WHEN “60 Minutes”, an American television news programme, visited a new district in the metropolis of Zhengzhou in 2013, it made it the poster-child for China’s property bubble. “We found what they call a ghost city,” said Lesley Stahl, the host. “Uninhabited for miles and miles and miles and miles.” Two years on, she would not be able to say the same. The empty streets where she stood have a steady stream of cars. Workers saunter out of offices at lunchtime. Laundry hangs in the windows of the subdivisions.

The new district (pictured), on the eastern side of Zhengzhou, a city of 9m in central China, took off when the provincial and city governments relocated many of their offices there. Then, high schools with university-sized campuses began admitting students, drawing families to the area. Last autumn one of the world’s biggest children’s hospitals opened, a gleaming facility with cheery colours and 1,100 beds. Chen Jinbo, one of the area’s earlier residents, bemoans the lost quiet of a few years ago. “Rush hour is a hassle now.”

The success of Zhengzhou’s development belies some of the worst fears about China’s overinvestment. What appear to be ghost cities can, with the right catalysts and a bit of time, acquire flesh and bones. Yet it also marks a turning-point for the Chinese economy. Zhengzhou still has ambitious plans, not least for a massive logistics hub around its airport. With such a big urban area already built up, though, vast construction projects have a progressively smaller impact on the economy. The city’s GDP growth fell to 9.3% last year from an average of more than 13% over the preceding decade. The downward trend will continue. As the capital of Henan, one of the country’s poorest provinces, Zhengzhou had anchored the country’s last, large, fast-growth frontier. Its maturation signals that the slowing of China’s economy is not a cyclical blip but a structural downshift.

When growth flagged in powerful coastal provinces a few years ago, the poorer interior picked up the slack. It was large enough to do so, for a time. Henan and the other inland provinces that have a similar level of income per head have 430m residents, nearly a third of China’s total. If they were a sovereign country, they would form the world’s seventh-biggest economy, ahead of both Brazil and India. The far west is China’s final underdeveloped region but it carries much less weight: it makes up less than a tenth of the national population.

So the question for China is not whether growth will rebound to anything like the double-digit pace of the past. Instead, it is whether its slowdown will be a gradual descent—a little bumpy at times but free from crisis—or a sudden, dangerous lurch lower. Figures released on April 15th revealed a further loss of altitude: GDP in the first quarter grew by 7% from a year earlier, the lowest since the depths of the global financial crisis in early 2009. Signs of stress are emerging: capital is leaving the country, public finances are more stretched and bad debts are rising.

Yet that is not the full story. China also has impressive underlying strengths and a new determination to fix its most harmful distortions. “Growth will keep on declining,” says Xiang Songzuo, chief economist with Agricultural Bank of China, a state-owned lender. “Our main wish is that the decline go smoothly.”

Storm warning

The darkest cloud over China is its property market. Factoring in its impact from steel to furniture, it has powered nearly a fifth of the economy. Now, it is set to subtract from growth. House prices have fallen by 6% over the past year, the steepest drop since records began. It is not the first time that the property market has looked fragile, but previous dips were driven by deliberate policies to cool the market. In recent months, it has been the opposite: demand has failed to respond to a series of boosts such as cheaper mortgage rates. This has prompted predictions of a coming crash.

Problems are real but such disaster warnings rest on a misdiagnosis. The oft-heard idea that China is sitting on mountains of unsold homes is an exaggeration. Those making this claim point to the gap between property sales and construction. Sales of residential housing last year were 20% higher than they were in 2009, but projects under way have more than doubled since then, according to official data. If true, it would take five years to consume the pipeline of homes being built, up from three before the global financial crisis.

But many of those projects are in fact little more than holes in the ground. Some have been halted for a lack of funds, others because developers want to wait to sell into a stronger market. The evidence for this is actual construction activity, indicated by property completions as well as cement production (see chart 1). These are a much closer fit with sales. It will take 16 months to clear China’s inventory of new homes at the current sales rate, up from ten months when the market was in better shape, according to E-House, a property consultancy. This points to a deterioration but hardly a nightmare.

