China’s economy for the past year has been slowing out of necessity. Its consistent 10%-plus real GDP growth rates for most of the past decade had contributed to a broad inflation, as well as severe distortions in the economy’s composition (a significant over reliance on fixed asset investment as the driver of growth). The government tightened policy as a result, and put shackles in particular on the residential housing market, which was at once overbuilt and still unaffordable for the vast majority of Chinese, thus contributing to social tensions here. (Overbuilt and overpriced is, to be sure, an economic oxymoron, but we’ll leave the explanation for that for later.)

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The tightening measures worked, arguably a bit more than the government intended, as it became clear in the first two quarters of this year that China was decelerating rapidly. Prime Minister Wen Jiabao in March officially lowered the government’s growth target for 2012 to 7.5%, and that should be considered a target that Beijing will be lucky to hit this year. The data these days — industrial production, electricity consumption — are weak, and the global slump in commodity prices, with inventories piling up in everything from coal to iron ore to crude oil, is obviously closely tied to macro weakness in China. It’s the unwinding of the decade-long, China-driven bull market in commodities that is now over.

Part of the China slow-down is driven by the disaster in Europe — what polite economists call a “recession,” but which is, let’s face it, nothing less than a depression in countries like Greece and Spain. Europe is China’s biggest trading partner, and China is plainly not immune to its deepening pain. The U.S. is China’s second-largest trading partner, and its weakening economy is obviously not helping China’s growth, either.

So a government-led deceleration, which was necessary, now has weakness in external demand added to it, and the result is not pretty. That’s particularly true for companies the world over that convinced themselves that China would grow at 10% per year forever, and scaled up capacity accordingly. Expect earnings disappointments from multinationals everywhere with big China businesses to increase.

But, having said all that, it’s critical not to exaggerate the current weakness. China is not in free fall. The macro issues it confronts pale in comparison with those now front and center in Europe and the U.S. Remember, first, that China can no longer accurately be characterized as an “export led” economy, so the damage the outside world can do is limited. Beijing’s current account surplus as a share of its economy is now slightly less than 3%. That’s down from 10% eight years ago. The unfolding economic debacle in the developed world is wounding China, but not killing it.

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Second, and more important, China has policy options that it has begun to use — the recent interest rate cut (signaling emphatically that growth has replaced inflation as the central bank’s primary concern) being only the most obvious. Quietly, as a recent research note from Jiming Ha, chief investment strategist at Goldman Sachs’ investment management division in China noted, provincial and local governments have begun to try to stabilize the housing sector. Banks in a variety of provinces are now offering mortgages to first time buyers that are available at a discount to the current benchmark rate (in the past they’d have to pay a 5%-10% premium over the PBOC’s benchmark rate.) The central government is looking the other way, and there are signs that housing markets, particularly in second and third-tier cities outside Beijing and Shanghai, are now rebounding a bit.

China’s consumers still want and need housing — and, critically, they can afford it. Real wage growth remains strong, despite the macro deceleration, and that in turn means consumption has held up pretty well. This is part of the reason the central government has not panicked in the wake of the growing global crisis. Believe me, in 2008 and 2009, the central government DID panic in the wake of the first phase of the global financial crisis. The site of tens of thousands of suddenly unemployed migrant workers clogging the trains stations in eastern China, headed home to much poorer interior provinces, tends to have that effect. Beijing dumped money furiously into the economy in order to stabilize it, succeeded in doing so, and then paid the consequences down the road in terms of higher inflation and a still unknown amount of bad loans. This time, the steps it is taking, in addition to loosening controls on housing sector, are so far all little tweaks — subsidies for the sale of energy efficient appliances, some targeted business tax cuts, quicker approval of investment plans by regulators — the small kind of stuff that doesn’t bespeak panic.

The more important point is that Beijing can do more if needed. Part of the bearish case on China is that all of the government driven capital investment that we saw in the last decade — and in particular in the last four years — is now over; it resulted in excessive growth overall and too much investment in heavy industries that are now plagued by over capacity. It’s resulted in a disfigured economy, with consumption comprising only 39% of GDP, a historically low figure even for developing countries. Simply put, China’s growth model is supposed to be dead, and if it doesn’t shortly turn into a manic consumption driven clone of the United States, well, the abyss is right over there. Proceed accordingly.

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This makes for a nice tidy bear case of the sort that short sellers and magazine editors love. The problem is, it’s not nearly that simple. Arthur Kroeber, the Beijing based Managing Director of GK Dragonomics Research, points out that despite the mind-bending amount of capital investment that’s taken place here over the past ten years, China’s total stock of fixed capital –infrastructure, industrial plants and housing — is still not all that high compared to the size of its economy or its overall population. In the developed world, Kroeber notes, a country’s capital stock tends be a bit more than three times the size of GDP. In China, it’s about two and a half times its GDP, or about where Japan was in the late 1960s.

China can, and indeed should, continue to invest for at least another decade. Kroeber believes it’s possible that overall capital spending can continue to grow by 10%-12% annually for the next couple of years before decelerating, while consumption growth continues to pickup at around 8% a year.

I admit that to anyone who has, like me, been here for most of the past decade, this is counterintuitive, to say the least. This country has been nothing but a construction site for that entire period of time. What Kroeber urges us to remember, though, is the sheer scale of China. As manic and as rapid as China’s “catch up” phase has been, he argues, it’s still not over.

China’s got lots of room to grow, lots of people to move from the countryside into the cities, and given that, it also probably has the wherewithal to withstand the intensifying crisis in the West.