By Ambrose Evans-Pritchard at The Telegraph
Bad debts in the Chinese banking system are four or five times higher than officially admitted and pose a mounting risk to the country's financial stability, the world's leading expert on debt has warned.
Harvard professor Ken Rogoff said China is the last big domino to fall as the global "debt supercycle" unwinds. This is likely to expose the sheer scale of malinvestment that has built up during the country's $26 trillion credit bubble.
Prof Rogoff said the official 1.5pc rate of non-performing loans held by banks is fictitious. "People believe that as much as they believe the GDP data," he told the World Economic Forum in Davos.
The real figure is between 6pc and 8pc. He warned that unexpected problems can come "jumping out of the woodwork" once a debt denouement unfolds in earnest.
Banks are disguising the damage by rolling over bad loans and pretending all is well, with the collusion of regulators, but this draws out the agony and ultimately furs up the financial arteries.
Ray Dalio, founder of Bridgewater, said the worry is that credit in China is still growing faster than the economy even at this late stage, storing up greater problems down the road. The efficiency of credit has collapsed. It now takes four yuan of extra debt to generate a single yuan of economic growth, compared to a ratio of almost one to one a decade ago.
China's foreign reserves have dropped by $700bn to $3.3 trillion as capital flight overwhelms the inflows from the country's trade surplus. Mr Dalio said the historical pattern is that falls of this magnitude are typically followed by 25pc devaluation.
"It is not always easy for governments to maintain clear control over the currency," he said. A major Chinese devaluation would be a global earthquake, transmitting a wave of deflation through a world economy already uncomfortably close to a deflation-trap.
Fang Xinghai, a top financial adviser to Chinese president Xi Jinping, said his country is absolutely committed to the defence of its new trade-weighted currency basket. "It is the decided policy of China," he said.
Analysts say the central bank (PBOC) spent roughly $140bn defending the yuan in December, clear evidence that they have pinned their colours to the mast.
Mr Fang admitted that the switch from a crawling dollar peg to the new regime had been badly handled.
"We're learning. We have to do a better job. Our system is not able to communicate seamlessly with the markets," he said.
Yet he insisted that the yuan has been been basically stable on basket-basis for several months and stressed that the country is a net creditor with little reliance on foreign funding."We have a sizeable current account surplus. There really is no basis for China to depreciate the currency," he said.
Mr Fang said a devaluation goes against the whole thrust of policy and the Communist Party's strategic switch to consumption-led growth.
"China is different from other developing countries. Our growth is largely fueled by domestic savings and capital. That gives us confidence to deal with whatever risks come out of financial markets," he said.
"If China was relying largely on foreign capital, you bet, any major financial risk could derail our growth. But China is different and this is a fact that a lot of people need to pay attention to," he said
Christine Lagarde, head of the International Monetary Fund, said the yuan has been "quite stable" against the new basket, and she berated the markets for its outdated fixation with a dollar-yuan rate that no longer has any relevance.
The problem is that investors are not entirely convinced that Beijing candefend the exchange rate even if it wants to.
"Most market participants believe that China will devalue the currency further," said Gary Cohn from Goldman Sachs.
He said it was likely authorities would engineer a depreciation to address slowing growth, adding that capital now moves across borders at the "speed of light".
The more China burns through reserves to offset capital outflows and hold the line on the yuan, the more it tightens internal monetary policy - a variant of the 'Impossible Trinity'. This worsens the credit crunch and causes yet more bad debts. China may be forced to pick the lesser of two poisons.
Yet opinions in Davos on China are deeply divided. Zhang Xin, founder of the property group Soho China, said stories of a property crisis are greatly exaggerated, insisting that the 'new economy' companies and internet firms are snapping up real estate for let. "We don't see a single building empty," she said.
"The economy seems to be doing alright but the stock market is trading at a huge discount. The message is not getting through," she said.
Nouriel Roubini, the former "Dr Doom" now turned semi-optimist, said markets have a manic depressive reflex on China, swinging from "excessive optimism to excessive pessimism."
"A year ago they believed the rhetoric that China could achieve a soft landing, and that the Chinese were a bunch of super heroic technocrats who could not do any wrong. And now they have gone to the other extreme, saying the policymakers are incompetent; they lie and cheat; that growth is not 7pc or 6pc, that it's 4pc, or zero," he said.
Mr Roubini said that reality is that China will muddle through with neither a soft landing or a hard landing. "It’s a bumpy landing, but the good news is that eventually the markets will calm down.”