That China’s property market is not about to collapse under the weight of oversupply is good. The bad news is that its growth is stalling. The housing sector started to take off early this century after the government allowed ownership of private property. Mass migration to cities added to demand; China’s urbanisation rate has more than doubled to 55% today from 26% in 1990. Both these factors are fading. Many Chinese have already upgraded to snazzier flats than their original state-issued boxes. And the pace of urbanisation is slowing. Many analysts now expect housing sales, which have reached about 10m units annually, to start falling soon. There will still be homes aplenty to build but fewer with each passing year. Those who were over-optimistic about the longevity of the boom are paying a price. Chinese steelmakers had created capacity for 1.2 billion tonnes a year. The 820m tonnes produced last year may well be the top. Property is thus turning from a driver into a drag for the Chinese economy. Wang Tao of UBS, a bank, estimates that every ten percentage-point drop in construction growth cuts as much as three percentage points off GDP. She forecasts a deceleration of about half that pace this year. The more sedate reality is sinking in. In the south of Henan province, the county of Gushi had wanted to expand its central city to reach a population of 1.2m, from 500,000 now. Construction work is feverish. The clang of hammers and the growl of diggers reverberate throughout its streets. But with housing sales failing to meet expectations, Gushi has lowered its sights. It is aiming instead for a population of 800,000. Muddy fields on the outskirts that had been zoned for development seem destined to remain untouched.

Dragged down by debt

One way China could rekindle its property market is by using its banks to pump cash into the economy, as it did in 2008 when the global financial crisis struck. Yet that would be a dreadful mistake. Officials have their hands full already trying to deal with the legacy of the previous lending binge. Total debt has surged, rising from about 150% of GDP in 2008 to more than 250% today (see chart 2). Increases of smaller magnitudes were precursors to financial turmoil in Japan in the 1990s and much of the West over the past decade.

With debt clogging up the economy’s gears, Chinese lending has grown less potent. In the six years before the financial crisis, each yuan of new credit resulted in about five yuan of economic output. In the six years since the crisis, each yuan of credit has yielded three of output. Banks report that a mere 1.25% of their assets have soured, but investors price their shares as if the true number is closer to 10%. Within banks themselves, there is distrust. “The headquarters don’t believe the provinces,” says a credit officer with a major lender. Until recently China could grow its way out of debt trouble. That is no longer an option. With deflation arriving and the economy weakening, nominal growth is a third as fast as a few years earlier. In the year to the first quarter of 2015, nominal GDP grew by only 5.8%. The financial system is also far more complex than it was in the late 1990s, the last time China had a surge in bad debts. State-owned banks accounted for almost all lending back then. Since the financial crisis their share has fallen to less than two-thirds. Loosely regulated “shadow banks” make up much of the rest. But there is no ironclad law that a big rise in debt must result in crisis. Much depends on how liabilities are managed. China has several advantages. The vast majority of its debts are held at home. In many cases both debtors and creditors answer to the same master, the government. A state-owned bank is not about to call in a loan from a state-owned shipbuilder. This buys it time to sort out the mess. Debts are also concentrated. Households have not borrowed much, nor has the central government. The main culprits are local governments and a relatively narrow group of companies: state-owned enterprises, property developers and construction firms. China’s defences are now being tested by the prospect of the first big default in its property sector. Kaisa, a developer embroiled in a corruption case, is in negotiations with bondholders to restructure its debt. So far there has been no contagion throughout the financial industry. Investors have come to the same conclusion as Moody’s, a ratings agency: it is an isolated case, not symptomatic of systemic risks.

In that respect, China’s debt problem is similar to its property malaise. An acute crisis is unlikely, but the prognosis is still bleak. Credit growth has fallen below 15% year-on-year, down by more than a quarter from the average of the past decade. But since nominal growth is even slower, China’s debt-to-GDP level continues to rise. Lending will thus have to slow yet further, one more dark cloud over the horizon.

