Source: Bloomberg

Over the past few weeks, people here in Beijing have been riveted by the so-called migrant “clean-out” -- the government's attempt to evict tens of thousands of migrant workers from their homes in the poorer parts of the city. What's not being discussed, however, is how the crackdown could threaten one of the government's other main priorities: managing debt.

In China, mobility is legally restricted according to a household registration system, called the hukou. Chinese citizens receive an urban or rural hukou which officially identifies them as residents of a specific area and which allows them to live and work only in that area. Few if any of the migrant workers affected by the current sweep possess a Beijing hukou.

Previously, this didn't really matter. For the past three decades, during the period of China’s furious economic growth, the country's fastest-growing regions were desperate for cheap labor to fill factories and build infrastructure. With local government officials graded in large part on their ability to generate rapid growth, they largely ignored hukou restrictions and made migration into their cities easy. Hundreds of millions of workers traveled from their hukou areas to wherever there were jobs, in particular big cities such as Beijing, Shenzhen and Shanghai.

The attitudes of local authorities may be changing now as the economy slows and officials become more concerned about unemployment and tensions over access to schools and other social services. One of the easiest tools the authorities have to manage both problems is to enforce the hukou rules that are already on the books. In Beijing, the campaign is broadly popular among legal residents, who complain about overcrowding and rising rents.

If it spreads, however, the crackdown could carry a significant macroeconomic cost. Enforcing the residency system nationally could severely limit labor mobility in China. This would in turn constrain monetary policy, which is critical to minimizing the cost to China of what's likely to be a very difficult adjustment after decades of deeply unbalanced growth.

How exactly would this happen? It's important to remember that while China is a huge economy with a great deal of variety across different regions, it can nonetheless operate effectively with a single currency because it has most of the characteristics of an optimum currency area. In the 1960s, Columbia University’s Robert Mundell argued that four conditions were required to establish such an area. They include high levels of labor mobility, high levels of capital mobility, a system of transfers that shares risks across the region, and coordinated business cycles.

If labor mobility in China slows dramatically, growth rates in different parts of the country would diverge even more than they have already, rather than converge. As a result, monetary policies aimed at restraining credit growth overall might end up being too tight for some regions, leading to accelerating bankruptcies, and too loose for others, fueling out-of-control credit growth. To prevent financial dislocation in the former, officials would likely tolerate faster credit growth for a longer period of time than they might otherwise. If labor mobility is restricted, in other words, it'll be harder to control the upsurge in debt.

For instance, GDP in China’s northeastern province of Liaoning, which suffers from rust-belt industries mired in debt and excess capacity, shrunk 2.5 percent last year. Even the ability of the provincial government to continue financing itself was thrown into question temporarily when one of its largest state-owned enterprises, Dongbei Special Steel, was forced into a messy default. In order to avoid surging unemployment and rising defaults, Liaoning needs low interest rates and temporarily easy money. But, if the central government wants to restrain credit growth in healthier and faster-growing provinces like Fujian, which grew last year by 8.4 percent, it needs to pursue diametrically opposed policies.

This is already a difficult enough problem. It would be far more difficult if Liaoning’s unemployed workers couldn’t migrate to where the jobs are, and if provinces like Fujian protected their residents by restricting immigration. Such provincial protectionism has a long history in China. Less than 20 years ago, provinces restricted trade among themselves so severely that one of the main reasons then-Premier Zhu Rongji pushed for China’s entry into the World Trade Organization was to use WTO rules to break down intra-provincial trade barriers.

For this reason, authorities should monitor labor practices carefully and take steps to prevent local officials from heavily enforcing the hukou. This may prove difficult, in which case they should consider alternative policies to reinforce monetary integration. They could strengthen fiscal policies that transfer income from faster-growing provinces to slower-growing ones, for example, or manage fiscal spending so that business cycles are more closely coordinated across regions.

One thing we know from the history of developing countries is how suddenly virtuous cycles can become vicious cycles. In China, rapid growth historically encouraged local officials to ignore hukou restrictions. This caused a sharp increase in labor mobility, which made monetary policy more effective and, in turn, encouraged even more rapid growth.

This self-reinforcing process could just as easily reverse itself, with slow growth encouraging officials to restrict labor mobility, weakening the transmission of monetary policy and slowing growth even further. Officials might want to think twice before making their own jobs harder.

This piece was originally published in Bloomberg.