Red ink rising | The Economist

An IMF working paper published last year identified credit growth as "the single best predictor of financial instability". Yet China is not obviously vulnerable to the two most common types of financial crisis. The first is the external sort, like Asia's in 1997-98. In such cases, foreign lending sparks a boom that eventually fizzles, prompting loans to dry up. Firms, unable to roll over their debts, must cut spending to save money. As consumption and investment slump, net exports rise, helping bring in the money needed to repay foreign creditors. China does not fit this mould, however. More than 95% of its debt is domestic. Capital controls, huge foreign-exchange reserves and a current-account surplus help defend it from capital flight.

The other common form of crisis is a domestic balance-sheet recession, like the ones that battered Japan in the early 1990s and America in 2008. In both cases, dud loans swamped the banking system. Central banks then struggled to keep demand growing while firms and households paid down their debts.

China's banks are certainly at risk from a rash of defaults. Markets now price the big lenders at a discount of about 30% on their book value. Yet whereas America's Congress agreed to recapitalise banks only in the face of imminent collapse, the Chinese authorities will surely be more generous. The central government's relatively low level of debt, at just over 40% of GDP, means it has plenty of room to help the banks. Indeed, with the right policies, China could survive a deleveraging without too much pain.

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China's government seems determined to prop up the yuan. But it may struggle to do so while the economy deleverages. The grinding recovery that would imply has political costs. And cutting rates to boost borrowing elsewhere in the economy would place further downward pressure on the yuan, forcing the government either to tighten capital controls yet more, run down its foreign-exchange reserves or let the currency drop.

With a deft enough touch, China's debt bomb could fizzle. The rapid pace of credit growth makes a benign outcome ever less likely, however. Given China's size, a prolonged deleveraging would place a dangerous drag on global demand growth, which the world's weakened economies would struggle to cope with. The sooner China turns off the credit taps, the better.