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China heading toward a debt crisis with global ramifications: Banking vet

China’s economic engine appears to be contracting, or at least slowing. Chinese PMI fell to 48.1 in March, an eight-month low, and the index has been below 50 since January. A PMI below 50 indiates a contraction in the manufacturing sector.

Last year Suntech Power, a Chinese solar energy company, defaulted on a $541 million bond followed by Shanghai Chaori Solar failing to make a $14.7 million interest payment on March 7. On March 18, Zhejiang Xingrun Real Estate Company defaulted on a $400 million loan. China is also taking large (and potentially unsustainable) debts in emerging markets prompting investor concern. China’s hard currency debt exposure was $223 billion at the end of 2013, according to Nomura Securities.

Related: Why the U.S. needs to "break up" with China

“China has significantly over-billed and created a significant amount of bad debt,” says Richard Vague, managing partner of Gabriel Investments. “They’ve grown private debt 56% in five years and their private debt levels are 180% or perhaps more.”

So is China looking at a 2008-style crisis with global ramifications?

“It looks to us like at least $2 trillion to 3 trillion in bad loans or suboptimal loans have been created so it’s not a small problem relative to their GDP, or the capital of the banks,” says Vague. But they have the capacity to rein in the problem, “both in terms of the reserves they have and they have capacity in terms of additional borrowing at the central government level.”

Related: Bond default a "moment of reckoning for the Chinese government"

Still, says Vague, “It’s going to take no less than a concurrent effort to go in and recapitalize institutions and extend the safety net.”

The best case for China going forward? Significantly lower growth levels, says Vague. And worst case? A banking crisis where things contract and hit the global economy.

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