China’s economic balancing act by Minxin Pei @FortuneMagazine January 13, 2014, 4:35 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons Xi Jinping FORTUNE — For more than two decades, the Chinese government has set an official annual GDP growth target and always managed to hit or exceed its announced rate. This year, Beijing has elected not to identify such a target, leaving many in the business community worrying whether China’s economic growth in the new year will decelerate further. (It has been falling steadily since 2010.) Lost in the obsession over growth targets is the fact that, if fully implemented, bold structural reforms announced at the Chinese Communist Party Central Committee’s 3rd plenum last November will transform China’s economy altogether. Like most reforms, the measures announced by the Chinese government may produce sustainable long-term growth, but they will almost certainly dampen growth in the short term. This is not lost on Chinese policymakers. They understand that they are in a no-win situation if they pick a hard GDP target for 2014. Rhetorically, doing so would discredit the new leadership’s pledge of ending “GDP worship.” In practical terms, setting the target too high would signal to the market that the government is prepared to sacrifice economic reform to maintain growth. But cutting the target would send an equally negative message and undermine confidence in China’s economy. MORE: Minimum wage campaigns’ biggest losers? Tipped workers Under such circumstances, it seems wise for Beijing not to declare an official target, at least for now, so that it can maintain some flexibility. But such ambiguity does not free the Chinese government from its economic dilemmas. Simply put, the new Chinese leader Xi Jinping and his colleagues must implement enough reform while ensuring that growth does not fall off quickly. Minor reforms such as streamlining approval of business registration, allowing small and medium-sized private banks, liberalizing the one-child policy, and expanding the flexibility of the exchange rate should boost growth modestly or have no effect. But these reforms will contribute little to affirming the new leadership’s credibility as radical reformers. The more consequential reforms — such as introducing market-based interest rates, reducing excess capacity, subjecting state-owned enterprises to increased competition and financial discipline, enforcing strict environmental laws, and raising prices of natural resources — are expected to depress growth. The greatest contributor to China’s GDP growth has been fixed-asset investment, a category that encompasses infrastructure, real estate, and manufacturing facilities. But investment-driven growth unavoidably leads to excess capacity, financial repression, and depressed household consumption. Beijing’s ultimate goal is to reduce the country’s reliance on this type of growth and shift to more sustainable, consumption-based growth. This objective sounds laudable and simple, but it is extremely difficult to achieve. Leaving aside opposition from interest groups that benefit from this model, any transition from investment-led to consumption-based growth entails, in the short-term, an inevitable dip in growth overall. (All of China’s East Asian neighbors experienced such growth contraction during this shift.) In China’s case, the principal function of the state will need to shift from making investments or running businesses to providing social services (such as health care, education, social security, and environmental protection). Even under the most ideal conditions, and assuming the government has the will and ability to enforce such reforms, the transition will take many years. MORE: Disney CEO Iger: Frozen has restored our mojo The worst temptation for a government caught in this dilemma is to continue to rely on the old investment-driven model to maintain growth during the transition period. This happened in the second half of 2013, when Beijing responded to slowing growth with a stealth stimulus plan that unleashed more bank credit for investment. The price was high. Although Beijing hit its announced growth target of 7.8% for 2013, China’s structural distortions (overcapacity on the order of 30% in nearly all manufacturing sectors, a real estate bubble, and excessive debt) have worsened. One might excuse Beijing for taking the easy way out in 2013 because its new leaders have been preoccupied with formulating a reform plan. But this argument will be unpersuasive in 2014. To determine whether Xi’s government will prioritize reform over growth, we need only watch one number — credit growth. If Beijing continues to allow credit to grow at roughly 20% of GDP in 2014 (the average rate for the last five years) and if most of the newly created credit is ploughed into investment, this will show that, for all its rhetoric, the new leadership does not have the stomach for reform.