China's debt problem is serious, but the risk of a hard landing or banking crisis is, in my view, low. The reason is that the potential bad debts are corporate, not household, debts and were made at the direction of the state—by state-controlled banks to state-owned enterprises. This provides the state with the ability to manage the timing and pace of recognition of nonperforming loans. It is also important to note that the majority of potential bad debts are held by state-owned firms, while the leverage of the privately owned companies that employ the majority of the workforce and account for the majority of economic growth isn't high. Additional positive factors are that China's banking system is very liquid, and that the process of dealing with bad debts has begun.

Cleaning up China's debt problem will be expensive, but will not likely lead to the dramatic hard landing or banking crisis scenarios that make for a sexier media story.

This is the first of a three-part Sinology looking at what could go wrong in China. Part II will discuss the risk of a property bubble, and Part III will explain why the absence of the rule of law is a serious long-term risk.

In the beginning: a response to the GFC

The origin of China's debt problem was the 2007 to 2008 Global Financial Crisis (GFC). Prior to that point, China's debt-to-GDP ratio* was relatively low and stable.

The GFC led to a collapse in global demand for goods, including exports from China. As Chinese exports plummeted, many factories closed and an estimated 20 million workers lost their jobs. The government was concerned that this spike in unemployment—primarily of young workers who left rural homes for urban manufacturing jobs—might lead to social unrest.

The government rejected the idea of a large currency devaluation to boost exports because the problem was lack of demand in markets such as the U.S. and Europe, not weak competitiveness of Chinese goods.