The Walled Garden of Debt
China borrows at 1.7% while the model says it should pay 13.4%. That 11.7-percentage-point gap — the largest structural distortion in global sovereign credit — is not a market signal. It is a wall. And walls, in the end, are what autocracies build best.
to GDP (2024)
incl. LGFV (IMF est.)
largest structural outlier
PBoC claims 14.8T
The Debt Architecture
China's debt is not one problem. It is four problems stacked inside a black box. The official general government debt — 69% of GDP — would be unremarkable for a major economy. But that figure is a fiction maintained by accounting convention. The real figure, once you include the off-balance-sheet liabilities of Local Government Financing Vehicles, is the IMF's "augmented" estimate of 124% of GDP. And even that understates total exposure: non-financial sector debt stands at 312% of GDP, a ratio exceeded only by Japan among major economies — and Japan is three times wealthier per capita.
The core pathology is the LGFV system: approximately 10,000 quasi-commercial entities created by local governments to circumvent borrowing limits. They funded the infrastructure boom. Now the boom is over, land revenues have collapsed, and LGFVs cannot service their debts. The IMF estimates LGFV liabilities at 58 trillion RMB (48% of GDP). The PBoC governor claims 14.8 trillion. The 4× divergence between China's central bank and the IMF on the same metric is itself a symptom of the governance topology: in an L=5 system, there is no independent audit, no free press to investigate, and no opposition to demand transparency. The debt's true scale is unknowable — and that unknowability is the risk.
— Michael Pettis, Carnegie Endowment, 2025
The critical dynamic: debt is growing at twice the rate of nominal GDP. Total social financing expanded 8.9% year-on-year through mid-2025 while nominal GDP grew just 4.1%. Each unit of new credit produces less than half a unit of output. This is the textbook definition of a debt trap — and it has been worsening since 2008. Prior to that year, China's rapid debt accumulation was matched by rapid GDP growth, keeping ratios stable. The divergence since is the strongest evidence that a rising share of investment is non-productive.
The Four Roads — Applied to China
The sovereign credit model identifies four historical paths out of unsustainable debt. For China, each path is constrained by the governance topology in ways that make resolution uniquely difficult.
The Structural Outlier
In the Governance Topology sovereign credit model, China is flagged as a "structural outlier" — meaning its yield cannot be explained by governance fundamentals and the mispricing is not tradeable. The model predicts that a country with Liberty=5, Tyranny=87, and debt/GDP of 124% should pay approximately 13.4% to borrow for 10 years. China pays 1.7%. The −11.7 percentage point gap is sustained entirely by the closed capital account: domestic savers have nowhere else to put their money.
This is what makes China simultaneously safe and dangerous. It is safe in the narrow sense that Beijing can suppress yields indefinitely as long as capital controls hold. It is dangerous in the profound sense that the price signal that normally forces governments to address debt problems does not exist. In democracies, bond vigilantes eventually impose discipline. In China, there are no vigilantes — just a walled garden where the rules of financial gravity are suspended by political decree.
Sensitivity Analysis: What Breaks the Wall
The model identifies six shock vectors that could breach the capital account wall and force market pricing onto Chinese debt. Each has a probability estimate, a transmission mechanism, and a severity assessment.
| Scenario | P (5yr) | Mechanism | Impact on Yields | Liberty Impact |
|---|---|---|---|---|
| Property cascade | 35–45% | Unfinished housing stock (est. 20M units) triggers bank NPL wave → state bank recapitalisation → fiscal cost 15–30% GDP → confidence collapse → capital flight pressure | +200–500bp if controls loosen; contained if not | Neutral to −2 (tighter controls) |
| LGFV default chain | 25–35% | Weaker provinces (Guizhou, Yunnan, Gansu) cannot roll over ¥10T+ in maturing LGFV bonds → contagion to wealth management products → retail investor panic | +100–300bp onshore; WMP losses trigger social instability | −2 to −5 (crackdown on dissent) |
| Trade war escalation | 20–30% | US/EU tariff escalation → export shock → RMB depreciation pressure → capital controls tighten → but reduced FX earnings weaken reserve buffer | +50–150bp (manageable unless reserves depleted) | −1 to −3 (nationalism + controls) |
| Taiwan contingency | 5–15% | Military action → comprehensive sanctions (Russia-scale) → capital account forcibly opened by asset freezes → yields go to market clearing | +800–1,200bp (sanctions regime) | −3 to −5 (wartime autocracy) |
| Demographic cliff | ~100% | Working-age population shrinking ~0.5%/yr → pension liabilities mount → savings rate declines → less captive capital to absorb government debt | +50–100bp by 2035 (slow, structural) | Neutral (but erodes fiscal base) |
| Capital account opening | 3–5% | Reform-driven or crisis-forced liberalisation → domestic capital seeks global returns → yield must rise to competitive levels → re-pricing of entire sovereign curve | +500–1,100bp (full re-pricing to model) | +5 to +15 (if reform) or −5 (if crisis) |
The Autocratic Trap: Vulnerability Through the Governance Topology Lens
The five transmission channels through which democratic erosion degrades sovereign credit — legal risk, information degradation, policy unpredictability, capital flight, and repudiation risk — operate differently in a system that was never democratic. China doesn't face erosion. It faces the structural vulnerabilities of consolidated autocracy: the features that make the system stable also make it fragile.
The result is a system that is stable but not sound. The wall holds — and behind it, losses accumulate in balance sheets that no outsider can fully audit. The IMF's best estimate is that restructuring the LGFV system alone could cost 15–30% of GDP. Property sector losses may add another 10–20%. State bank recapitalisation could require a further 5–15%. These are not additive — there is overlap — but the aggregate fiscal cost of true resolution likely exceeds 30% of GDP, or roughly $5 trillion.
Beijing's chosen path — financial repression — is the autocrat's classic resolution: force the losses onto households through suppressed deposit rates, destroyed property values, and reduced social spending. It works. Japan has sustained a version of this for 35 years. But it guarantees a generation of suppressed consumption, demographic decline, and slow growth. The 5% target becomes 3%, then 2%, then the number that dare not speak its name.
The governance topology model assigns China a <2% probability of regime-threatening credit event in the next five years — because the wall is strong. But it assigns a 35–45% probability of a chronic growth downshift that erodes the social contract without breaking it. The danger for China is not explosion. It is slow suffocation — a system that cannot reform because reform would expose the scale of prior losses, and cannot grow because the debt overhang absorbs all new capital.
For sovereign credit investors, the conclusion is simple: China is not tradeable. The yield reflects political control, not credit quality. The day the wall comes down — whether through reform, crisis, or geopolitical shock — yields reprice by 500–1,100 basis points overnight. Until then, the 1.7% yield is the sound of a system talking to itself.