Water has long been the most precious of resources in northern China, where rain barely falls for six months of the year. Now rapid industrialisation and misguided policies threaten to create a chronic water shortage that could see economic growth in China’s heartland dry up.

The country’s annual per capita water availability stands at 2,200 tonnes — 25 per cent of the global average. The government reckons peak water shortage will come in 2030, when a population of 1.6bn will have just 1,760 tonnes of water per person, a level defined by the United Nations as the “threshold of concern”. Wang Shucheng, the minister of water resources, warns: “To fight for every drop of water or die — that is the challenge facing China.”

The situation is most desperate in the densely-populated north China plain, which sweeps down from Beijing in the north to Jiangsu province in the Yangtze basin. Here, the average water resource per head is 710 tonnes, well below the UN’s “danger threshold” of 1,000 tonnes. Tianjin, the driest city in the region, has a per capita supply below that of Saudi Arabia.

Of China’s 660 cities, more than 400 lack sufficient water supplies, and 110 suffer serious shortages.

Worryingly, as much as 75 per cent of the north China plain’s water supply is extracted from aquifers.

This is unsustainable. Ma Jun, an environmental consultant and author of “China’s Water Crisis”, observes: “In some cities, within 8-10 years we will not be able to extract ground water. We are coming to the very limit.” In Beijing, the water table has fallen by almost 50 metres in a little over 50 years.

Three solutions to China’s water crisis are commonly touted: giant engineering projects to move water from the water-rich south to the parched north; more market-based pricing to encourage efficient use; and improved recycling.

True to form, the central government has opted for engineering projects and supply management, rather than trying to constrain demand and improve efficiency.

The keystone of China’s water management engineering is the 50-year, US$60bn south-north water diversion project, which will finally realise Mao Zedong’s plan to water the arid northern plains with river water from the Yangtze, which frequently floods in summer. Although the entire scheme is set for completion by 2050, the first Yangtze water from the project should flow into the lake at Beijing’s Summer Palace in 2010.

Mr Ma says the scheme may temporarily slake the capital’s thirst, but will also cause severe environmental degradation to the Yangtze tributary serving as the main artery for the diversion. “There is too much emphasis on big engineering projects,” he says.

In the past, water supply enhancement works aimed at helping farmers in arid regions in the north contributed heavily to Tianjin’s water shortage. Crop selection in northern China is often unsuited to local conditions and three quarters of crop production there rely on irrigation. Over 50 per cent of the country’s wheat and nearly 40 per cent of its cotton, both highly water-consumptive crops, are grown in three provinces in the north China plain.

Reducing water use in agriculture is the real key to the water problem. Agriculture consumes 65 per cent of available water, compared with 25 per cent for industry and 10 per cent for residential users. Sou Lisheng, the vice minister of water resources, says half of the water used by agriculture is simply wasted.

One solution would be to switch irrigated wheat land to vegetable production – a labour-intensive crop that would make more efficient use of China’s resources and bring higher financial returns. In theory, China could then “import” water by decreasing domestic production and buying more grain from countries where it can be grown more efficiently.

Water trading is another option. Pilot schemes are underway in the north China plain that allow downstream industrial users to pay farmers in upstream regions for their water rights. Farmers may then raise their income by selling a portion of their water rights and then invest in more water-efficient crops and technologies.

A far simpler solution, however, would be to make water more expensive. Until 1985, water was provided for free by the state, which gave scant incentive for farmers to invest in efficient irrigation technologies or for industry to worry about recycling waste water. Despite modest price increases over the past 20 years, China’s water tariffs remain 70-80 per cent below those in countries with four times more water per capita. Water costs around US$0.16 per cubic metre in China, compared with US$2.50 in the US, reflecting neither the cost of delivery nor the scarcity of water.

The government’s big problem is that price rises for farmers conflict with the more urgent short-term goal of increasing rural incomes. As Mr Ma points out: “We need to move from planned prices to a more market-based system. But the reforms cannot be made on a purely market basis because water is not a common market commodity. There is a social equity issue at stake here.”

The China Economic Quarterly is an independent newsletter devoted to analysis of the Chinese economy and business environment since 1997. It draws on the 25 years of combined experience of its editors, veteran financial journalists Joe Studwell and Arthur Kroeber, and also publishes articles by leading China-focused economists and journalists. This column appears exclusively on FT.com on alternate Mondays.

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