China’s economy continued to chug along through the financial crisis, as other economic engines sputtered. But it’s becoming increasingly apparent that that stability came at a heavy price -- a huge expansion in debt that now threatens to destabilize the economy.

For China watchers, predicting the country’s imminent demise has been a fairly reliable gig since the late 1990s. The most famous of the China bears is Gordon Chang, an American lawyer who wrote in a 2001 book “[t]he People’s Republic has five years, perhaps ten, before it falls.” Ten years later, Chang doubled down on the prediction, writing in Foreign Policy magazine that his prediction was wrong, but only by a year. “Instead of 2011, the mighty Communist Party of China will fall in 2012. Bet on it,” Chang said.

Chang might be the most audacious of the China bears, but he’s far from the only one. In 2010, hedge fund manager Jim Chanos told Charlie Rose that China was “on a treadmill to hell” because “they can’t afford to get off this heroin of property development.” And Morgan Stanley Economist Andy Xie compared the Chinese stock and property markets to a horror movie. “People like to watch, but don’t want to be in it,” he said in 2014.

China has so far chugged along against all their predictions, lifting hundreds of millions of people out of poverty and engineering the longest high-growth episode that the world has ever seen. But now, as China’s growth slows, the returns on additional investment diminish, and foreign economies remain weak, the predictions of China’s perma-bears seem more ominous than ever.

Markets momentarily cheered last week when the Chinese central bank announced a monetary stimulus. China cut its bank reserve requirements. It’s questionable how much effect the cut will have, however, since there isn't much desire among businesses to borrow given relatively low demand for their goods and services.

The Chinese government is walking a thin line. If growth slows too much, companies in the indebted property and industrial sectors could begin to go bankrupt, posing a broader risk to the financial system. Stimulate too much, however, and China risks a further build-up in debt, as well as growing asset bubbles in an already over-heated property market.

Including borrowing by the government, banks, corporations and households, China’s total debt now equals 282 percent of gross domestic product, according to a recent report by consultancy McKinsey. That is far higher than the average for developing countries, and greater than the debt load of Australia, the United States, Germany or Canada.


McKinsey

What’s more concerning than the overall size of China’s debt is its fantastic pace of growth. China has accounted for more than a third of total debt growth since 2007, some $20.8 trillion. Put another way, China’s overall debt has quadrupled in just seven years, from $7 trillion in 2007 to $28 trillion in mid-2014.

The Chinese government has relatively little debt, and average people -- who only recently acquired credit cards and tend to pay big down payments when they buy houses -- have even less. China’s corporate sector, however, is one of the most indebted in the world. This debt is mostly concentrated in capital-intensive industrial firms, and, especially, among property developers.


The property sector occupies a special place in the Chinese economy. Property has long been a primary store of wealth for the Chinese middle and upper classes, since the country’s underdeveloped financial sector offers few other investment opportunities besides real estate and a notoriously volatile stock market. Property has also been a primary source of funding for most city and village governments. Unlike in most countries, local governments in China don’t have the authority to levy their own taxes or issue bonds (outside of a few trial programs). Instead, they’ve relied on selling local land to property developers to generate a big chunk of their revenues.

Property development has been a huge generator of wealth for the country in recent years, and it is now also a massive repository for its debt. Repeated wins in the property market encouraged some developers and financiers to take on risky and unnecessary projects, including miniature versions of Paris and Manhattan. McKinsey estimates that, excluding the financial sector, almost half of China’s debt is directly or indirectly related to real estate, about $9 trillion. The property market is very diffuse, with more than 89,000 mostly small property developers contributing about 15 percent of the country's GDP growth and accounting for 28 percent of fixed-asset investment.


McKinsey

The risk is that China's slower economic growth might reduce profits and thus result in defaults among some of these developers. Those defaults could potentially trigger other bankruptcies, perhaps ultimately destabilizing governments, households and the financial sector. As the McKinsey report says, “Throughout history and across countries, rapid growth in debt has often been followed by financial crises."

McKinsey and other analysts say that, should a property crisis occur, the Chinese government probably has the resources to bail the sector out. But as a middle-income country with a per capita gross national income of only $11,850 in 2013 in purchasing power parity terms, China could put its financial resources to much better use doing something else – such as expanding medical care or funding an insolvent pension fund system. Bailing out the property sector would diminish the government’s ability to spur growth later, perhaps resulting in a “lost decade” like that of Japan.

To avoid this fate, China needs to create the conditions for continued growth without expanding lending. This is a tricky task, but there are several ways that the government could encourage its corporate sector to deleverage.

First, China could carry out reforms to ensure that loans go to the most profitable sectors of the economy. According to McKinsey, this includes setting up independent rating agencies for banks, improving credit risk assessment, and increasing transparency across the financial system. The consultancy also argues for better data in the real estate system, which could help the market to identify when bubbles are forming, as well as an effective bankruptcy system to help companies discharge bad debt in an orderly way. In general, the government needs to continue toward its goals of liberalizing the financial system, increasing competition for capital and broadening and deepening financial markets to give ordinary people better ways to safely invest their money.

As Ryan Rutkowski of the Peterson Institute suggests, the government could also substantially reduce debt in the state sector by restructuring and selling off stake in state-owned companies to private investors, as it did in the 1990s. To discourage wasteful property development, China also badly needs to strengthen the ability of local governments to raise money, for example by expanding property taxes. Upper levels of government could also do a better job encouraging lower-level officials to focus on sustainable development, rather than launching capital-intensive projects that temporarily pump up GDP.

Even with these steps, China will face a substantial debt burden and the risks that accompany it for a long time. But if it hopes to avoid a financial crisis, the country has no other choice than to work down this debt. The recent increase in debt is unsustainable, and as the economist Herbert Stein famously claimed, if something is unsustainable, it will stop.