As more bad economic news continues to filter out of China, most eyes have been fixated on the volatile fluctuations of the nation’s equity markets and the potential spillover effects reverberating throughout the United States and Europe.

China’s crashing stock market comes as the result of its slowing economy, and it will compound the nation’s problems as its incipient investing class has been losing a lot of money with each successive market tumble. But it’s important to remember that while stock market shifts may grab headlines, it is the debt markets that truly determine the fate of an economy.

In the United States, the financial system nearly collapsed after the nation’s most systemically important financial institutions bet on the idea that real estate prices would continue to rise forever, or that financial engineering would save them when prices finally did fall. In China, the real estate market works much differently, but it remains the driving force behind a massive debt explosion that now threatens its entire economy.

In the U.S., it was collateralized debt obligations that helped create the demand to invest in residential mortgages, with debt being issued to homeowners, many of whom would end up not being able to repay after the bubble burst. In China, there is no private land ownership like there is in the United States, and so there isn’t a problem of average citizens taking out mortgages they can’t pay back. Instead, local governments, motivated by their inability to levy taxes, have increasingly relied on “local government financing vehicles” (LGFVs) to finance infrastructure projects. As Liao Fan, a professor at the Chinese Academy of Social Sciences has written:

Though dressed up as business corporations, LGFVs have been more of a disguised arm of local governments. Their most—or even only—reliable asset is land. Often empowered by local governments as land banks, they use land as the main collateral to secure long-term loans from China Development Bank (CDB), originally a policy bank but has gone far beyond that over the years. With this initial funding, LGFVs are able to start operation and borrow further by seeking short-term loans from the state-owned commercial banks or selling bonds on the inter-bank bond market. Since the proceeds from selling or developing land are the main source to repay such debts, local governments behind LGFVs have all the reason and incentive to expropriate more land and keep the property price at a high level, so as to continue the cycle.

Local governments have borrowed this money with the blessing of China’s central government. In fact, China’s much-lauded $570 billion stimulus package in 2008, which dwarfed the American response to its crisis relative to each country’s respective GDP was funded mostly by local government debt. That program helped power China’s economic growth since 2008, but the dividends are now drying up. As Chinese growth slows, the central government is worried about the local governments’ abilities to finance the debt.

China could continue to kick the can down the road by bailing out its insolvent local governments. But this would run counter to President Xi Jinping’s efforts to curb the power of local officials and shift China’s growth model from investment led to consumption led. Last week, Beijing placed a $16 trillion yuan cap on Chinese government debt, up $600 million yuan from a cap it set last year. And this is after the government has been swapping debt with local governments, buying up real estate-financed local debt in place of government debt officially backed by the Chinese government.

 

As Bank of America’s David Cui points out, this strategy could lead to “some defaults … reasonably soon,” since this cap will effectively prevent some local governments from rolling over debt it can’t currently repay. And the central government’s apparent unwillingness to extend more credit to local municipalities is lending credence to critics of the 2008 stimulus package, who argued that while it may have given a short-term boost to the economy, the long-term effects to the Chinese economy would be deleterious because these local governments weren’t investing in projects that made economic sense.

Only time will reveal the full magnitude of China’s economic slowdown. But if we are nearing a financial crisis in the world’s second largest economy, the debt markets will be the first to crash.