Chinese banking narrowly avoided a high profile embarrassment last week after the Industrial & Commercial  Bank of China Ltd announced that holders in a financial product issued by China Credit Trust could redeem their funds by selling out to unidentified buyers, according to an investor quoted by Bloomberg.

See Charlene Chu’s GS interview on China

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The prospect of the default had engaged international attention and was particularly ill-timed considering the global turmoil emanating from emerging countries in recent days.

China’s insidious shadow banking industry

Yet the incident was a chilling reminder that China’s vast shadow banking industry was really joined at the hip with its official banking sector, a fact often asserted by Charlene Chu, a banking analyst formerly employed by Fitch.

Chu has often been unpopular in Chinese financial circles for her frequent criticism of the massive credit expansion unleashed by the country in an effort to prop up GDP growth through a housing and infrastructure boom of unheard-of proportions.

Chu estimates that the $15T credit expansion (bubble?) also helped spawn a huge shadow banking industry that remains mostly unregulated and is the purveyor of loans and credit that rival the mainstream banking system in scale.

“The banking sector has extended $14 trillion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China,” says Chu in an article by the Telegraph.

Of ghost towns and real estate bubbles

Chu has also made no secret of her observations during travel inside China of vast “ghost towns” that are on paper occupied and thriving, but in reality are empty and deserted save for skeleton maintenance personnel – a clear indication according to Chu of a real estate bubble.

Chu worries that these trends could culminate in a financial crash that could stamp out growth in a vast country that does not have strong social safety systems in place as in the developed markets.

“To me, it’s much less about how much the sovereign issues in terms of debt to bail out the financial sector. It comes down to how much of a hit does growth take and what is the impact of that on the populace and do we start to have any other issues that arise from that?” asks Chu.

Low foreign debt

One blessing, according to Chu, is the country’s low level of foreign debt – the reason why the situation in China has been stable up to this point. But unless things are taken in hand, this too could change. According to reports, mainland borrowing of offshore funds from Hong Kong has already crossed the $1T mark.

Chu also rejects a view that in the event of a crisis, the PBOC could use its foreign reserves to effect a rescue of the system. “I believe they can’t be used in their entirety by any means because they are offset by the other side of the balance sheet of the PBOC [People’s Bank of China],” she avers.

Chu currently works for Autonomous, a reputed international research firm.