AUSTRALIA depends on China. Forget riding on the sheep’s back. We ride the dragon! But the thing about dragons is they breathe fire. We could go up in flames.

This week a US hedge fund published a serious warning that China’s economy is incredibly fragile, and could start to collapse within months.

“The timing of the bursting of the Chinese currency and credit bubble is imminent in our view,” wrote Kevin Smith, chief Investment officer of Crescat Capital, and his colleagues, in a note to clients.

“The bust in some form will be triggered by bank runs from the masses of Chinese depositors when they learn that they are the ones holding the bag with respect to China’s insolvent banking system.”

A Chinese bust could be a disaster here too.

“Three large (G20) countries are flashing warning signals today for impending banking crises based on such imbalances: China, Canada, and Australia,” wrote Mr Smith.

Australia’s devotion to China as provider of minerals and destination for real estate investments has driven our economy (and house prices) to ever-higher levels. As the following graph shows, China has become Australia’s lifeline for trade.

China has been a tremendous bet for a very long time. In setting a new world record for growth it has given millions of Australians a lifetime of prosperity. If you bet on Chinese growth starting in 1980 you’re on a multi-decade winning streak.

China was able to grow so quickly mainly because it stopped being a truly communist country.

Decades of central planning had brought crushing poverty to a proud nation. When Deng Xiaoping let market forces loose he found China was full of raw potential. Over the 1980s, 1990s and 2000s China caught up to the rest of the world at breakneck speed.

But slowly, questions began to be asked. How long can a winning streak go on? And where is all this growth coming from?

The answer to the first question is unknown. But the answer to the second question is very clear. The growth comes from debt. And China’s debt has exploded.

China’s ghost cities are legendary and they are only the most visible part of the debt-funded build-up, which feature an incredible stock of very fast railways, commercial real estate and freeway systems even Los Angeles would be proud of.

But infrastructure doesn’t always create economic growth. The Chinese government has made it look easy, but generating economic growth is actually hard. (Just ask Scott Morrison).

China started from a position where they could play a lot of catch-up. Just getting everybody fed was a big start. But once people are middle-class and markets are operating, creating further economic growth is a grind. Just building things is not enough. Borrowing to expand depends on having good things to invest in. The recent experience of Chinese firms is that profitability is hard to find, as this next graph shows.

A lot of the private sector debt has been funnelled through non-official channels that are poorly regulated. This is known as the shadow banking system.

WHY NOW?

Betting on China has been like betting on the racehorse Black Caviar. But racehorses retire. Countries doesn’t get that privilege. They keep racing forever. That means a stumble will come, and the only question is if it is now or in ten years.

Crescat Capital believes the stumble could come any moment, thanks to the big meeting of the Chinese Communist Party in Beijing in November (the NPC).

“Over the past several weeks, we have been hearing over and over that the Chinese leaders will not let the bubble burst before the NPC in November. Such is the conventional wisdom on Wall Street today,” wrote Kevin Smith and Colleagues.

“The takeaway for us is that Wall Street is finally acknowledging that China is indeed in a massive credit bubble. Before, during, or after the NPC, the timing of the bursting of the Chinese currency and credit bubble is imminent in our view.”

There is no doubt the level of debt has recently made the Chinese government uneasy. The Reserve Bank has described a big crackdown by the Chinese government this year on the so-called shadow banking sector.

“The latest reforms are targeted at loopholes that have allowed these less regulated forms of credit to grow rapidly in recent years,” it said in a paper published in August.

This follows a warning delivered by the RBA governor in person in February. “”Each year we go along and I get more nervous about the medium-term risks,” RBA Governor Philip Lowe said to a Senate Economics Committee. “That risk is out there and it’s getting bigger.”

If that’s not enough warning bells at once, The Bank For International Settlements, also sounded major warnings on China in its 2017 annual report. The BIS, which watches for global stability issues, found China is in excess of “critical thresholds” for debt that have been good warning signals in the past.

“These indicators have often successfully captured financial overheating and signalled banking distress over medium-term horizons in the past. Since the late 1970s, the critical thresholds … were breached at some point in the three years preceding banking distress in more than two thirds of cases, while providing few false alarms.”

That, however, is all spreadsheet work. Are there signs in the real world?

ANBANG ETC

Anyone looking for signs of a wobble in the Chinese economy has been paying close attention earlier to an insurance company called Anbang. The company had been on a buying spree of foreign properties, including the Waldorf Astoria Hotel. Earlier this year its CEO was detained by Chinese authorities and it was temporarily banned from selling new products.

More recently, Dalian Wanda (a Chinese commercial property company) was rumoured to be pulling out of Australian real estate investments, a rumour it denies. But other mysterious rumours have been dogging the firm for months.

Are these mysterious blips in the Chinese corporate environment sign of systemic trouble? It is not clear. They could be nothing. China’s economy is not transparent yet and the government has the incentive to keep things looking good.

For better or worse, the big unknown in China is the role of the communist government. Does the rigid grip of the state on the economy mean they won’t let things slip into crisis? Or does it mean that problems that are building up to crisis levels are harder to spot?

The answers to these questions will only be known once the dragon starts to plummet to earth.

Jason Murphy is an economist. He publishes the blog Thomas The Thinkengine. Follow Jason on Twitter @Jasemurphy