Caofeidian lies a three-hour drive east of Beijing, a Chinese industrial dream jutting into the sea. A decade ago, it was a pretty coast whose shallow waters were dotted with fishing vessels. Today, it's a manufacturer's paradise in the making, its eight-lane roads connecting sprawling factories to a vast port. Named after a former imperial concubine, it was a place of feverish fantasy, where borrowed money fuelled a vast reclamation effort to create 200 square kilometres of land and build something new.

When former Chinese president Hu Jintao came here in 2006, he called it a "treasure of a location" and likened it to "a piece of white paper, and the best and newest pictures ought to be drawn on it."

What he likely did not envision: a giant money pit, half of whose debt seems unlikely to be paid back.

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Caofeidian was to be home to a million-person eco-city, a massive steel factory, a power plant, an oil refinery and a panoply of apartments, bus makers, warehouses, lumber plants, a Sino-Japanese business park, even an "exhibition centre of strategic new industries." A decade of spending poured $100-billion into the soil here, the equivalent of the annual budgets of British Columbia, Alberta, Manitoba and Saskatchewan combined.

But the loans that allowed all that spending have just 50 per cent odds of being paid back, says an independent research group that has spent years studying Caofeidian. The stakes are enormous. Caofeidian was a project of national importance for China, a "flagship," according to Jon Chan Kung, chief researcher at Anbound, a Beijing think tank.

"If this project fails, it proves that the major model driving China's development has also failed," he says.

Debt now stands to undo at least some of what China's spending has accomplished. Some of the country's major projects have done little more than strand vast amounts of invested capital. Debt is just one of the ticking time bombs in China today. China must also cope with the fallout from slowing spending in a place where social stability has been largely defined by one thing: the non-stop accumulation of wealth.

"There will be a financial crisis. And I feel that the financial crisis is in the near term," says Anne Stevenson Yang, co-founder of Beijing-based J Capital Research. "There will be a recession and then a long period of very, very slow growth. That's my definition of collapse. I'm not talking about people running through the streets with torches. That may or may not happen."

China has, for years now, become the engine of global growth. Its building sprees have kept afloat thousands of mines, its consumers have poured billions into the pockets of car manufacturers around the world, and its flush state-owned enterprises (SOEs) have become de facto bankers for energy, agricultural and other development in just about every country. China holds more U.S. Treasuries than any other nation outside the U.S. itself. It uses 46 per cent of the world's steel and 47 per cent of the world's copper. By 2010, its import- and export-oriented banks had surpassed the World Bank in lending to developed countries. In 2013, Chinese companies made $90-billion (U.S.) in non-financial overseas investments.

If China catches a cold, the rest of the world won't be sneezing – it will be headed for the emergency room.

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And there is cause for worry. China has now become an "economy that is actually worth a lot less than they pretend it's worth," Ms. Stevenson Yang says.

By her estimate, 60 to 70 per cent of new lending is now going to service old debt. In 2006, $1.20 in new credit could stoke $1 in economic growth. Today, it takes over $3. At that rate, it takes a greater than 20-per-cent annual expansion in credit to sustain China's target 7.5-per-cent economic growth. "That just means that the problem itself is getting bigger," said Jonathan Cornish, managing director for Asian operations at Fitch Ratings.

China has spent the past three decades building wealth at a pace never before seen in human history. Now the world's second-largest economic power, it has pried hundreds of millions from abject poverty and built cities, factories and high-speed rail networks that are stunning in their modernity.

But the new face of China has come at an immense cost. Debt has exploded throughout the economy. According to Partners Capital, a private investment bank based in London, Boston and Hong Kong, the country's financial system has accumulated some $23.3-trillion in assets – loans made to companies and individuals – equivalent to about 260 per cent of gross domestic product. That's up by a whopping $15-trillion in only five years.

Interwoven networks of credit have developed with a byzantine level of complexity. They are underlain by a furiously competitive, and lightly regulated, shadow lending sector that has poured money into investments of vastly differing quality. Even the most cautious lenders in China, the state-owned banks that supported developments like Caofeidian, now find their portfolios strewn with rotten projects.

Much of the credit expansion is due to the explosion of shadow banking, which consists of trust companies, leasing companies, insurance firms and other types of non-bank financial institutions. Such shadow banks typically lend money to industry from capital raised from wealth management products sold via traditional banks to everyday individual investors who may not know exactly what they're buying into or understand the risks.

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The shadow banks' growth spurt is the result of the 2008 global financial crisis, which rattled China. The country's growth rate tumbled from double-digits to just over 6 per cent. Hundreds of thousands of workers lost jobs. In response, Beijing unleashed a massive stimulus program. Credit demand exploded, to the point that credit has reached "bubble" status, according to some economists.

