FORTUNE — China’s growth model is unsustainable. The costs of that growth are readily apparent in the country’s cities. Most pronounced are the stifling smog and serious water pollution. But vast energy consumption, health problems, density of population, and social stress are emerging problems exerting new pressures. Yet with a shrinking rural, agriculture sector — under 40% of the population — that’s now only about 10% of the Chinese economy, urbanization is both at the heart of China’s future growth and prosperity and posing a vexing challenge. If the country continues along the same path, the migration of another 300 million people into cities over the next couple of decades will impose a terrible price — not just on the Chinese people but on the rest of the world.
But the good news is that China’s leaders have set as a major priority the need to build more sustainable cities to buttress China’s transition to a new economic growth model and minimize social stress. In every country, including China, urban incomes are higher than rural ones. Therefore, moving more labor from farms into cities can increase productivity and domestic consumption, helping China to rebalance its economy. If done well, urbanization has the potential to expand prosperity in China and create significant consumer markets for other economies around the world, while limiting its environmental impact.
But China needs to urbanize strategically and sustainably, not just rapidly. Simply packing more people into cities and building infrastructure will not automatically raise living standards for the next 300 million and will only worsen pollution, congestion, and inefficiency. For the next two decades, China’s success in its economic transition will depend in many ways on how it urbanizes sustainably. We must not underestimate the complexity and importance, to China and the world, of adjusting China’s economic model to balance growth with sustainability — perhaps among one of the most important economic and environmental events of our time.
China’s recently concluded urbanization work conference also has wisely emphasized the people-centered aspects of urbanization. They recognize that with 710 million urban residents as of 2012, China is already an urban nation and that many of the polices put in place in previous eras, when China was predominantly a rural country, need to change.
Why sustainable urbanization?
China’s existing model of growth has been premised on capital-intensive investment in fixed assets, and exports to consumers in the advanced industrial countries. But both pillars have frayed. Locally, Chinese mayors have enthusiastically met growth targets mandated by Beijing — on which their promotions are largely based — through inefficient and substandard building sprees, which have resulted in a huge buildup of local debt that could test the financial system.
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But a strategic, environmentally friendly, and people-centered approach to urbanization can help to solve some critical, interconnected, and underlying problems:
First, China needs job creation in cities. A key aim of economic reform must be to spread the benefits of growth to more Chinese citizens and address widening inequalities. That means assuring good, higher paying urban jobs, so that employment opportunities are available for the swelling ranks of college graduates and the many migrants who now more or less permanently reside in cities.
Second, China needs to normalize its labor market by legalizing migrants who will move to cities. For decades, hundreds of millions of migrants have constantly moved between rural areas and the cities in search of better opportunities, and many have stayed. But they are usually doing so illegally. Turning these rural migrants into legal urban residents, working in urban jobs with higher incomes won’t be easy. But if done properly, it could reduce social inequality and give the migrant class a shot at entering the new urban middle class, supporting consumption along the way.
Third, China’s economy must shift from one dominated by production to one in which consumption contributes a larger percentage of GDP (only about 45%). Legal urban residents working at good jobs can help to do this. Indeed, China needs to create millions of new jobs, including even for high-skilled college graduates and existing urban residents. One way to do this is to expand the urban services sector. Services, unlike industry, tend to be less energy-intensive but more job-intensive, which can serve the dual purpose of boosting consumption and creating jobs.
Fourth, China needs better urban planning so it can continue to avoid the slums so prevalent in other major developing nations. A sound calibration between supply and demand of infrastructure can help reduce the proliferation of irrational investment, especially in the wake of China’s 2009 $586 billion stimulus. Across China, poorly designed and economically questionable “white elephants” have cropped up. Better urban planning at the local level can improve infrastructure investment and reduce overcapacity.
Fifth, China’s cities need better environmental and energy policies. The current growth model is energy-intensive and environmentally damaging. Evidence is clear for everyone to see, as air pollution blankets Chinese cities. Recent studies from Chinese researchers suggest that in 2010, the environmental cost of growth had reached some 3.5% of GDP.
One important way for China to address this is to shift from an industrial powerhouse to a services juggernaut. This will have a major and positive impact on China’s resource consumption, which has primarily fed China’s hyper industrialization. For instance, China consumes nearly as much coal as the rest of the world combined and churns out about half the world’s steel, much of it goes into the skyscrapers that now dot China’s skylines. A more balanced model can go a long way toward minimizing air pollution, conserving a dwindling watershed, and preserving the diminishing stock of arable land. The costs of the current model of urbanization will constrain future growth, but a better model could unleash it.
Migration: A key to balanced urbanization
At the top of the list of needed reforms is getting migration policies right.
Much of China’s labor remains locked up in the countryside, contributing a limited share to China’s GDP. Just 52% of China is urbanized, in contrast to around 80% in countries like South Korea. Part of the reason is that a restrictive system of internal residency permits called “hukou” prevents migrants from becoming legal urban residents.
