For decades, the burgeoning power of China’s middle-class has been promised as a cure-all for many of the global economy’s troubles (not to mention its own). Enriched by three decades of rapidly rising wages, Chinese consumers should have long ago begun turbo-charging sluggish economies everywhere.

That hasn’t happened. In past years, it’s largely been because they received a much lower share of national income than was their due. But there’s a new reason, one that should alarm both China’s leaders and the scores of foreign companies still waiting for China’s middle-class consumers to ride to their rescue.

After a decade-long real estate boom, home prices in many Chinese cities are unnaturally high. In Beijing and Shanghai, buying a home costs about what the average family would earn in 23 years if it spent none of its income. And in 2016, Chinese residents began splurging on borrowing, most of it in the form of mortgages—as well as untold sums of high-interest personal loans—to buy increasingly pricy homes. With somewhere around $6.8 trillion in personal debt, with most wrapped up in real estate, the risks of a sharp drop in prices setting off a financial crisis akin to that of the US or Spain in 2008 are rising. The alternative, however, is only slightly less ominous.

New analysis reveals that consumer debt rose at a much brisker clip than the GDP or household disposable income. Thanks in large part to this latest home-price boom, Chinese consumers are now stuck shelling out more of their income covering debt payments than ever before—and a greater share of their incomes than their counterparts in the US, Germany, France, or Japan. If this continues, Chinese consumers may soon find themselves too overwhelmed by debt payment to power the consumption boom foreign companies, trade partners, China’s own leaders, and, indeed, the world economy have been counting on.

China’s “silver bullet”?

Chinese consumers are different from those pretty much anywhere else. In most places, everyday consumer spending contributes somewhere between half and two-thirds of national economic output. Not, however, in China.

Chinese shoppers weren’t always so unusual. In 1990, domestic consumer spending’s share of real GDP was about 60%, according to the Penn World Table, a database of national accounts. That share plunged in the decades that followed—by a far greater magnitude than normally happens when a country industrializes.

The flip-side of this was an over-reliance on investment and exports to power ultra-fast growth, which resulted in wasteful corporate spending—and, as a result, outstanding corporate debt of at least $20 trillion.

The world has been waiting for China’s economy to shift back to a greater dependence on domestic consumer spending. Over the last three decades, scores of multinational companies have set up shop in China, making expensive bets that consumer demand—pent up after decades of privation under Communist Party economic mismanagement—would finally be unleashed, promising huge profits on everything from fast food to SUVs.

Real consumer spending has indeed surged since the late 1990s, turning China into the planet’s second-biggest consumer market. But that boom was vastly smaller than it should have if Chinese consumer spending grew at the same pace as GDP. For instance, if consumption levels had stayed at the level they were in 2000, Chinese households would have consumed an average of nearly $1 trillion more a year over the next 12 years, according to one study.

Most companies have done fine. Some—GM and Apple spring to mind—have even come to rely on Chinese consumption. (China is, after all, a vast market, and wages—and therefore buying power—have been rising swiftly.) But despite frequent lip service from the government about the need to “rebalance” back toward consumer spending-driven growth, the much-anticipated Golden Era of the Chinese middle class consumer never dawned.

The back-up engine

For economists and other observers, the chronic thrift of Chinese consumers has long implied the existence of a backup engine for when growth stalled and corporate debt maxed out.

“For years, there was this idea that China’s silver bullet for an economic slowdown was its high household savings rate,” says Andrew Polk, economist at Trivium, a Beijing-based research firm.

This was the flip-side of China’s under-consumption: Consumer balance sheets were pristine. If the government needed to unlock consumption potential, Polk said, they could always encourage household borrowing, with more favorable mortgage policies, for example, or encouraging expansion of credit card issuance. Indeed, in 2016, the head of China’s central bank and the all-powerful State Council (pdf, p.415) both declared as much.

Suddenly, however, what had been a rainy-day abstraction became a reality. Chinese consumers are now deep in debt.

