3 Things China Do To Avoid Getting Crushed By Deleveraging

Years of easy financial conditions have pushed China into a self-imposed deleveraging cycle.

In the post-crisis years, China's heavy investment into state-run infrastructure and real estate projects (at the expense of the private sector) fueled "sectoral overcapacity and potential financial stability risks," writes Morgan Stanley economist Helen Qiao in a new note to clients.

Though it must stomach deleveraging's bitter pill, China can still set itself up for long-term growth, Qiao writes.

Here's how:

1. Raise productivity

"Before households can change saving patterns to increase consumption (with the help of a strong social security safety net and healthcare benefits), China urgently needs to calibrate the direction of investment to increase its return," according to Qiao.

2. Promote the private sector

Qiao writes that China's current policy of "guo jin min tui" (the state advances while the private sector retreats) needs to be replaced with "guo tui min jin" (the private sector advances while the state retreats). Qiao notes that Chinese policymakers have shown they are willing to implement structural adjustments here. "The recent shift towards a more pro-growth stance suggests the administration recognizes the importance of macro stability and will aim to prevent tail-risk events," she writes.

3. Introduce short-term policy measures to limit downside risks

"Our analysis of the previous deleveraging experience in the 1990s suggests greater caution should be used on the pace and intensity of major policy changes if aggregate demand is weak," Qiao writes. "In addition, an adequate policy cushion to supplement the reform measures is warranted to prevent a hard landing, in our view."

In the past, China's sweeping economic reforms have resulted from widespread instability. That doesn't have to be the case this time, Qiao argues. China shouldn't look for a "silver bullet" reform, writes Qiao, but should instead implement "many silver needles, in an acupuncture-style reform."