"What that stimulus program rested on was credit creation," said George Magnus, senior independent economic adviser to Swiss banking giant UBS. "There was some fiscal stimulus, but it was relatively minor. The lion's share of China's program was opening the sluice gates of lending. … The legitimacy of the Communist Party in China was high economic growth."

The traditional banks, which are instruments of government policy, were essentially given carte blanche to support government investment programs, such as the construction of infrastructure. The shadow banks filled much of the fresh credit demand in the private economy. Their growth was assisted by the hefty rates they paid to investors over the regulated, and artificially low, rates paid by the banks. "Shadow banking is itself a reaction to the financial repression caused by regulated deposit and lending rates," HSBC Holdings chief executive officer Stuart Gulliver said in a March 27 speech in Hong Kong.

The growth of China's shadow banking system has been phenomenal. In 2000, about 80 per cent of all credit was supplied by the traditional banks, with shadow banks supplying the rest. By last year, the split between traditional banks and shadow banks was roughly 50/50. China's debt to GDP rose accordingly.

"The speed of accumulation of debt is what scares a lot of economists," Mr. Magnus said. "The credit creation in China has now become excessive. The new leadership of China knows this and the development model of China has to change or they could end up with a really nasty financial accident."

Since debt appears to be rising faster than nominal GDP, bad debts will inevitably rise among private companies, SOEs and local governments. The default rate, while still small over all, is rising. Bailouts are no longer automatic. "This is a good thing," Mr. Magnus says. "If you think your growth model has been overly reliant on credit, you have to allow this thing to take place."

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Chief economist of Denmark's Saxo Bank, Steen Jakobsen, like Mr. Magnus, thinks that the Chinese government will deflate the credit bubble by allowing some defaults and bankruptcies – capital destruction, in other words – and attempting to reform SOEs and local governments. The process, of course, will remove some momentum from economic growth. The question is by how much.

Mr. Jakobsen predicts that "China, for a number of years, will have subpar growth to rebalance its economy. … Over-investment will have to be replaced by under-investment to get back to the mean."

Alarm bells ringing

Signs of corporate pain are emerging. In the past month, Xuzhou Zhongsen Tonghao New Board Co. Ltd., a construction materials company, and Shanghai Chaori Solar Energy Science and Technology Co. Ltd., a solar panel manufacturer, both defaulted on bonds. Zhejiang Xingrun Real Estate Co., a real estate developer, also collapsed after failing to pay back $620-million in debt. A $495-million trust fund called Credit Equals Gold No. 1 narrowly averted default earlier this year when it was bailed out by an unknown group. And authorities had to resort to unusual means – including stacking bills high behind teller windows and keeping branches open 24 hours – to head off a recent run on Jiangsu Sheyang Rural Commercial Bank, a small bank in rural China.

On Monday, the China Iron and Steel Association said the first quarter brought $373-million (U.S.) in losses to the country's steel industry, with fully 45 per cent of firms posting red ink. All but one Chinese province missed growth targets in the first quarter, as China reported national growth at 7.4 per cent, below the 7.5-per-cent goal. In another troubling sign, China's Yurun Food Group reported declining Chinese food and beverage consumption, a startling reversal that prompted J Capital to say it marks "the end of an era in China."

"China is in alarming territory," said Victor Shih, a U.S. academic who was among the first to raise the alarm several years ago. "People in Beijing, including the highest leaders of China, may want to slow down this process of leveraging. But at this point, it's extremely difficult to do. The bubble is so big that when you try to deflate it, it may pop. The central government is walking a very tight line between wanting to delever a little bit while avoiding a financial crisis."

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In the meantime, borrowed money is finding ever-more creative ways to flow through China, with a proliferation of schemes.

Under one increasingly popular financing structure, called trust beneficial rights or TBRs, banks buy only the cash flow of a particular asset. It's a complicated structure, with a simple, if worrisome, result: Using it, a bank can effectively lend to companies, but book the loan as an interbank asset – an investment – that allows it to assign a far lower risk weighting. That, in turn, allows the bank to apply a lower capital adequacy ratio rating, meaning it has less money on hand to backstop loans gone bad. It is a recipe for banking instability.

"It's totally sneaky. I hate it," says Jason Bedford, a Canadian who recently stepped down from nearly a decade with KPMG as an auditor and consultant in China. Among the problems the structure creates is "a perverse incentive to try to take a distressed loan and rebook it as a TBR. Why? Because you don't have to provision against investment losses."

"This is like the worst conspiracy theories that I've been hearing about for the last four years suddenly coming true. Banks really are hiding loans," he said.