The Bank for International Settlements calculates that individual Chinese borrowers owe $6.8 trillion, as of December, up from $4 trillion three years earlier, much of it for home mortgages.

The “silver bullet” economic stimulus that Polk mentioned hinges on the fact that when people borrow, they have more cash to spend—for instance, to buy a new car. Those who purchase new homes through mortgages might increase their spending to furnish their apartment, because their new monthly mortgage payments are less than their rent was, or because owning a home makes them feel more financially secure.

Given the staggering scale and pace of this recent household credit binge, that should have boosted consumer spending. However, any such effect was temporary at most.

Last year, auto sales fell for the first time on record. Apple and Starbucks (paywall) surprised shareholders with warnings about weak China earnings. More general measures of spending have faltered too. So what’s behind the silver bullet’s misfire?

Wage growth, for one thing. According to Polk, annual salary increases that had been in the double-digit growth a few years ago have since slipped into the low single-digits.

Then there’s the impact of the recent consumer borrowing stimulus to consider—specifically, the cost of monthly interest and principle payments, says George Magnus, an Oxford University economist and author of Red Flags: Why Xi’s China Is in Jeopardy. And indeed, this is where the picture gets troubling. But to understand why, it helps first to understand the origins of Chinese households’ unusual zeal for real estate.

The origins of China’s real estate mania

China’s housing market is an economic marvel. In most countries, a 30% surge in home prices every couple years would swiftly give way to financial crisis. Not in China. Its housing market is yet another example of the country’s eerie, and widely envied, immunity to market consequences.

Its crash-proof nature is all the more astonishing given that home ownership is among the highest on the planet. Back in 2015, more than nine in every 10 urban households already owned at least one home, according to a recent survey by China’s Southwestern University (link in Chinese). And not only is home ownership unusually high; so is multiple home ownership. It’s common for owners to keep their apartments empty, foregoing rental income, since unlived in apartments tend to have better resale value.

Small wonder, then, that housing accounts for around four-fifths of Chinese household wealth, according to Wei Yao, economist at Société Générale.

A clue to this puzzling phenomenon lies in the way the Chinese government manages its financial system. To create the cheap pool of savings needed to fund hyper-industrialization, the authorities have long barred households from investing outside the country. That has left them with few—and mostly lousy—options for preserving the value of their savings.

1 The government had begun loosening these restrictions a little starting about a decade ago. However, in the last, facing a rising specter of capital flight since 2015, it has since tightened them once again.

There was one major exception. In the late-1990s, the government privatized the housing market, allowing resident families to buy their apartments from the state-owned companies that owned them—and for a huge discount. These dingy apartments were on the most coveted plots of city real estate, and as China urbanized, their value rocketed. These served as original stakes of wealth that households sold at a massive profit, funding still more home purchases.

“Commercial apartment units have been far and away the best-performing assets for the Chinese investor,” wrote Anne Stevenson-Yang, founder of J Capital Research, a China-focused research firm based in Hong Kong, in a May 2018 note. Official home price data—which have tended to understate sharp rises in home values—show that prices fell only once in the two-plus decades since China privatized housing. (And that year, 2014, average prices were still 9% higher than two years earlier.)

“So in the worst year historically for Chinese housing, in the worst local markets, investors still made 4.5% on a two-year investment,” she said. “This is a much better proposition than, certainly, the stock market, which has led to heavy real losses for retail investors more years than not, or average yields on bank wealth products over the same period of time.”

Thanks to the sure bet provided by property investment, China’s economy has become disproportionately reliant on the real estate industry to keep growth aloft. Beyond spurring construction, it also boosts consumer spending—on things like new washing machines and furniture—as well as banking and manufacturing. Counting the knock-on effect to other sectors, economists estimate that real estate activity contributes somewhere between 20% and 30% of China’s GDP.

The problem is, the economy—and, therefore, income growth—has been slowing. That means keeping the Chinese housing market chugging along requires that new homebuyers rack up more and more debt.

