Local government debt is now mostly raised on land collateral, and local government budgets have been funded by commercial banks that are effectively inseparable from the state. The property boom that has followed China’s urbanisation drive has resulted in low-quality apartments in major Chinese cities being priced to match Vancouver, London and Sydney. In such conditions, it is not hard to imagine that debt-deflation could spread should asset prices fall.

Now consider that, in China, almost all banking units have implicit government guarantees in their debt-issuing and asset-ownership positions, while government and bank are effectively lending to each other.

Combine these two factors and it is easy to understand why global risk merchants are starting to fret over Chinese local governance — a matter that was conveniently ignored throughout the growth boom of the past two decades.

It does not matter if it is called ‘government debt’ or ‘corporate debt’. In China, the firm and the state are both lender and debtor at the same time, and any truly private capital still comes back to the commercial banks, which are again the state.

When agricultural and urban wages begin to converge and China’s urbanisation nears completion, there will be no radical increase in demand for housing — so where will the asset price growth come from to support the yields?

Chinese property price growth has the added stimulus that capital cannot, or at least is not supposed to, leave China’s shores. Capital cannot easily escape, and the floor of urbanisation keeps pushing upwards to make Chinese property, and the industrial sectors that build it, into a ‘sure bet’.

This key feature of the Chinese economy is a straightforward case of financial repression. Capital cannot go anywhere except either the savings account or property, and the commercial savings account is lent to the local government to speculate on more apartments. So earning interest below inflation or speculating on property are the only capital outlets. But the closed capital account means even a successful property speculator cannot exit the market and must instead plug the gains back into the same loop.

For the past decade the international trade community has carefully courted China in the hope that once the mainland became a net importer it would open its trading institutions and capital account to outsiders. Yet despite China moving to drastically increase its imports, it shows no signs of opening its capital institutions. Instead China has turned to international capacity cooperation, where China exports its ‘excess capacity’ to help develop other nations’ infrastructure and industrial capability.

International capacity cooperation is the financial mechanism for the Belt and Road Initiative (BRI). It effectively reorganises local government bond debt, which is recommissioned for relending via international investments.

This operating model is a quasi-sovereign wealth fund, with provincial government midstream and state-owned enterprises (SOEs) at the front end. It is being used to export China’s industrial policy, circumventing the established trade and investment architecture, without reciprocal opening of Chinese capital or consumer markets. This means exporting the same systemic financial risk from China’s capital markets to external ones.

Any future debt deflation contagion could spread beyond China’s own borders if it continues to export capital in this way while failing to reform its domestic institutions. China’s BRI partners are exposing themselves to what is essentially local government debt with unpriced risk — and to a serious chance of a debt-deflation scenario.

Without an open capital account, this specific form of investment is not interchangeable with other capital — it is effectively a parallel trade and investment architecture. But China is institutionally ill-prepared to develop a parallel bond and credit rating architecture to match, since its banking sector is immature and its local government financing mechanisms are weak. And financial SOE reform lags far behind the many excellent policy reforms China has achieved over the past two decades.

To finance its overseas operations, China itself maintains two pools of capital for the renminbi — an offshore pool and an onshore pool. Perhaps it is time for economies deeply integrated with Chinese capital to consider a similar airlock to prevent a debt-deflation contagion spreading throughout the worlds’ markets.

Until China allows private capital to compete with Chinese capital, protected local governments and their local SOEs will continue to roll in the mud of cheap credit. For China to take this risk is its sovereign right, but to export such debt-deflation risks to its trade and investment partners demonstrates an immaturity in both policy and financial circles.

Tristan Kenderdine is Research Director at Future Risk and a PhD Candidate in Political Science and International Relations at the Australian National University