(FORTUNE Magazine) – A billion-dollar steel mill isn't easily swept under the rug. But give the Chinese city of Changzhou credit for trying.

For the past year, city officials have touted Jiangsu Tieben Iron & Steel, a giant industrial complex rising from rice and cabbage fields on the edge of town, as the community's big chance to cash in on China's boom. But in April a squadron of inspectors from Beijing descended on the project and halted construction. Half-a-dozen local officials were censured or sacked. Nine executives were carted off to jail. Now Changzhou scarcely acknowledges the project. Police patrol the facility's half-finished skeleton. Local media have kept mum, leaving displaced farmers to wonder about promised factory jobs. A Changzhou government spokesman rebuffed FORTUNE's queries with a warning that contacting anyone involved with Tieben Steel would be "illegal."

Beijing says it scuttled the steel mill because Tieben failed to secure permits for building on farmland. In fact, the crackdown was the opening salvo in a broader campaign to curb overinvestment and reassert central government control over unruly local leaders. Until recently, Beijing's planners tolerated--and often encouraged--dubious ventures like Tieben Steel's as good for jobs and growth. But after two quarters of runaway economic expansion, they have begun to view such projects as "red elephants"--extravagant totems that bring prestige to local chieftains but devour scarce resources and threaten to weigh down the nation as a whole.

A full-fledged capital market would do much to cull the herd, allocating credit to good ventures while letting wasteful ones starve. But China has yet to foster mature, privately owned financial institutions equal to that task. Instead, central government leaders are beating back rogue provincial projects one by one. The arrests in Changzhou came a day after the plant was discussed at a State Council meeting led by Prime Minister Wen Jiabao.

The struggle between center and periphery is as old as the Middle Kingdom itself. With Tieben Steel, China's modern rulers have fallen back on a time-honored tactic: "killing the chicken to scare the monkeys." But this time, provincial monkey business has reached new extremes. Local officials have lavished money on airports, public buildings, and a bewildering array of monuments. In Suide, in impoverished Shanxi province, officials spent millions to pave streets in marble. In the dusty northwestern province of Gansu, leaders of one small town are digging a 1,000-acre lake. In Fuyang, officials recently reopened an airport closed three years ago because it drew 7,000 passengers a year --493,000 fewer than it was built to accommodate. "China's system has few mechanisms to force officials at the local level to take responsibility" for squandering public funds, complains Mao Yushi, founder of the Unirule Institute of Economics in Beijing. "It's all just other people's money."

But Beijing is partly to blame. When China's economy showed signs of slowing in the wake of the Asian financial crisis, then--Prime Minister Zhu Rongji urged local governments to spend. The state-controlled banking system contributed to the mess. Now, says Joe Zhang, China economist at UBS Securities in Hong Kong, Beijing has lurched too far in the opposite direction. The central government's recent assault on big-ticket projects is "unnecessary, unwarranted, and completely irrational," he warns--and already suppressing worthwhile investment. Among the possible victims: mass-transit projects, something China needs to reduce its crippling dependence on imported oil. That could be bad news for foreign firms such as Germany's Siemens and France's Alstom, which are bidding on multibillion-dollar transport projects, including a 900-mile high-speed train connecting Shanghai with Beijing that could cost $40 billion--a project that has now been delayed.

Collateral damage is inevitable as Beijing struggles to regain control. With an economy this big--and a political system this dysfunctional--"fine tuning" doesn't cut it. On balance, though, the evidence suggests Wen & Co. have things about right. The smart money is still betting they'll succeed in downshifting by two or three percentage points to a more manageable cruising speed of 7% or 8% GDP growth. China remains the global economy's most promising new giant. For the moment, though, this colossus is trying to think small. --Clay Chandler