Risky borrowing takes off

That’s what happened in 2016, when a home price rebound set off a parallel jump in mortgage debt. But the soaring cost of housing has become a growing source of urban popular outrage (particularly among younger workers keen to live on their own, but whose earnings barely cover mortgage payments). To keep the lid on home-price froth, the authorities pressured banks to curb mortgage loans, raised mortgage interest rates, and increased the requirements for down payments.

That backfired, big time.

Though property sales slowed somewhat, people didn’t stop buying homes. Instead, they supplemented their mortgage borrowing with higher-interest consumer loans, including from ultra-dodgy peer-to-peer (P2P) lending platforms, said Ernan Cui, an analyst at Gavekal Dragonomics, a research firm in Beijing and Hong Kong, in a recent note.

2 P2P refers to online platforms that connect would-be borrowers with individuals looking to lend their savings for a hefty enough return—thereby cutting out banks and other traditional financial intermediaries.

So how much has this consumer borrowing binge strained household budgets? It’s hard to know; the only publicly available estimate comes from the People’s Bank of China, which puts the debt service ratio at 9.4% at the end of 2017 (pdf, p.39, link in Chinese).

However, in a note published last month, Cui reported the results of her own estimates. As of the end of 2018, China consumers were forking over between 8.1% and 11.3% of their disposable income (depending on which calculations of household income used) to keep current with monthly interest and principal payments. However, including high-interest borrowing conducted via P2P platforms and other non-bank financing would likely push this burden even higher.

That puts China in the middle-upper range of global household debt-service burdens. More worryingly, though, is that it seems likely to climb in that ranking.

“If these trends continue, China’s debt-service ratio will likely reach 12-13% in no more than three to four years’ time,” Cui says. “This may not prove to be a hard ceiling, but relatively few countries have sustained debt-service ratios above this level.”

Putting it all together

So what happens when consumer borrowing bonanzas finally ends? The most notorious way debt-service ratios tend to fall is through housing market crashes; over time, the mass foreclosure and consumer belt-tightening that follow tend to bring debt-service burdens down to more manageable levels. That’s what happened in the US and Spain over the last decade or so.

Even without a housing market meltdown, though, when consumer debt rises suddenly and sharply, economies suffer. Research on 30 countries from 1960 to 2012 by Atif Mian and Amir Sufi, two leading scholars of debt dynamics, found growth slows after booms in consumer borrowing. (Interestingly, that was true only of household—and not corporate—borrowing.) What’s more, the burden of debt service accounts for almost all of the hit to growth, according to follow-up analysis by BIS economists (pdf, p.22).

The risks might be even greater for China than other countries’ fates suggest. Thanks to the central role real estate plays in powering the Chinese economy, its leaders faces a nasty dilemma.

If they curb credit growth and home-buying too much, it will be near-impossible to hit the 6%-plus official growth target (an aim of unique political urgency this year, which happens to be the 70th anniversary of Mao Zedong’s proclamation of the People’s Republic of China). But that might let Chinese households clean up their finances, increasing the chance that they’ll eventually start spending on goods instead of mortgage payments.

3 To its credit, the government has rolled out a series of fiscal stimuli aimed at households, including personal income tax cuts and subsidies for electric appliances and vehicles. That should help revive consumption a bit, though it's still too early to tell by how much. Separately, the government's aggressive crackdown on P2P lending improves the outlook for household balance sheets.

On the other hand, another round of loose lending will undoubtedly let China reach its politically sacred GDP goals. Home prices will, of course, shoot up too—and with it, the household debt burden.

The authorities seem to have opted for the latter course. That will let jittery global investors and central bankers relax a little. And foreign companies will welcome the (temporary) reprieve from uncomfortable China-related earnings revelations. For a while anyway. The odds are good that in a couple years, China will find itself in the exact same place—but with more household debt, more empty houses, and even less means of paying for it.