According to Shih's study, the total borrowing of LGFVs is 11 trillion yuan ($1.6 trillion), which breaks down roughly into 7 trillion yuan borrowed for infrastructure spending and 4 trillion yuan for "other" purposes. These figures match China's domestic credit growth in 2009 of about one-third of GDP and go a long way in explaining the credit bubble (we knew about the lenders, but little about the borrowers).

LGFV debt is big enough to be a potential source of major macro-economic instability. LGFV borrowing adds about another 30 percent of GDP to public sector debt; is equivalent to 25 percent of outstanding bank credit; and more than 80 percent of new bank loans during the 2009 credit bubble. This hidden debt is equivalent to 225 percent of bank equity capital, meaning that a loss-given-default ratio of 30 percent would wipe out two-thirds of existing bank equity.

This LGFV edifice will not survive credit tightening, because it is a Ponzi-type pyramid built upon borrowing more to service existing borrowings. But timing the day of reckoning is complicated by the fact that China's credit bubble is domesticated, because it is built on debts owned and borrowed at home. The LGFV scheme is credit borrowed and lent between State entities or, in the case of banks, between semi-State entities.

So the authorities can fudge and fiddle as they did when a similar, but smaller and foreign-financed, ITIC (investment trust) credit bubble burst in the mid-1990s. LGFV bad debts will be surgically removed together with collateral to the State-owned asset management corporations where they will linger unresolved for a good time (old debts are still there today).

This is a nice rosy scenario, which will undoubtedly be pedaled under the "we believe in the China story mantra" by all those institutions with an interest in doing so. And there's no doubt that ultimately the Chinese will try and navigate this course.

But we can't share such optimism about the outcome. That's because the problem is economically huge. In a nutshell, the LGFV crisis completes the picture of China's bubble, by showing who were the excessive borrowers, to match the excessive credit that the banks pumped into the system.

It confirms that the China story is a credit bubble story of its own and not the answer to the West's credit crisis or growth deficit.

The author is president and global strategist of Independent Strategy Ltd, and author of Sovereign DisCredit.