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A rural migrant who moves to a Chinese city without being able to change their hukou is ineligible for urban social services, such as housing, health care, and education, on the same basis as legal residents. This constrains labor mobility and represses consumption as migrants deploy what little income they have to cover social services that might otherwise be cheaper or, in some areas, handled by the state.
The solution is to strategically relax the entire hukou system, normalizing the labor market and reducing barriers to internal migration. This means giving Chinese farmers the functional equivalent of property rights, like those accorded to urban residents. In China, all land is owned by the state. But giving farmers lease, transfer, and stronger usage rights would provide the flexibility that would allow farmers to view land as a tangible asset. Hukou reform would also help spur the creation of new service sectors geared toward a growing class of consumers.
Turning urban residents into consumers
China’s leaders also need to reform and strengthen the social safety net. Chinese, whether in cities or migrating to them, generally over-save and underinvest. This is a result of incomplete health and pension reforms, as well as the lack of investment opportunities for ordinary citizens. Expanding social services in cities, while enfranchising migrants into the same system, will help to reduce precautionary savings and promote both consumer spending and private investment.
The state has worked hard to expand health care, including initiating a major overhaul in 2009 that aimed to expand coverage nationwide to urban and rural households. But for migrants outside the formal urban workforce, even though they work in cities, they have no access to the employer-based services available to most urban workers. And without a hukou, they are even ineligible for social welfare benefits distributed by urban local governments, which are considerably higher than rural benefits.
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In short, hukou reform without parallel reforms to China’s social welfare system would only solve part of the consumption puzzle. China needs to reduce the high “entry cost” to becoming an urban consumer and create a more integrated and balanced national health care system. The country does have a national social security fund, but it is woefully underfinanced. Addressing this inequity will be expensive and politically difficult but necessary to urbanize successfully.
Fixing municipal finance
A third set of needed reforms will be to fix a flawed system of municipal finance that has fueled debt, corruption, and dissent.
Municipal debt is a deepening challenge for Chinese cities. Mayors lack real budget authority and accountability but are saddled with the burden of implementing policy mandates from the central government. And mayors have few independent sources of revenue to do so except to seize land on the outskirts of cities — or remunerate the occupants for it at sub-market rates, and then resell it to developers at a higher price. These flawed financial practices not only fuel corruption but also unsustainable construction projects that degrade the environment and promote urban sprawl. Not surprisingly, they are also the leading source of social protests in China, rivaled only by protests over environmental conditions.
To address these financial vulnerabilities, China’s leaders need to undertake serious reforms that yield transparent municipal budgets, for which mayors are fully accountable, and devolve more tax authority directly to cities. Without these reforms, and transparent municipal financial statements, China will confront significant difficulties in funding its urbanization effort.
Improving urban planning
Finally, more innovative urban planning and considered design are needed. If Chinese cities start with the wrong plan, every other challenge will become more difficult. To meet the urban middle class’ rising expectations on quality of life, future cities must seriously take into account energy efficiency and environmental sustainability.
Suffocating traffic and pollution besiege many of China’s major cities. And these environmental woes often spill over beyond China’s borders. Experts have found that dirty air from China contributed up to 20% of the ground-level pollution on the U.S. West Coast in 2010. Yet this is when Chinese vehicle ownership is only about 60 per 1,000 people. Imagine what could happen when China’s vehicle ownership approaches European levels of 400 in 1,000 — that’s more than 550 million personal vehicles.
Another example is construction. Buildings are notorious consumers of energy, and each apartment building put up today will have a lifespan of several decades at least. An approach that features smaller blocks and mixed-use neighborhoods and accessible public transportation would alleviate these unintended consequences. Better building codes and sustainable materials can also help matters. Such “livable cities” would balance economic development with energy efficiency, improve air quality, and possibly reduce congestion.
Enforcement
Beijing’s own plans suggest that it fully grasps the scope and urgency of the problems it faces but reforms will yield huge pushback from entrenched interests. China needs to fight through that skepticism, recognizing that it does not now have the institutions or the rule of law in place to enforce its new policies.
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The central government needs a performance evaluation system for mayors with the proper incentives to enforce their new urbanization policies. Also, an environmental tax applied to carbon-intensive commodities like coal and oil has the potential to be particularly important in curbing pollution, but the Ministry of Environmental Protection is still developing its enforcement capability.
China’s Urbanization and the Rest of Us
The cooperation of the U.S. government and that of other nations, major corporations, and the nonprofit sector, including my own research institute, are helping bring China the tools it needs to prioritize design issues in cities and adapt better infrastructure plans now. These tools include instruction in sustainable practices for government leaders, public education in environmental issues, and specialized training for the country’s urban planners.
This is, ultimately, a joint responsibility. For the sake of our environment and the global economy, we all need Chinese urbanization to succeed.
Henry M. Paulson is chairman of The Paulson Institute, an independent center at the University of Chicago. He served from 2006 to 2009 as the 74th U.S. Secretary of the Treasury. Earlier in his career, he was chairman and chief executive officer of Goldman Sachs.
