Moreover, annual consumer and producer inflation dropped to 1.5 per cent and -3.3 per cent, respectively, last December, owing partly to the sharp decline in world oil prices. China now faces deflation and an inhospitable external economic environment, and its urban centres are struggling with the complex interaction of solvency, liquidity and structural issues.
But some cities are better equipped than others to weather these challenges. China's first- and second-tier cities are very wealthy, benefiting from high property values and the continuous inflow of talent, capital, companies and investment projects. Despite a property-market slowdown, Beijing's recent land auction concluded with record-breaking prices of about 38,000 yuan ($6,200) a square metre.
Third- and fourth-tier Chinese cities, however, face more challenging balance-sheet adjustments, owing to falling asset prices, outflows of labour and the need to define new growth models. In the aftermath of the post-2008 debt-fuelled infrastructure-investment boom, these cities need to reform how revenue is shared with the central government, increase the transparency and accountability of local budgets, and overhaul the use of municipal-bond and public-private partnership models for local infrastructure projects.
But before such changes can be implemented, these cities must address the overhang of poorly performing projects and loss-making state-owned enterprises (SOEs). In fact, Chinese cities and local enterprises will need even more liquidity than would be required in a classic case of deflation, credit tightening and falling prices, because infrastructure and property investments by local governments and SOEs are still consuming funds. And, given state intervention, interest rates do not adjust quickly enough to allocate resources efficiently.
Of course, the People's Bank of China could lower the interest rate and relax its liquidity policy. But it remains concerned that doing so would spark inflation and fuel wasteful investment - and greater excess capacity - in the real-estate sector.
Maintaining relatively tight liquidity, however, also has serious consequences. For starters, as long as external conditions remain relatively liquid, tighter conditions in China put upward pressure on interest rates in the shadow-banking sector. Together with the growth of the renminbi carry trade, this has pushed up the exchange rate at a time when non-dollar-linked currencies are largely depreciating.
Moreover, interest-rate volatility and uncertainty encourages arbitrage and investment in socially costly rent-seeking and speculation, with central-bank liquidity flowing to financial markets, instead of fulfilling its intended purpose of helping the real sector. Despite slowing growth, China's A-share market has risen by nearly 50 per cent since last July, and the banking sector's margins remain exceptionally large. Meanwhile, confidence in the non-financial private sector remains depressed, as diminished demand leads to increased production costs.
China's growth model hinges on a governance system in which regions, cities, companies and individuals compete within an increasingly market-oriented, but still centrally regulated, economy. But in a country as large and diverse as China, a one-size-fits-all approach will not ensure that the market functions effectively. After all, different local economies have different needs.
Consider the city of Foshan's economy, which, driven by private-sector activity, boasts a higher per capita gross domestic product (GDP) than Beijing or Shanghai. Given that Foshan's ratio of bank credit to GDP in 2011 was only 85 per cent - much lower than Shanghai's 184 per cent and Beijing's 221 per cent - the city could use land as collateral to borrow money to expand investment. A tight national credit policy, though potentially useful in some highly indebted areas, would impede such growth-enhancing activities in Foshan.
More generally, most of the structural tools needed to strengthen market allocation - including planning, zoning, environmental standards, property rights and bankruptcy procedures - are implemented at the local level. And, adding yet another layer of variability, local economies may experience "creative destruction" as their growth models change, potentially causing temporary slowdowns that drag down overall growth.
Against this background, the best way to sustain China's economic transition and prevent a hard landing is to implement looser monetary and credit policies that enable the most productive cities, companies and industries to generate new added value. With the risks of inflation and asset bubbles being mitigated by lower oil prices and excess capacity, now is a good time to initiate this policy shift.
Of course, China will probably face some short-term headwinds, so the positive effects of this shift will take some time to emerge. As the central government consolidates its power through fiscal reform and an anti-corruption campaign, orchestrating the next phase of structural reforms at the local level will require deft coordination.
After decades of high-speed growth and policy experimentation, cyclical overshoots - reflected in excess capacity, ghost towns and local-debt overhangs - are no surprise. Now it is time to address them. Only by confronting these structural issues can China complete its shift to its new, more developed and more equitable "normal".
Sheng is Distinguished Fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance. Geng is Director of Research at the Fung Global Institute
Copyright: Project Syndicate, 2015