China is set for a hard landing. We now know that much of the credit explosion in 2009 that boosted economic growth went into local government entities where it was wasted on unproductive real estate and infrastructure projects. These entities are mostly insolvent and will create huge bad debts for the banks as credit is tightened this year.

It shows that China has its own sovereign debt crisis and is part of the global leverage problem, not the solution.

China is an economy where bank credit equals 130 percent of GDP - twice the penetration of peer emerging markets and where credit grew by one-third last year, adding money to the system equal to nearly 40 percent of GDP. Worse, the productivity of such lending plummeted; it took 6 units of new credit to create 1 extra unit of GDP last year. It used to take only 1.5 units of credit back in 2000.

We at Independent Strategy Ltd narrowed China's credit bubble down to lending between the State-owned banks and the State-owned enterprises (SOEs). But now the location of potential bad debts is getting clearer, thanks to research by Victor Shih at Northwestern University in Illinois, US.

According to Shih, the rot is located in the so-called local government financing vehicles (LGFVs) belonging to one of China's many levels of local governments ranging from towns and counties to cities and provinces. LGFVs are conduits, like the special investment vehicles (SIVs) were for Western banks, used by local governments to borrow and spend on infrastructure and other projects (like real estate).

Local governments inject land banks, SOEs and cash into a LGFV to give it assets and a capital base for borrowing. Guarantees of LGFV debt by local governments are also common (as are guarantees of one LGFV's debts by another). The usefulness of the LGFV is that it allows a local government to borrow and spend way in excess of its own budget, where normally tax revenues cover only about half of the expenditure (with the rest coming from Beijing). Local governments are not allowed deficit spending.

There are more than 8,000 LGFVs in China, with only paltry information available for all but 100 of them and even for those the information is incomplete.

Local authorities have used LGFVs to divert funds borrowed for authorized projects to other ends (that is, loans for infrastructure spending channeled into real estate speculation by local officials) or to borrow and feed back the proceeds to local governments. LGFVs are predominantly unprofitable, with the debt service on existing debts being funded by further cash subsidies from local governments and additional borrowings.

And they have been financed by asset injections at inflated prices (that is, local government land banks) to dress up their balance sheets and facilitate borrowing, despite often being insolvent.