The provinces of China have in recent years faced a host of problems, including slowing growth rates and rising debt. Interestingly, some of the problems affecting Chinese provinces are similar to those afflicting the eurozone, where a combination of limited mobility of labor and a wide international productivity disparity, coupled with a unified monetary policy, have contributed to the European debt crisis. China must take specific steps to ensure it does not fall into a similar fiscal crisis.

Even though China is a unified country, there remain serious institutional obstacles preventing interregional migration. China’s system of official registration — the hukou — ties people to certain locations and makes it hard for migrants to claim public benefits, such as social security, health care, and schooling for their children. Since the pension system is currently only unified at the provincial level, migrants who change provinces have serious difficulty obtaining their pensions.

Furthermore, land in rural areas remains collectively owned and unable to be sold on the free market, meaning rural laborers lack the funds to move to a city — funds that they could gain by selling property. Without free mobility, the income disparity between China’s provinces is even greater than the disparity between the countries of the eurozone. Three of China’s municipalities — Beijing, Shanghai, and Tianjin — have GDP per capita rates four times higher than rural provinces such as Guizhou or Gansu. The ratio between Germany and Greece, among the wealthiest and poorest countries in the eurozone, respectively, is only 2-to-1.

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Under a unified currency system, poorer regions do not have independent monetary policies to depreciate their currency and boost economic growth. In theory, if a province with low productivity also has a low average wage, economic competitiveness with other provinces can be maintained. However, this would create a wide interregional income disparity, which is politically unacceptable. As a matter of fact, inland provinces in China, which are generally much more underdeveloped than their coastal counterparts, are also increasing minimum wages, thus reducing the labor market flexibility.

Since many of China’s inland regions are relatively far from the coast, it’s much more expensive to develop export-oriented industries there. International trade by sea is much cheaper compared with other methods of transportation. Inland provinces must therefore focus on developing their local industries, such as agriculture, tourism, and mining, instead of trying to export everything that they produce. This is what the central states of the United States are doing. However, industry production is of course constrained by the amount of local natural resources.

The inland provinces of China are currently experiencing low productivity, low competitiveness, and expensive transportation costs, while still retaining large populations. Lacking the ability to operate independent monetary policies, they can only feed their populations and provide employment opportunities by borrowing from banks or issuing bonds.

These provinces have borrowed heavily to finance local economic development and public services, and the local governments’ debt-to-GDP ratios are rising. Who borrows the most? Looking at the total amount, it is the richer coastal provinces, but their total debt-to-GDP ratios remain lower than those of poorer inland provinces since they have higher per capita GDP figures .

According to a 2015 report from Guotai Junan Securities, a domestic securities company, China’s central and western provinces — all of them inland — have high debt-to-GDP ratios. When taking the three richest municipalities — Beijing, Shanghai, and Tianjin — out of the mix, the negative correlation between GDP per capita and debt-to-GDP ratio across all of the Chinese provinces is clear. This is similar to the situation in the eurozone, where poorer states have a higher debt burden. In both the eurozone and in China, the areas with lower GDPs do not have their own currencies to depreciate.

Debt-to-GDP ratio also reflects input-output efficiency, since in China, government debt is not used to fill the deficit of pension funds, but rather invested mainly in economic development and public services. Much of the debt is used for the construction of industrial parks, new towns, and public housing. Anyone who has visited the inland provinces will see industrial parks everywhere — each county has at least one. However, many of them remain vacant since it remains cheaper for companies to keep their manufacturing centers in the coastal regions, where exporting is much cheaper. Industrial parks built inland are often just the pipe dreams of the local governments, which hope that building them will bring investment.

However, one striking difference from the eurozone is that in China there is a central government that can pay off local government debt. But before doing so, the Chinese central government must be aware of two things.

First, even if the central government steps in, the debt does not disappear. Instead, it is converted into central debt, which then falls on every Chinese national, either in the form of tax or future inflation.

Second, and more importantly, the implicit guarantee by the central government may lead to a moral hazard. This is when a local government takes more risks in borrowing money, believing that the safety net of the central government will always protect them from a fiscal crisis.

Taking into account the problems of a unified currency paired with a wide interregional income gap, China must instigate the following reforms to avoid falling into a crisis similar to that of the European debt crisis and to improve the competitiveness of the country’s poorer provinces.

First, it is important to increase citizens’ mobility by reforming the hukou system. Only free mobility of labor can lessen an interregional income gap, and this in turn would allow different regions to develop local economies based on their specific industrial advantages.

Second, land use rights, which are distributed by the central government, should follow a similar path to geographic migration. The current policy induces regions with declining populations to develop their local industries, since it makes migration difficult. However, policymakers must understand that this system is counterproductive, and that people migrate with jobs and income. 

Third, the central government should stop investing in current projects that show few economic returns. In China, many people believe that local government debt has been transformed into productive assets, but this is simply not the case. A productive asset brings revenues, but those eight-lane roads in mountainous regions, vacant industrial parks, and ghost towns have not and will not generate revenue. To avoid a potential crisis of debt default when halting further investment, the debt from these money-losing projects can be repaid by the central government, but the cities that incurred the debt should be restricted from borrowing more in the future without offering solid development plans.

The currency across the provinces must remain unified, but China needs to implement reforms that will make sure the country doesn’t follow a similar path to the European debt crisis. This may be achieved through free mobility of labor and narrowing the disparities of regional productivity. The eurozone is taking similar steps in this regard, but it too remains far away. China should try to emulate the U.S., which is closer to the ideal model.

(Header image: Workers clean windows of a building in a commercial district in Beijing, April 20, 2015. Kim Kyung-Hoon/Reuters/VCG)