The ongoing debate about Chinese growth, both how much of it is real and whether the government can reign it in gradually and avoid a crash, is about to be put to the test. Chinese development firm Zhejiang Xingrun Real Estate Co. is insolvent with 3.5 billion yuan ($562 million) in debt and its residential projects put on hold, Bloomberg reports, and this looks like just the beginning.

China Chinese

When booming GDP growth was the main priority, the Chinese government was content to allow lax lending standards to drive investment in projects that had little hope of becoming profitable. Many analysts understood that eventually the country would eventually need to replace its reliance on capital investment with increased consumption to keep GDP growth sustainable, but it never quite happened, and China’s manufacturing sector now has to compete with other Southeast Asian economies to keep exports high.

The question is what happens when more developers start going under and non-performing loans come home to roost.

China on verge of collapse: Rickards

“China is on the verge of a financial collapse of unprecedented magnitude,” writes James Rickards, portfolio manager for the West Shore Real Asset Income Fund, anticipating just such an occurrence. The problem, he argues, is that the government won’t be able to contain the fallout from these failing projects.

Rickards says that most Chinese investors have very limited investment options, spawning the creation of so-called wealth management products that are heavily exposed to companies like Zhejiang Xingrun Real Estate Co. and other unprofitable ventures, making them unable to achieve the rates of return that investors were promised.

“Banks cover this up by selling new products and using the proceeds to pay off the old ones. This is exactly how a Ponzi scheme operates,” writes Rickards.

Rickards concerned about global fallout

The scenario is quite bearish, assuming that the Chinese government won’t be able to intervene at any step of the process, but it’s not completely unrealistic either. He imagines the wealth management products failing and investors pulling their money out of the banks that sold them just as the percentage of NPLs is rising, causing GDP growth to become essentially flat as financial panic halts spending and investment across the country. And this isn’t just something that EM investors need to worry about:  if 10% of the world’s economy simply stops growing sometime this year or next, the weak recoveries in the US and Europe could be threatened as well.

“Investors should be well-prepared for these scenarios,” warns Rickards.