China may be one of the fastest growing economies in the world, but analysts say that the country’s bad corporate and local government debts have reached alarming levels. Societe Generale economist Wei Yao said in a research report that China’s corporate debt is now 1.5 times the size  of economic output of the world’s second largest economy. Debts above 120 percent of annual economic output are considered alarming.

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What’s worse is that the situation has become more like a Ponzi scheme. About one-third of Chinese firms are borrowing further money to pay hefty interests on their existing debts. In an interview with Michael Janda of ABC News, Wei Yao said that there could be two potential outcomes of the current situation. One, a consistent slowdown in China’s economy and two, a Japan-like collapse followed by a long-term recession.

China’s Rising Debt Doesn’t Help GDP Growth

Another big problem is that though corporate debt is increasing, it’s not generating much of a real growth. The rising debts could translate into real GDP growth because they go to interest and principal payments. So, the companies are borrowing more to pay interests and roll over the principal. That’s why debt is increasing without any positive impact on GDP. Wei Yao estimates that about one-third of Chinese firms are finding it hard to fulfill their debt obligations.

Yao said China is now engineering a slow-busting scenario in a multi-year process, rather than having a big crisis. That will prove painful in the mid-term. Societe Generale expects China’s economic growth to decline every year for the next five years at least. The growth is expected to come at 7.6 percent this year, 7.4 percent next year before falling below 7 percent.

Another Societe Generale analyst Albert Edwards said that China’s total debts rose at more than 20 percent in the first quarter this year. That’s more than twice the growth rate of China’s GDP. In fact, China’s credit growth has been higher than the country’s economic growth for the past five years.

Since 2009, China’s credit growth has been higher than the nominal economic growth in every quarter except Q4 of 2011. Meanwhile, shadow banking continues to rise. Last year, total bank loans grew at around 15 percent, compared to about 50 percent increase in loans through non-banking sources like trusts.

If you include non-bank debts as well, the country’s total debt has risen to 205 percent of GDP, according to the research firm CLSA. A large part of this debt growth came after the global financial crisis because China’s total debt stood at 148 percent of GDP in 2008, which soared to 205 percent by the end of 2012.

China’s Local Government Debt

The local government debt in China has swollen to about 20 trillion yuan ($3.2 trillion), according to ex-finance minister of China, Xiang Huaicheng. That’s almost double the figure reported by the National Audit Office in 2011. The combined debt of China’s local governments, including provinces and cities, is estimated to be 30 trillion yuan.

Over the past few months, China has tried to restrict local government borrowings due to concerns that banks will be burdened with bad debts. In 2011, the People’s Bank of China estimated that local governments had formed more than 10,000 financing arms to raise funds for the construction of bridges, road and sewage plants. That’s because local governments in the country have been barred from selling debts or directly taking bank loans.