Debt at the local level, too

The problems of local government lending -- local governments have set up an estimated 10,000 investment companies -- make the capital requirements of the big Chinese banks look like pocket change. Local government debt is officially estimated at $1.68 trillion. Not all of that consists of loans to businesses. Some of it represents debt that local governments took on for their own projects.

Whether to companies or to the governments themselves, many of the loans share two problems. First, the projects the loans funded aren't generating returns large enough to pay the interest on the loans, let alone pay them off. In some provinces, estimates say as much as 85% of such loans have gone bad.

Second, the loans ultimately rest on real-estate collateral. Local governments have relied on land sales to make up for insufficient tax revenues. Borrowers from local governments used land to back their loans. But now the volume of real-estate sales is falling, and so, too, is the value of the land used as collateral.

The result has been a kind of national fire sale, with companies and local-government-affiliated investment companies selling off assets to meet their debts. The State Assets Supervision and Administration Commission sold off $487 million of corporate assets between January and June of 2011, reports the Financial Times. That compares with sales of $346 million in all of 2010.

But as quickly as the pace of asset sales is increasing -- and we're looking at a 40% increase from the 2010 total in just the first half of 2011 -- the proceeds are wildly inadequate for addressing a $1.68 trillion problem.

The unofficial debt collection

And let's not forget the third part of this problem, the unofficial financial system of trust companies, private banks and completely off-the-books lenders. This world has grown, thanks to an official government policy that capped interest rates for bank depositors below the inflation rate. Money fled that money-losing proposition to unofficial lenders paying higher rates for deposits because they were charging, not the official 6.5% rate for a loan, but 30% to 70%.

Who would pay that kind of rate? Companies cut off from the official banking system when Beijing restricted credit to slow the economy, that's who. Big, state-owned or well-connected companies didn't have problems getting loans. Small and medium-sized businesses, though, borrowed from this unofficial banking system or they didn't borrow at all.

No one knows how big the unofficial financial system is, but it is large. (China's big banks helped fund some of these unofficial lenders as a way around Beijing's efforts to tighten credit.)

Nomura Securities estimates that loans in China's unofficial financial system rose to $1.65 trillion in the first quarter of 2011 and now make up about 20% of all loans outstanding.

No one knows, either, how many of these loans have gone bad or are at risk of going bad. But China's press is starting to report scattered anecdotes of local business owners who have gone into hiding in an attempt to avoid some of the more-violent methods of debt collection used by some of these unofficial lenders.

How big is the debt bomb?

If you put all these numbers together, the total gets very large very fast. Nomura estimates that if China's government were to assume responsibility for all this debt, the country's debt-to-GDP ratio could top 135%.

That's higher than Italy's 120%.

It's clear that China won't assume all this debt. But, this being China, where the economy mixes the government and private realms in a sometimes-capricious manner, there's no telling where the line will be drawn.

Yes, China will have to spend some of its reserves and construct some of its patented you-buy-my-bonds-and-I'll-buy-your-bonds investment vehicles to capitalize its big banks. It will have to find a way to bail out local governments and at least some of the government-affiliated lenders. I think it's likely that China will set up special-purpose financial vehicles, as it did after the Asian currency crisis of 1997, to bury some of this debt. What Beijing will do about the unofficial financial system is anyone's guess at this point. Mine would be that each unofficial lender will wind up with an individual deal that reflects its clout with officials in the national or local government -- or with those officials' children.

One of the reasons China's leadership so fears slowing the economy too much is that slow growth makes all these problems worse by increasing the rate at which loans go bad. This is one reason I think the People's Bank will start to loosen credit and cut interest rates as soon as it can without losing face. Look to the September inflation numbers, due to be released Oct. 14. If inflation drops again -- from August's 6.2% to, say, 6.1% or 6.0% -- I think we might see interest-rate cuts before the end of this year.

That, of course, would be exactly the kind of big money commitment -- not a paltry $30 million -- investors in Shanghai, Shenzhen and Hong Kong are waiting for.

The coming 'kick the can' rally

At this point, you're entitled to shake your head and say, "But that won't solve anything. It's just papering over the problem."

And I'd reply, "Exactly. It's the Chinese version of the game of 'kick the debt can down the road' that the United States is playing with its debt and that the eurozone is playing with its debt."

Can everybody put off paying the piper forever? No way. Are things going to get really nasty -- so nasty that 2011 might seem like the good old days -- when the bill comes due? You bet.

Does that mean there won't be profits to be made by cynically holding your nose and investing in the moment? Of course not.

The grasshopper had a great time singing, "Winter is far away, and it is a glorious day to play."

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All we have to do is figure out a way to enjoy some of the profits of summer and avoid freezing to death when winter comes.

That's all. Piece of cake.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages,Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did not own shares of any stock mentioned in this column as of the end of June. Find a full list of the stocks in the fund as of the end of June here.

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

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Stocks mentioned on previous page: Bank of America (BAC, news), China Construction Bank (CICHY, news) and Bank of China (BACHY, news)