As China's leaders gather for the annual "two sessions" to set the direction for government policy this year, they face a challenging outlook. China's economy has enjoyed a rapid recovery since the coronavirus pandemic, but growth has slowed sharply in recent months for several reasons:

First, macroeconomic policy was relatively tight last year as the government used a strong economic rebound and buoyant export demand to rebuild fiscal buffers and refocus on financial sector de-risk. The latter, in particular, has affected the real estate sector, leading to a sharp slowdown in private investment.

Second, the more transmissible Delta and Omicron variants have led to more frequent outbreaks, delaying the normalization of domestic consumption, particularly in service sectors such as retail and travel.

Finally, while FDI inflows continue to remain strong, continued global uncertainty and tighter regulation in domestic markets dominated by digital economy sectors are weighing on private investment sentiment.

The Chinese government has already begun to recalibrate policy to meet the challenge. The pre-issuance of special bond quotas and the carry-over of unused funds from 2021 are likely to boost local government infrastructure investment. The Treasury also announced additional tax breaks for small and medium-sized businesses, which are most affected by prolonged uncertainty.

Moreover, the People's Bank of China has taken steps to ease monetary policy as authorities grapple with slowing economic growth. The partial easing of property lending restrictions appears to have had some stabilizing effect, with home prices rising and the decline in property sales easing in China's first-tier cities.

Nevertheless, the Chinese economy still faces significant downside risks. Domestic uncertainty stems from the future course of the pandemic and the knock-on effects of the downturn in the real estate sector, including the impact on the fiscal capacity of local governments. On top of that, global risks have clearly increased, with rising inflation and a global liquidity crunch coupled with the impact of catastrophic developments in Ukraine. China's net exports contributed about 1.7 per cent to economic growth in 2021, but may not do much this year and could even become a drag on growth if the global recovery stalls.

If downside risks materialise, China still has monetary and fiscal room to respond. The bigger dilemma for policymakers is not a lack of policy space, but the risk that excessive easing could exacerbate risks related to high corporate leverage and, in some cases, excessive local government debt. It is therefore unwise to revert to the traditional strategy of relying on infrastructure and property stimulus to maintain growth targets.

Instead, policymakers should calibrate support in line with the long-term structural transformation of China's growth model. The following policy options can help China's economy transition to a greener, more resilient and inclusive sustainable growth path.

Financial support could be geared towards accelerating the green transition, for example by providing time-limited subsidies for private sector investment, while announcing a tightening of the emissions trading system from 2023. This will incentivize companies to front-load investment to reduce emissions, create a short-term multiplier effect to stimulate the economy, and contribute to China's "double carbon" goals of carbon peaking by 2030 and becoming carbon neutral by 2060.

Fiscal reform is urgently needed to address the limited fiscal space of local governments, including to help them advance the government's goal of common prosperity. The authorities could use the central government's fiscal space to encourage such reforms by compensating local governments for temporary revenue shortfalls, for example, by introducing a property tax or expanding unemployment insurance coverage through provincial-level pooling of social insurance.

In the face of domestic uncertainty, improving the social security system, especially for migrant workers, can reduce precautionary saving incentives and encourage a shift toward greater consumption.

To mitigate financial risks from monetary easing, China should develop more effective measures to allow inviable companies to exit and resolve failed financial institutions. This will free up resources to reallocate credit to growth areas such as green investment and small and medium-sized enterprises.

In addition, structural reforms can help improve the competitive environment and encourage more private sector investment. For example, further liberalisation of protected services could increase access to quality services and increase employment in high-value services. Liberalizing the hukou system in all urban areas would help remove current labor mobility constraints and support the development of a vibrant service economy in big cities.

In the face of greater uncertainty, China's leaders should not ignore the necessary rebalancing of the economy. This requires targeted rather than across-the-board stimulus and a sustained focus on structural reforms.