Back-up power

Reporting about China’s economy sometimes gives the impression that it is one giant credit-fuelled property bubble. Were that true, the twin slowdowns in construction and lending would be enough to wrestle growth down to the low single digits, perhaps even into recession—a scenario touted for years by the most bearish analysts. China’s downturn still has a way to run but such pessimism has consistently been wide of the mark. A simple, if under-appreciated, reason is that it is a continent-sized economy, with a lot more going for it than one or two industries. And although the days of explosive catch-up growth are over now that China has gained middle-income status, it has scope for more moderate catch-up. Its per-capita GDP at purchasing-power parity is $12,000, not quite two-thirds that of Turkey and barely a third of South Korea’s.

A much-needed shift towards consumption-led growth is just getting under way. Investment accounts for 50% of economic output, well beyond what even Japan and South Korea registered in their most intensive growth phases. Without rebalancing, overcapacity in industry would only get more severe, further undermining the return on capital. At last, there are glimmers of hope. Investment growth has halved in recent years but consumption growth has held steady; in future, as China’s growth slows, consumption should contribute a bigger share of it (see chart 3).

This is in part testament to the government’s progress in constructing a social safety net. Health insurance, old-age benefits and free schooling, though works in progress, appear to have helped check the remarkable propensity of Chinese to save. At 40% of income, the household savings rate has stopped rising in recent years. Still more important is a change in economic structure. Services took over from industry a couple of years ago as the biggest part of China’s economy, and the gap has widened. Last year services accounted for 48.2% of output; industry’s share was down to 42.6%. Services are more labour-intensive, which brings two benefits. First, China is now able to generate many more jobs at lower levels of growth. Though growth dipped to its slowest in more than two decades last year, China created 13.2m new urban jobs, an all-time high. Second, the strong jobs market has allowed wages to keep on rising at a steady clip, a prerequisite for getting people to consume more. Even in Gushi, a county officially classified as impoverished, people throng to clothing stores, beauty parlours and the town’s one foreign restaurant (a KFC). Like many there, Zhang Youling, 43, spent much of his adult life away, going to where the jobs were. He worked as a builder in Beijing, a courier in Shanghai and an ice-cream wholesaler in Zhengzhou before returning to Gushi to be with his wife and two children. For the coming summer, he has set aside 6,000 yuan ($970) to take them to Beijing on holiday. “We used to save everything. These days we have the confidence to spend some of what we earn,” he says.

Changing course

It would be complacent to expect that rebalancing alone will spare China from trouble. Surging debt and property overinvestment stem from flaws in the economy’s foundations. Regulations constrain investment options, making property one of the few viable assets; this drives up house prices. Local governments have limited tax powers, and so rely on land sales; this leads to more property development. The belief that the central government will always prop up cities induces banks to lend with little regard for creditworthiness; this heaps bad debt onto the economy.

These interlinked problems were easily ignored while growth surged ahead. Now the government can avoid them no longer. It is trying three kinds of reform.

The first is financial liberalisation. Monetary policy is virtually unrecognisable from five years earlier, when the central bank controlled all key interest rates. Funding costs throughout the economy are now more market-based. Banks compete for deposits with an array of investment products; households place 30% of their savings in bank-account substitutes, up from 5% in 2009. Official deposit rates are still fixed, but regulators have given banks flexibility (currently, a 2.5-3.25% range) and hint at full liberalisation within a year.

The government has also relaxed capital controls. Companies previously needed approval for overseas investments above $100m; late last year the threshold was raised to $1 billion. In recent months, capital outflows have surged. Some say this is because Chinese are losing faith in their country. Regulators are far more sanguine, pointing to it as a sign of a better-balanced economy. The alternative—trapping money in China at artificially low interest rates and encouraging wasteful investment—was bound to be more destructive.