Cheung’s assessment adds to warnings from hedge-fund manager Kyle Bass, Autonomous Research analyst Charlene Chu and the International Monetary Fund on China’s likely levels of troubled credit. The IMF said last month that the nation may have $1.3 trillion of risky loans, with potential losses equivalent to 7 percent of gross domestic product.

‘Shadow Banking’
CLSA estimates bad credit in shadow banking -- a category including banks’ off-balance-sheet lending such as entrusted loans and trust loans -- could amount to 4.6 trillion yuan and yield a loss of 2.8 trillion yuan.

CLSA cites a diminishing economic return on stimulus pumped into the economy as among the reasons for a worsening outlook, with Cheung saying at a briefing that bad loans had the potential to rise to 20 percent to 25 percent.

“China’s banking system has reached a point where it needs a comprehensive solution for the bad-debt problem, but there is no plan yet,” he said in the report.

Eoin Treacy's view

Concerns about the scale of nonperforming loans have been voiced by international investors on more than a few occasions over the years and yet very little has been done to tackle the issue. In fact the ham-fisted approach to market regulation under the Xi administration has probably exacerbated the problem. 

This story detailing how more than a 1000 peer to peer lenders / asset managers collapsed in the last year highlights how another part of the financial sector was opened up with no thought to regulation. Many of these asset firms are now being forcibly evicted from office spaces lest they become the focus of demonstrations by disgruntled consumers. Meanwhile there is an increasing appetite for Cultural Revolution rhetoric among the ruling class. 

The FTSE/Xinhua A600 Banks Index has been ranging higher in a gradual reversion towards the mean, but having now closed the overextension potential for at least some consolidation is looking more likely than not. 

No one knows quite how large the bad loans situation is but the tipping point is likely to be if the monetary authorities target shadow bank lending or refuse to force banks to honour trust debts. So far they have been reluctant to enforce losses on larger investors but that might not always be the case. How the ongoing rationalisation of overcapacity in the materials and infrastructure sector is handled is likely to have a significant bearing on how the bad loans situation evolves.