China’s debt bomb

June 28, 2011, 6:41 PM UTC

As the world watches the Greek credit crisis unfold, a Sino-debt disaster is brewing halfway around the world.

Jim Chanos, the hedge fund manager who is famously shorting China, told Fortune late last year that the country was “embarking on something unprecedented.” He was referring to the massive construction boom that has been underway for years, and that was supercharged by a 2008 stimulus package that pumped four trillion yuan ($586 billion) into the economy. In his opinion, the speculative bubble in real estate would end in a big pop, empty buildings, and pain for the country’s broader economy.

For those who side with team Chanos, data is seeping out of China that suggests that he may right.

Most recently, China’s top auditor said that loose lending standards and a sharp rise in local government borrowing (for building projects, of course) may have created a mountain of debt that cannot be repaid, reports the New York Times. All it will take is a fall in housing, or some sort of economic slowdown, to reveal an untold number of bad loans.

In a speech that coincided with the release of the government report, the head of China’s national audit office Liu Jiayi said Monday: “The management of some local government financing platforms is irregular, and their profitability and ability to pay their debts is quite weak.” Audit officials and Chinese central bankers say that local government debt accounts for between 27% and 30% of China’s GDP, and totals $1.7 trillion to $2.2 trillion. Those numbers come in higher than estimated. The Times notes that borrowed money has been used to finance not only real estate construction, but also low-return infrastructure projects like bridges, tunnels, subways, and roads.

The estimated 6,500 to 10,000 local government investment companies created to borrow money have made a construction boom that has kept China’s export-reliant economy from feeling the extreme pain of the global economic slowdown.

Despite talk of a burgeoning middle class that can support the Chinese economy with consumption, the country still relies on exports to keep the economy growing fast enough to create jobs for its large population. It takes a per-capita GDP of $5,000 to create meaningful discretionary spending power in China, writes economist A. Gary Shilling. But Shilling says only about 8% of the population has that kind of economic clout. And with inflation threatening to run out of control, citizens will need higher wages, too.

What’s happening in China should sound familiar because it is reminiscent of what happened here in the US. Confronted by an economy that couldn’t deliver real wealth to the people, our bureaucrats loosened borrowing standards in the 1990s. The result: an uptick in local government spending, a real estate bubble that made investors feel artificially wealthy, a construction boom that created jobs, and debt that can’t be repaid.

China even exacerbated the credit problem with securitization, just like we did, spreading potentially toxic loans around to investors. So-called informal securitization became popular (but was then frozen in 2010) in China, according to a special report published last year by Fitch Ratings. This simply means that the Chinese re-packaged bank loans (rather than mortgage-backed bonds) into investment products. The trend “[distorted] Chinese banks’ credit data at an institutional and system level, resulting in pervasive understatement of credit growth and credit exposure,” according to a statement from Fitch.

Just like in the US, securitization and off-balance sheet accounting was encouraged by banks that wanted to adjust their loan balances and investors who wanted higher yields, said Charlene Chu, the head of Fitch’s Chinese bank ratings. And since China’s credit-backed investment products have been treated like ultra-safe bank deposits, investors believe that they carry an implicit guarantee, according to Chu. Fitch’s Chu remains worried about China, and has recently said that the country has been dependent on loose credit to grow.

At the end of the day, Chanos will probably be proven right on China; but he erred when he said that the country was embarking on something unprecedented. The country is making the same lend-and-pretend-that-the-loans-are-good gamble that the world’s largest economies have all made. And as you can see from what has happened in the US and all over Europe, it’s a losing bet. The question is not whether China will hit the debt wall, but when.