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Future Growth? The Answer Is Megacities

Karin Slade | The Image Bank | Getty Images

The economic slowdown has led to a search for growth opportunities. Urbanization is being raised as a possibility for China's economy. It could be but not in the context being discussed. The country's growth in the future depends on raising productivity. Urbanization, if structured efficiently, could help in that regard.

Urbanization as an untapped resource is not available. When one travels through the countryside, it is apparent that old folks and children dominate. There isn't a big and untapped source of workers in their prime available for migration. The maximum source of labor available for migration is the children growing up to join their parents who already work in cities. It may add 1.5 percent to the existing urban population, similar to the natural growth rate in many countries and hardly a torrent requiring massive resources for building new cities and expanding existing ones.

The National Bureau of Statistics reports that China had 9.8 billion square meters of property under construction in October, of which 4.8 billion was residential. China is building roughly 50 Hong Kongs. Compare this to the requirements for urbanization and overbuilding is apparent. So it is high risk to pursue urbanization per se for juicing up GDP growth. It will lead to bigger debt crises down the road.

How Will Tier Three Cities Succeed?

The 2008 stimulus catapulted a massive construction boom in tier three cities. Property developers poured funds into them, believing that the lower land prices were an arbitrage opportunity relative to tier one cities. The land sales revenues pumped up their fiscal revenues and increased local purchasing power for properties. For a period, the arbitrage seemed to be working. Unfortunately, it was a self-fulfilling bubble. As the funds inflow slows, purchasing power declines too. This is why the property sales in tier three cities have dropped so dramatically.

Some local governments blame property-tightening policies for their troubles. But, such policies are not in force in tier three cities. If one looks closer, a lack of competitive industries is to blame. Why would people pay lots of money for a property in a city without good job opportunities? China's villages are like small cities anyway. Housing has no cost there. So, if one is left without much to do, staying in a village is a better choice.

(Read more: China November Factory Output Jumps to 8-Month High)

Small cities must survive on some industries that are competitive in the global economy. That is how such cities in Europe or the United States survive. Some cities are merely company towns, depending on a single firm. When the company loses competitiveness, the whole town loses viability. This is why there are ghost towns everywhere.

Living on building a city itself means building ghost cities to begin with. It is happening in China because the financial system is government-owned and credit allocation is heavily influenced by political considerations. Still, if there is enough money to build a city, how will it survive afterwards?

The Changsha Model

In a property market downturn, Changsha is selling more than any other city. Why is this tier two city able to do this? The reasons are that its industries are competitive, growing and attracting more workers, and its property prices never went crazy and are close to two months of salary per square meter. Affordable prices and booming industries support the property market there. The property market can only follow, not lead an economy.

A decade ago, I wrote that Wuhan could be China's Chicago because I anticipated the gradual migration of industries up the Yangtze River. I failed to recognize the industrial dynamism in Changsha. Then, it was small compared to Wuhan, but it is now comparable in GDP and fiscal revenue. Its success is due to its focus on industrial development. Now it is in a virtuous cycle. Successful factories attract others. The self-feeding process will turn it into one of the largest industrial bases in China.

In contrast to Changsha, many cities have relied on high and rising property prices to grow the economy because they turn bank loans into fiscal revenues and household income, which in turn turns into property demand. So many have become used to this model that they have no plan B and are now just waiting for the bubble to return. Unfortunately, China's property market has made a historic turn in 2012. The odds are that land prices will decline for five years or even forever, as the demographic burst follows the post-bubble adjustment, just like in Japan.

The Future Is Megacities

China's growth potential is in raising productivity. The country's per capita income was US$ 6,000 in 2012, of which about 40 percent was household disposable income. Compared to US$40,000 to US$ 50,000 in per capita income and 75 percent of it as household disposable income in developed countries, China has a long way to go.

Many experts argue that China has not exhausted its demographic dividend or room for urbanization and, hence, could grow like in the past. This really misses the point. The past is over. But the future could be brighter if one recognizes reality. Raising productivity cannot be planned like building infrastructure. It happens as the market system optimizes the allocation of resources like capital and labor. Both are now beholden to the government. Hence, growth revival requires China to shift from the government to a market-led growth model. Reform, not more investment in the same stuff, is the key to reviving growth.

(Read more: China Party Chief Stresses Reform)

In productivity-led growth, megacities could play a key role. Economies of scale, i.e., one plus one is more than two, are like a free lunch. This is well understood in manufacturing. The development of a car may cost US$ 1 billion. Its profitability depends on how big the sales are relative to the development cost. This is why auto manufacturers have to be very big to thrive. A hypermart is an example in the service industry. Warehousing all the goods for household demand in the same store creates economies of scale in shopping. Infrastructure is the ultimate example of economies of scale. A highway system, for example, can accommodate more cars than if the roads are not connected.

