reduce reliance on credit-fueled construction to soak up labour supply.

But the huge debts created by the credit boom remain a major problem. No other economy has ever experienced such a boom and avoided a financial crisis or major growth setback. Optimists often stress two ways in which “China is different.” First, many debts involve different arms of the Chinese state – owed, say, by state-owned enterprises (SOEs) and local governments to state-owned banks.

Second, China’s central government has low debt – only 22% of GDP at the end of 2013 – and thus significant fiscal firepower. With the financial sector facing a large volume of non-performing loans, the government could repeat what it did in the late 1990s, absorbing bad debt and recapitalizing banks, rather than allowing defaults and bank failures to shock the economy into recession.

But, though China enjoys more room for manoeuvre than other countries facing similar credit booms, the risks remain serious. The bad-loan problem may be most severe among SOEs, but slightly more than half of new business loans since 2010 have been to the private sector, which plays a major role in the troubled property market. And when property booms head south, efforts by companies and households to deleverage can undermine growth – even if banks are not allowed to fail. A balance-sheet recession does not require a financial crisis.

The more China achieves its stated objective of “a decisive role for the market,” the less the “China is different” argument applies. Interest rate liberalization would increase borrowing costs for many over-indebted borrowers. A no-bailout rule for shadow banking entities would produce losses that hit confidence. The more the capital account is opened, the more China’s huge debts will be held by banks and other institutional investors around the world.

In an economy with inherited debts equal to 250% of GDP, simply tightening credit supply and imposing market discipline could be a recipe for disaster. Instead, China should use direct fiscal stimulus to offset the deflationary effect of declining credit growth and deleveraging. And it should clean up its banks’ balance sheets through debt write-downs and recapitalization before undertaking full financial liberalization.

China undoubtedly needs to rebalance its economy and introduce more market discipline in its financial system. Demography will give a helping hand with the former challenge. But without careful policy design and sequencing, there could be major setbacks along the way.

Published in collaboration with Project Syndicate

Author: Adair Turner, former Chairman of the United Kingdom’s Financial Services Authority, is a member of the UK’s Financial Policy Committee and the House of Lords.

Image: A general view of the Shanghai’s financial district of Pudong, with the Shanghai Tower (R), which is undergoing construction and scheduled to finish by the end of 2014, in Shanghai July 31, 2013. REUTERS/ Carlos Barria