Harnessing the competitive streak

Regulatory arbitrage arises from competition among central government agencies for the authority to regulate - competition that often delays market reforms and institutional change, owing to agencies' unwillingness to accept one another's authority. For example, overlapping regulation by at least five agencies and ministries has delayed the development of China's bond market considerably.

The best example of healthy competition in China is that which occurs among cities. China has 287 prefecture-level cities, with a median population of 3.7 million and median per capita GDP of $5,800. Sixteen cities have already crossed the World Bank's threshold for high-income status, with annual per capita incomes of more than $12,616, and four - Beijing, Shanghai, Guangzhou and Shenzhen - have global reach. These cities hold the key to the ability of China as a whole to avoid the middle-income trap.

That should come as no surprise. The secret of China's economic success since 1979 has been the easing of central-planning rules to empower cities, markets and private businesses to experiment, innovate and grow. Given the difficulty of identifying which of the old rules needed to be reformed or eliminated, the process depended on the delegation of the central government's powers to local governments, which were better equipped to experiment with market rules to boost economic growth.

At the same time, in order to preserve the system's stability and integrity, these efforts were accompanied by the centralization of fiscal authority and certain oversight powers. This balance between horizontal competition and vertical regulation was critical to promoting growth and dynamism in Chinese cities.

But the balance has been far from ideal. Indeed, competition among cities - intensified by the large role that municipal-level GDP growth plays in determining local officials' career paths - went too far, creating destabilizing imbalances.

Yes, local autonomy facilitated bold productivity enhancing activities, such as the use of rural land for industry and commerce and the creation of public-private partnerships to finance major infrastructure projects; private enterprises were thus able to seize market share from SOEs in the service and manufacturing sectors. But cities' hasty efforts to imitate one another's growth models also led to overwhelming environmental pollution, mounting debt, excess infrastructure capacity, rising inequality, depletion of farmland and rampant corruption, including administrative abuses that encroached on citizens' property rights.