A rating above 10 indicates a banking crisis within the next three years.

The problem stems from the fact that Beijing has long relied on credit expansion to fuel its economic growth. This credit has been used to expand SOEs, build new infrastructure and government buildings, engage in property speculation, and, more recently, simply to pay down preexisting loans. According to The Economist, roughly two-fifths of all new debt goes directly toward paying interest from previous loans. Unsurprisingly, it’s getting more and more difficult to convert credit into productive GDP value.

The speed of China’s debt accumulation was singled out by the BIS as particularly worrisome. China’s total debt-to-GDP ratio grew to 255% this year, up from 147% in 2008.

Dealing with debt

The debt problem is obvious, but dealing with it is a question of political will. The issuance of new debt has ensured continued growth under difficult global circumstances; turning off the taps will slow the economic engine, which is a sensitive issue for the Party. The debate is surely playing out behind the closed doors of the Xi administration, as is the norm for Chinese politics. We caught a glimpse of it back in May, when an anonymous letter from a top official was published in People’s Daily. The letter took policymakers to task for allowing debt to balloon, warning that debt-fueled growth could not go on forever.

Many Chinese policymakers believe that now is not a good time to deal with the debt situation. China is currently facing a laundry list of serious, albeit manageable economic issues. Capital is flowing out of the country at a steady clip (2016 has seen $400 billion transferred offshore so far), foreign reserves are being drained to prop up the yuan, yet another property bubble seems to be inflating (Shanghai home prices rose 4.4% in August), the huge state-owned industry is largely unproductive and in need of reform, and memories of the stock market crashes of last year still remain.

These issues are contributing to pressure not to ‘rock the boat’ of economic development, and as a result debt continues to expand at a frenetic pace.

There are two takes on where this will all end. Some believe that the problem is controllable given the Chinese government’s large foreign reserves and the amount of government control in the Chinese context. China is still a close financial system, and most of the banks in question – and their debtors – are owned by the government. For now, bad debts can be rolled over at Zhongnanhai’s behest, corroding the productivity of the world’s second-largest economy. If things get really bad, the government can just step in and eat the write-off similar to TARP in the United States post-2009.

Others believe that the massive size of the problem makes it impossible to contain. Chinese banks now account for a staggering $34 trillion in assets. Should an inflection point be reached and non-performing loans start to erode asset prices, even a modest reduction would reverberate around the global economy.