Urbanization may lead to policy shift

The reliance on land revenue is also becoming an obstacle for China to move away from exports and investment, and focus on services.

The dangers of the investment-intensive growth paradigm also lie in the dwindling return on investments.

A recent report by the International Monetary Fund said that China's largely State-led investment has seen a steady fall of return over the last five years.

In the first quarter, China's GDP grew 7.7 percent year-on-year, well below the forecasts of many financial institutions. Smits said this could be partly attributed to the effect of slower credit injections, but that it can also signal something more troubling.

"The worry is that money is flowing to a certain group of sectors that are not very productive, for example the real estate sector," Smits said.

Another example of misallocation of resources is the labor market.

"China is very lucky because you have enormous labor potential. But because of the hukou (household registration) system, there is a lot of rigidity for workers to move to the most productive areas," Smits said.

Responding to concerns that giving migrants equal access to public services such as housing, healthcare and education might encourage more migrants into crowded big cities, Smits said that China should adjust its policies to let migrants move to cities not for the sake of better public services, but for the sake of making contributions to those cities.

This objective should be achieved by giving basic packages of services to all the Chinese citizens, no matter where they live, according to Smits.

"China's urban residents have privileges in accessing better hospitals and schools, and they fear that their cake would be shared by migrants," he said.

"But if the central government can offer all citizens a common package, for example for pensions and healthcare, there is less incentive for migrants to move to cities just for the public services there."

He also noted that the current problem of providing equal access to citizens is that "everybody knows how much it costs, but no one knows who is going to pay for that".

"The central government should work hand in hand with local governments. You can't make reforms by giving everybody equal access without answering how the project is financed," Smits said.

But the need to rebalance the economy is increasingly urgent, meaning that correcting these structural distortions is increasingly becoming a must, rather than an option, he said.

For example, one of China's perennial problems is its underdeveloped consumption demand, which could be partly explained by the fact that China's 260 million rural migrants are not yet full urban residents.

"Under the current system, many rural migrants could not bring their family members to cities. They do not consume and enjoy the urban lifestyle as their counterparts in the cities do. They do not dream of buying a house in the city. Mentally he is still with his family back home," Smits said.

To save enough money to build a house in their rural homes, they save every penny they earn in the city, and so do many young college graduates. This in turn contributes to China's high savings ratio. And with huge deposits, it's easier for Chinese banks to lend money to State-owned companies with low interest rates, which is a distortion of the capital market.

Building public housing is important to address the migrants' housing problems, but alone it will not address the distortion in the land market, he warned.

"In general, by examining urbanization you could touch a mix of deeper, structural problems in China," Smits said.

"China has tremendous opportunities from the process of urbanization by unlocking these distortions."