Still, Mr. Bedford cautions against extrapolating one potentially bad apple to the whole tree. On the whole, he believes, the risks to the formal Chinese banking system have been overstated. He has spent years auditing banks, speaking with branch manager after branch manager who boasted not about interest margins or profitability – but about the solid performance of their lending portfolio.

The happiest are those who are "beaming and bragging about how they've never had a non-performing loan," he says. In China, "banks are in the business of avoiding risk, as opposed to managing risk," he says. That creates its own set of problems, but it does reduce the risk of bad debt.

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Then there is the matter of the vested interests of the Chinese state. Financial stability and social stability are tightly linked, a relationship no one at the top levels of Chinese leadership is blind to. That offers a powerful argument against the likelihood of a dramatic crisis, something Beijing would like to avoid at all costs.

A landscape of busted dreams

History offers more reason to distrust the doomsayers. In the 1990s, amid another credit explosion, Chinese banks saw non-performing loans rise to at least 25 per cent of their portfolios – some believe the real number was as high as 40 per cent. In early 1999, Guangdong International Trust & Investment Corp., or GITIC, went bankrupt, leaving investors with $4.4-billion in unpaid loans. Worried observers called China's financial system among the worst on earth and predicted economic collapse.

It didn't happen. Banks were recapitalized with $32.5-billion in bond sales, and some of the bad debts were tossed into a series of state-owned asset management companies. Growth slowed – from 13.1 per cent in 1994 to 7.6 per cent in 1999 – but by 2003, the economy was roaring on again at 10 per cent.

The current situation nonetheless offers real reason for concern. In the 1990s, China's debt-to-GDP ratio, at 25 per cent, was far lower than most developed countries. Today, it's far higher. By how much is unclear, given the lack of solid official numbers and a vast disparity in external estimates. But it's evident that China has less room to manoeuvre now than it did 20 years ago.

And as Caofeidian makes clear, the problem today is on a scale far bigger than before. The steel industry was meant to be Caofeidian's champion, with Capital Steel, the Chinese corporate giant, its anchor tenant. But that industry is not doing well. Local reports suggest Chinese steel makers are sitting on $266-billion (Canadian) in debt they're unlikely to pay back – a bit more than Canada's annual federal budget – and Capital Steel, in particular, has fallen on hard times. In Caofeidian, only two of its eight stacks showed any signs of life on a recent visit. An official at a nearby port office said it was operating at 25 per cent capacity.

The company's Caofeidian steelworks lie on a landscape of busted dreams. The refinery hasn't been built to its expected size, given it was predicated on an oil field that turned out to have less than a quarter of the oil once thought. The Sino-Japanese park is a yawning dirt field, where nothing has been built.

The strategic industries exhibition centre has shiny, but empty, office buildings next to at least a dozen concrete skeletons of apartment buildings, all abandoned unfinished. There are no workers, and an access road has been drizzled with broken bottles to keep out cars. "There's no money," a local caretaker says, by way of explanation.

Not far away, down a six-lane road empty of traffic, lies another concrete shell, this one for a factory to build batteries for a next-door bus plant. Construction started in 2009, but it's nowhere near finished. "The boss has overdeveloped in this area," the project's caretaker says. "He has too many projects, and he's too short of capital."

Chen Baocun, who helped sell some of the area's first real estate developments, says early investments in Caofeidian "have been buried" in its reclaimed land. "And the infrastructure is far from complete." Parts of Caofeidian aren't even dry earth, with just under half of the expected land reclamation not accomplished.

Farther away, the road passes over two metal bridges that counsel against vehicle traffic, warning: "This bridge is dangerous." This is one of the ways to the eco-city, which is today three small clusters of buildings, two of them unoccupied. A visit to the eco-city's grocery store finds no customers, a wall split by a giant crack, and the lights kept off.

The eco-city's head planner, a man who co-ordinated 10 design firms to lay out a city for a million people, hasn't heard anything about the project in three years. After speaking with a reporter, Neville Mars, a Dutch architect based out of Shanghai, attempts to find out what happened, only to discover that those he used to work with at the project are no longer there. "That's not a good sign," he says. "It's clear that if the industrial projects are stalling, there is simply no impetus for the eco-city to be built."

And in many ways, as Caofeidian goes, so goes the rest of China – and, perhaps other parts of the world, too. "The Chinese government did not do well in controlling the speed of development, and it turned irrational," said Mr. Kung of Beijing's Anbound think tank.

"High-speed economic growth created the Chinese miracle, and created the four golden BRICs. But I feel it will destroy the miracle, and destroy the four countries, as well."