Pessimists worry about a catastrophic crash in China. Optimists are more sanguine, expecting a soft landing with gradual reforms correcting the systemic issues.
The crash scenario is predicated on continuing increases in debt levels and over-investment. Policy adjustments are fatally delayed. Ultimately, authorities are forced to tighten credit, triggering failures in the financial system and a sharp slowdown in growth.
Weaknesses in financial structure exacerbate the money-market tightening, causing liquidity-driven problems for both vulnerable smaller banks and the shadowbanking entities.
The rapid decline in credit availability results in problems for leveraged borrowers, such as those in local governments and property sectors.
The larger banks are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadow-banking sector due to risk aversion or regulatory pressures.
The deceleration in credit growth and liquidity results in lower levels of economic activity. Foreign-capital inflows, which have enabled the People's Bank of China to provide liquidity to the financial system, slow and then reverse.
At the same time, capital outflows, especially from corporations and also the politically wellconnected and wealthy, increase, drive further contraction in credit.
Optimists counter that debt levels are manageable because of high growth rates, the domestic nature of the debt, high savings rates and the substantially closed economy.
They argue that the banking system has low leverage, a large domestic funding base and low levels of non-performing loans. They also rely on the high level of foreign-exchange reserves and modest levels of central government debt.
They believe reform programmes will ensure a smooth transition. China will rebalance its economy from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.
The central government is seeking to steer a middle path, which is both difficult and has significant risks. The strategy will entail continued credit expansion, providing liquidity, managing non-performing assets and using transfers from households to the financial and corporate sector.
The central bank will continue to provide abundant liquidity to the financial system. The authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years.Defaults in the shadow-banking sector will also be managed.
Where appropriate, banks and state entities will intervene to minimise investor losses by taking over the loans or reintegrating assets into regulated banks. Non-performing loans will be sold to asset-management companies to avoid a banking crisis.
In effect, instead of resolving the debt problems, the Chinese government will oversee a process of supporting overindebted borrowers and the banking system.
As in a shell game, bad debts will be shuffled from entity to entity, delaying the recognition of losses. The ultimate price of this strategy will be to lock the Chinese economy into a lower growth path with the risk of a destabilising crash.
Over time, increasing amounts of capital and resources will be locked into unproductive investments which do not generate sufficient returns to service the debt incurred to finance it. The cost will be borne by households, with slower improvement in living standards and erosion of the value of their savings.
Authorities will have to keep saving rates high to provide the capital needed to pursue this strategy. They will ensure that the bulk of funds remain in the form of lowyielding deposits with policy banks, which can be directed by the central government as required. Interest rates will remain low, below inflation.
Banks will need to maintain a large spread between borrowing and lending rates to ensure sufficient profitability to absorb the cost of non-performing loans. Borrowing rates and the cost of capital will also need to be kept low to support the investment strategy and also reduce pressure on unprofitable or insolvent businesses.
The loss of purchasing of household savings will provide the economic basis for the transfer of resources, amounting to as much as 5 per cent of GDP, to banks and borrowers, primarily state-owned enterprises and exporters.
The necessity of high saving rates will impede the rebalancing from investment to consumption. It will also impede the development and deepening of the financial system. In addition, China will have fewer resources available to improve health, education, aged care and the environment.
In the short run, continued malinvestment and deferring bad-debt write-offs will provide the illusion of robust economic activity.
Over time, households will discover that the purchasing power of their savings has fallen. Wealth levels will be reduced by the decline in the prices of overvalued assets. Businesses and borrowers will find their earnings and the value of their overpriced collateral are below the levels required to meet outstanding liabilities.
China's Potemkin economy of zombie businesses and banks will create progressively less-real economic activity.
Satyajit Das is a former banker and author of 'Extreme Money' and 'Traders, Guns & Money'
Continued malinvestment... will provide the illusion of robust economic activity