Eight years ago, the accountants Ernst and Young got in trouble with the Chinese authorities for estimating the bad debts in the Chinese banking system at $911 billion – it was especially tactless in that the major Chinese banks were mostly within months of doing IPOs in the international markets. Since then, the Chinese bad loan problem has been pushed under the rug, and we have had to make do with guesses about its scale, although China’s 2009 spending “stimulus,” funded by the banks rather than by the Treasury as in the West, clearly made matters much worse. However following a recent study of the Chinese shadow banking system by the Financial Times, the current scale of the problem is becoming clear, and it has serious implications both for the Chinese past we have unquestioningly admired and the future we can expect.

China’s shadow banking sector has grown exponentially since the government started pulling back on the banking system at the end of 2009, providing more than RMB 30 trillion ($4.8 trillion) of loans since 2007, and together with the banking system expanding loans by 87% of GDP since 2006, according to the FT. That’s more than double the expansion in U.S. credit from 2002 to 2007, and indicates the potential for a severe crisis. More than 10,000 “local government financing vehicles” have been set up to circumvent local government borrowing limits, and by the end of 2013 they held more than 31% of GDP in off-budget financing for local governments. Total debt in the Chinese economy has risen from 130% of GDP in 2008 to 220% of GDP in 2013, with assets in the formal and informal banking sector increasing from $10 trillion to $25 trillion.

That’s the killer statistic. For the rise in Chinese debt from 130% of GDP to 220% in only 5 years shows that debt has risen by 18% of GDP per annum beyond the increase in GDP during that period. However, Chinese GDP growth has averaged only 8.9% in those five years. It therefore follows that growth in debt during the period was double the growth in real GDP. In other words, net of the increase in debt, Chinese GDP in 2008-2013 shrank substantially.

Of course, some of the debt may be backed by real assets, and hence may represent a real increase in GDP. Indeed, if all the debt were solid, Chinese GDP would indeed have grown at 8.9% per annum, as officially stated. However we know from anecdotal evidence of empty office buildings and superhighways that a very substantial percentage of that new debt is bad. If 25% of the new debt is bad, then China’s real GDP growth in the last five years has been only half its stated level, or 4.5% per annum. If as much as half the new debt is bad, then China’s GDP growth in the last five years has been zero.

This column specializes in taking wild-ass guesses at reality, so I’ll do so with the new Chinese debt. This was indeed something we did frequently as merchant bankers forty years ago; lacking number-crunching capability beyond a pocket calculator, faced with accounts that outside Britain and the United States generally bore little relation to reality (and economic data that bore even less relation to economic reality) we were forced to make a “banker’s estimate” of the true quality of a loan book or an economy. Given sufficient practice, these bankers’ estimates became quite good; after all the Medici and the Rothschilds managed to build large banking empires in the days before decent accounting or data manipulation, and their loan loss percentage must have been considerably better than that of Citigroup, RBS Group or Lehman Brothers in 2008, otherwise their banking houses would not have survived.

So as a former banker I’ll “estimate” that Chinese bad debt losses will prove to be about three eighths of the new loans put on since 2006. That would make China’s true annual growth in the last five years 2.2%. It would also imply that the net bad debt loss to the Chinese banking and secondary banking systems will be about a third of reported 2013 GDP, or about $3.5 trillion. Of course loans that “go bad” would in this case be substantially more than this, but there would presumably be some recoveries, although given Western investors’ experience of accounting fraud in Chinese companies, the level of recoveries may not be all that great.

If real Chinese growth in the last five years was only 2.2%, and there is a $3.5 trillion net overhang of bad debts waiting to take down the Chinese financial system and the economy in general, then the prognostication for China going forward must be pretty grim.

Presumably the majority of the funding needed to fill the $3.5 trillion hole in the financial system will come from the state, which can well afford it since China’s debt is still relatively low. However running an additional public sector deficit of 7% of GDP for five years, the probable period over which the hole would be filled in, would itself destabilize China’s public finances. Of course, in principle it would be possible to raise taxes or cut other government spending to fill the gap, but doing so within what would almost certainly be an unpleasant recession would be very unpopular. In practice therefore the Chinese government will do as so many Western governments have done since 2008. It will print money and increase government debt to solve the problems of the financial system.

Sorting out the financial system’s hole will cause a substantial recession, for two reasons. First, since China’s true growth rate over the last five years has been only 2.2%, any substantial slowdown will push the economy into recession. Second, much of the bad debt will prove to be located in the consumer sector. China’s automobile market of 18 million vehicles annually, for example, has been predicated on an artificially high GDP and level of prosperity. Hence when recession hits and the air goes out of the economy, many consumers will find they cannot really afford the shiny new Buicks they have bought on credit, and loan defaults will occur. In addition, wage levels have been rising rapidly in real terms in recent years; at least some of these rises will prove to be artificial, as companies can no longer afford to manufacture in China given the new higher costs. There will thus be both unemployment and draconian wage cuts.

China’s long-term future remains hopeful. But it’s likely to be at least a decade before the GDP per capita of around $10,000 (at purchasing power parity) reported in 2013 is achieved in reality, and growth beyond that point will proceed at 5% rather than the recently reported 9-10%.

The unrest caused by such a growth hiatus, unexpected as it will be to a Chinese public used to three decades of rapid and almost uninterrupted progress, will be considerable. The prediction above thus represents something of a “best case” outcome, in which the Chinese government does not disrupt the necessary restructuring progress by foolish policies, and the Chinese public avoids a level of unrest that would itself cause a major disruption to economic life.

In practice, foolishness by the Chinese government and anger from the Chinese people are both rather likely. In this respect India is luckier than China; its democratic system may make foolish mistakes, as in 2004, but it has the capacity to correct them in the long run, as last month. In China, the political system is so rigid, and the politicians so unused to economic difficulty and so instinctively averse to allowing market forces to sort out problems, that the chance of foolishness is very high indeed. Most likely, that foolishness will take the form of government subsidies to failing projects, banks and industries, propping up dying businesses and outright malinvestment and preventing the market from reallocating capital properly.

The successful resolution of the 1990s U.S. savings and loan crisis, in which Bill Seidman sold off dud real estate for what it would fetch, and allowed the buyers to make ungodly profits if they bought at a sufficient discount, is not a process likely to appeal to Chinese state bureaucrats. Yet only by such a process can Chinese capital be liberated from the mistakes it has made and re-allocated to productive new investment. Empty luxury office blocks in obscure provincial towns need to be sold off for 5 or 10 cents on the dollar, and used as warehouses, low-income housing, or whatever the market will bear. Mao would have been horrified by this process, and his ideological successors in the senior reaches of the Chinese Communist party will be equally so, but it needs to happen.

As to popular unrest, apart from the economic damage it will cause directly, it will result from economically difficult times, in which the free market system will appear to have failed. Hence it is very unlikely that the unrest will produce a government better able to cope with China’s economic problems. More likely, it will produce an economic reversion towards a populist version of Maoism, as similar protest movements have done in the less prosperous parts of the former Comecon bloc.

The outlook for China is thus exceptionally clouded. If all goes well, the country will suffer a substantial recession and return by about 2024 to the level of living standards it thought it had achieved in 2013. However the probability of a worse outcome is very substantial indeed.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)