China Can Reform Without Any 'Wrist Cutting'

Chinese soldiers marching in front of the Forbidden City in Beijing, China.
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Chinese soldiers marching in front of the Forbidden City in Beijing, China.

A sharp and sudden draining of funds from the interbank market a week-and-a-half ago, followed by equally fast liquidity injections, is an example of how China can support reforms to modernize the economy without harming its growth outlook.

In this particular case, measures were taken to restrain an informal network of money lenders while quickly restoring and protecting the financial intermediation by the regulated banking institutions.

This was a small-scale trial balloon of "creative destruction" – a process of innovation where a new system takes over from an old order – which China wants to implement in a vast program of reforms to build what President Xi Jinping calls "socialism with Chinese characteristics." What that means in purely economic terms is not clear, but it looks like something along the lines of the European model of "social market economy."

(Read More: China Turns From Driver to Drag on Global Growth)

At any rate, that seems to be implied by China's new leaders promising market economy and market-based reform mechanisms. Apart from that, little is known about the specific features of these reforms. A high level commission, presided by Mr Xi, is currently working on a detailed reform program to be presented next October to the third plenum of the 18th Central Committee of the Communist Party of China. Traditionally, third plenums are the launching pads for major policy changes.

Gradual and Orderly Reform Process

But one thing is clear. Reforms intended to create a more efficient economic system need not lead to slowing demand and output, as foreshadowed in repeated government statements.

No, the reform process China's Prime Minister Li Keqiang calls a "self-imposed revolution" does not have to "feel like cutting one's own wrist," a flagellant metaphor he used during his inaugural press conference last March.

On the contrary, China has the means to change the current structure of its economy in an orderly and gradual manner, and to make these changes politically and socially acceptable by maintaining its potential and noninflationary growth of about 8 percent. In fact, Mr Li (we should call him Dr Li because he is China's first prime minister with a doctorate in economics) said that such a growth rate was "within the reasonable expectations of our macroeconomic controls," during his recent visit to Germany.

(Read More: Why China's Economy May Be Headed for a Crash)

China is not a newcomer to structural changes and a creative-destructive process that follows in their wake. Just think of all the changes that were managed successfully from the time of an impoverished China Deng Xiaoping inherited in late 1970s, after the devastating Cultural Revolution, to the world's second-largest economy it is today.

Many of the reform processes that took place over that period of 35 years have been experiments with free and open markets and special economic zones - a reformist equivalent of the "Great Leap Forward" under the stewardship of the former Prime Minister Zhu Rongji during Jiang Zemin's presidency in the 1990s. That was the time when many inefficient state-owned companies were closed down, or merged in new entities, with millions of people losing their jobs in precarious conditions of a quasi inexistent social safety net.

Regulatory Changes and Huge Development Projects

Today's China is vastly different. It is a country whose foreign currency reserves are nearly half of its gross domestic product (GDP); its budget deficit is about 1 percent of GDP, the public debt is only 22 percent of GDP and the inflation rate of 2.1 percent is an example of price stability. This is a country with plenty of room for monetary and fiscal policies to support economic growth on the way to the "social market economy" - if that is what Beijing wants.

Apart from regulatory changes to modernize the fiscal and financial systems, and to increase the labor market flexibility, the main factors that will drive the process of China's structural transformation are (a) urbanization, (b) development of service sector industries and (c) the growth of household consumption.

(Read More: Even Resilient Yuan Is Feeling China's Pain)

There is enough there to sustain a high level of economic activity to mitigate short-run problems of frictional unemployment and temporary demand-supply mismatches in the existing labor force.

Consider, for example, the huge, epochal project of urbanization Mr Li called "one of the top priorities" when he came to power last March. Some 400 million rural dwellers are expected to be moved into cities over the next decade at an estimated cost of more than $6 trillion – a sharp acceleration of a trend already under way since the early 1980s, when 80 percent of China's people were living in the countryside. That is now down to about 50 percent. And the goal is to fully integrate 70 percent of the population into urban areas by 2025.

Think of the infrastructure, new transportation networks, production of consumer durable goods and health and education services such an enormous project will entail.

Urbanization will also be the key vector for structural changes of Chinese economic growth. It will spur the development of service sector industries and will shift resources away from exports to household consumption.

These trends are already under way. In the first quarter of this year, China's economy showed for the first time that services overtook manufacturing, accounting for 48 percent of GDP compared with 46 percent for the goods producing sector.

Being highly labor-intensive, service industries created 12 million new jobs in 2012, despite the fact that last year China's economic growth of 7.8 percent was the slowest since the late 1990s. Clearly, expanding services are providing employment opportunities to people who are made redundant in shrinking manufacturing and farming sectors.

Urbanization and rapidly developing services will also increase the share of household consumption in aggregate demand – an important policy objective as China seeks to reduce its reliance on exports and excessive investments. A notable progress has already been achieved in that area: consumer spending has been a bigger growth driver than investments since 2011.

All this shows that no "wrist cutting" is needed to create a more efficient, market-driven Chinese economy in an environment of sustained 7-8 percent growth that will preserve price stability and avoid destabilizing sectoral imbalances.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.