A deceleration in China's economic growth is inevitable. Sustainable annual real GDP growth is probably between 7% and 8%, but official figures have put real GDP growth at 9.1% in 2003 and 9.7% in the first half of 2004.

Rapid growth has been led by investment, which is normally a good thing, but fixed-asset investment in China has been growing by around 30% a year and the investment boom has pushed the investment-to-GDP ratio up to 44%, a record high. This boom has produced supply bottlenecks and electricity shortages, and there are concerns this will eventually lead to a new wave of asset-quality problems in the banking sector.

China's challenge is to bring down the investment-to-GDP ratio, which means investment growing less rapidly than GDP for several years, while at the same time ensuring that overall GDP growth does not fall too far. Growth of 7% to 8% is probably what the authorities consider essential to generate enough jobs and to keep the lid on China's social and political tensions. It is a difficult balancing act, but the good news is that the adjustment is going well so far.

The authorities have relied almost exclusively on administrative measures, which are blunt instruments that have starved credit to good projects as well as bad projects, potentially threatening a more dramatic slowdown. This has prompted some calls for an early easing of the austerity drive.

Yuan Revaluation A Matter Of Time
A pause in the policy tightening would be a mistake. However, China needs to slow its economy down and a premature pause would only increase the prospect of more severe austerity measures later on, with a bigger negative impact on growth.

What China should do is to broaden the tightening to include more market-led adjustments. A yuan revaluation also remains only a matter of time. Allowing the yuan to move stronger would help cool China's economy down and would also help reduce the speculative capital inflows.

The macroeconomic challenge China faces in achieving an orderly slowdown is daunting. But there are two reasons to be optimistic on its chances of avoiding a hard landing. Firstly, China continues to make impressive progress in restructuring its economy. Secondly, China isn't facing a major inflation problem and any further tightening will not have to be too severe. Inflation has accelerated to between 5% and 5.5% a year, a seven-year high, but the rise mainly reflects higher food costs.

Meanwhile, a hard landing for China would mean GDP growth slowing to a yearly figure of 3% or 4%. This could happen either because its current tightening has a more severe impact than we expect in 2005, or because the authorities ease prematurely, forcing a more severe tightening and hard landing later on.

Finally, what would a China's outlook mean for Asian markets? Confirmation of an orderly slowdown should lift Asian equity markets. We expect Asian equities to outperform other major regions and have thus overweighted Asia in our asset-allocation models. The yuan revaluation we expect should also lead to stronger foreign exchange rates across Asia.

Kevin Grice is a senior economist with the global economics unit of American Express Bank. Mr. Grice is based in London.