China's Economy Could Implode — Here's How to Fix It

China's economy is slowing down. From April to June 2013, the country's GDP grew by 7.5%. That's 2% less than this year's first quarter and 2% less than the quarter before that. It might not seem like much, but in its most recent report on the Chinese economy, the International Monetary Fund emphasized the need for more sustainable growth.

"Since the global crisis, a mix of investment, credit, and fiscal stimulus has underpinned activity," the report states. "This pattern of growth is not sustainable and is raising vulnerabilities."

But how large is this vulnerability that we should be worried? What does a slowing Chinese economy mean? To answer that question, it's important to understand the factors that have led to China's success over the past few decades.

China's economy has been mostly export-led. Its focus on external demand has stifled domestic consumption and has ramped up investment in a way that wouldn't be possible if the country relied solely on domestic demand. But it's not working anymore.

When the financial crisis of 2008 hit, China's trading partners like the United States and the neighboring Asian countries stopped demanding Chinese goods for fear of more debt. So the country focused even more on investing in sectors like real estate and infrastructure while keeping their currency weak so that their GDP would keep growing.   But Chinese consumption hasn't really moved and lending standards have become lax.

"The credit-driven growth model is clearly falling apart," Fitch Ratings senior director in Beijing Charlene Chi said to The Daily Telegraph. "There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signaling."

With the Eurozone still digging its way out of recession and the U.S slowly recovering, China's weakening economy is not the greatest news.

According to the economist John Maynard Keynes in his book The General Theory of Employment, Interest and Money, more investment is good, especially during times of recession, to keep people employed.

That's exactly what China has been doing. The past three decades have been filled with massive infrastructure projects and creating hundreds of factories. But the consumer economy and healthcare, among other sectors, have been neglected. Banks have become used to large credit expansions and lending out to investment projects that may not pay back.

Somehow, it all has to be reined in. Countries like Australia, South Africa, and Brazil depend heavily on exporting to China and would be hit hard if Chinese investment suddenly buckled. U.S. companies like Yum! Brands, Inc. (which owns Taco Bell, KFC, and Pizza Hut) and Intel have already started seeing slower growth in China.

Fortunately, China has a lot of foreign currency reserves which could serve as a cushion for the government while they try to transition the economy from external to domestic consumption. But in doing so, China would have to step away from the export-led growth model that has proved so successful in past years and focus their attention on getting the Chinese to buy their own goods.

On Friday, the People's Bank of China announced that it would lift restrictions on bank lending rates by no longer setting a minimum rate for corporate loans.

"It's a big symbolic move," Wang Tao, a Hong Kong-based economist at UBS, said to the New York Times. "It means banks could charge rates freely according to their own risks assessments." Deposit loan rates would stay the same although economists see that as a crucial next step to reward households.

It's a sign that China is working to rebalance the economy, shifting towards market-led growth. But this is only the beginning. It all depends on China's willingness to suffer short-term loss for long-term growth or risk dragging the rest of the world down with them.