The big city has a bad reputation. Experts often criticize its shortcomings like traffic congestion, pollution and social problems. These criticisms don't explain why big cities keep becoming bigger, while small cities struggle. People choose to live in big cities because they are better off there. The only barrier to entry is high property prices. Of course, the high price partly reflects insufficient supply. From a social justice perspective, the government should accommodate people's desires and increase supply to lower price and to accommodate more people. It is unfair to keep people out through limiting supply.

Megacities with over 20 million people each are the future of urbanization. As I argued before, a small city must rely on a few competitive companies to survive. If they lose competitiveness, the whole city goes down. It is a high-risk model for urbanization. A megacity has a diverse economy. When one part loses competitiveness, the city can absorb the loss. Over time, new competitive businesses rise up. This is why big cities tend to come back again and again. Size is their insurance.

Job creation cost, i.e, capital expenditure per job, is inversely correlated with the size of a city. Economies of scale in infrastructure formation and the market size for division of labor are the key factors in lowering costs for employment creation. China must boost household income to balance the economy. This means less money for investment. To make more out of less, focusing on developing megacities is a way out.

The big city diseases like congestion and pollution are really design or management problems. Big cities per se don't bring such problems. When 20 million people live in a city designed for five million people, the problems become serious. This is why policy is so critical. If a government is against megacities, it won't support designing a city for 20 million people. When so many people show up, the city exhibits big city diseases. The critics of big cities then point at the problems and justify their criticisms. This is a vicious cycle. Greater Tokyo has a population of 30 million. It doesn't exhibit big city diseases. If China chooses rationally to encourage and invest in big cities, the country could have 20 to 30 of them in the next two decades. They will power the Chinese economy to the pinnacle of the global economy.

Social critics consider big cities cold and lacking in compassion. Actually, small cities are less friendly. Their closely knit relationship networks limit opportunities to a small group of people. This is a major reason that people gravitate towards big cities. While connections are always important to opportunities, size can create enough opportunities for those who have no connections but try hard. Megacities, not small cities, offer better social justice.

Towards Efficient Urbanization

The property boom has provided the finances for virtually every town to build up massively. Urbanization has occurred on money availability rather than efficiency, future viability or quality of life. As the property bubble winds down, the financing is drying up. Debt crises and unfinished buildings will plague the economy for years. In addition to the financial cost, urbanization everywhere has damaged the environment severely. It will haunt the country for decades.

A dozen years ago, I advocated concentrating resources to develop megacities for efficiency and environmental protection. If China builds up 30 cities with 30 million people each, the pressure on the land will be sharply reduced. China's large population is turned into an advantage in scaling up cities rather than a disadvantage in damaging the environment. It may be too late, as most water resources have been severely polluted already. But, if the trend isn't changed, the environment would only become worse.

There are two ways to develop megacities. One is to pick winners: some cities with large populations and vibrant industries could be elevated to provincial status like Beijing and Shanghai. For example, Shenzhen, Guangzhou, Nanjing, Changsha, Wuhan and Chengdu could be elevated. These cities should have freedom in issuing development bonds and land usage. The current model of approving increases in urban land for each city encourages overbuilding in unviable cities. Freedom in finance and land would catapult these cities to megacity status.

(Read more: What China's New Leadership Means for the Property Market)

Alternatively, all cities could have the right to issue bonds, as long as the market buys. Like the enterprise bond market, this works only if some cities are allowed to go bankrupt if they can't meet their debt obligations. If the market force is allowed to work, efficient urbanization will naturally result. The chances are that megacities will win out. This model won't work if the market assumes that the central government won't allow any city to go bust. It will lead to greater misallocation of capital because failing cities are incentivized to borrow more to stay alive for as long as possible. It is just bad money driving out good. The market model works only if the rule of law overrides administrative power. That would require substantial political reform to work.

Efficiency as a Necessity

China has achieved a high growth rate in the past decade. It's happened despite obvious waste and inefficiencies in so many areas. Joining the WTO and demographic dividends have paid for the waste and inefficiencies. As China's share in global trade stabilizes and the wages of blue-collar labor rise faster than productivity, neither dividend is available anymore. If the waste and inefficiencies continue, China will face slow growth and inflation. Efficient resource allocation has become necessary even for sustaining a 7 percent growth rate.

As most investment is related to urbanization, improving its efficiency is a necessary condition for the country to revive growth. Creating another bubble would certainly bring calamities to the country, even if it is widely supported by vested interests. The world has changed. If China's policy doesn't, the economy will remain stuck.

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