Last month, we reported that Marc Faber commented that China is going to slow down in 2010 (see the video in Is China going to dump their excess metal stockpiles?). The question investors should ask themselves is that whether China is going to slow down to say, 3% to 6% GDP growth or is it going to crash?

We will come to the question later. But first, the current mainstream forecast believes that China will grow 8% to 9% in 2010. Why? Because last Friday, Premier Wen Jiabao announced that he is targeting growth to be 8%.? China is the only country in the world where the government knows in advance what the GDP growth figures will be. If they declare that target for GDP growth is 8%, it will be at least 8%. The question is (1) how much the statistics are tortured and fudged to get arrive at the intended figure and (2) the quality of the GDP growth.

Now, here comes the question: will China crash in 2010/2011?

We don’t know the future, but this is a possibility. According to Marc Faber, the reason is because the Chinese government is clamping down on rampant credit growth. For debt-addicted Western economies, a significant slow down in credit growth will have serious negative impact on the economy. Correspondingly, a clamp down in credit growth will have unpredictable results to the Chinese economy.

The clamp down in credit growth is part of bigger picture. Unlike prior to 2008, China seems to be getting more serious about restraining the economy from overheating. All they have to do is to look across the ocean and look at Japan as an object lesson for not reining in credit and asset price bubbles early on. Since today’s Chinese economy is still developing (unlike the developed Japanese economy in 1990), the consequences of a burst bubble will be much more damaging than Japan’s long-term stagnation. Two months ago, in Chinese government cornered by inflation, bubbles & rich-poor gap, we were pondering what will China choose- voluntary slow-down or an involuntary inflationary melt-up.? As we wrote,

But there will be a day when they have to tackle the inflation problem.

There are signs that the Chinese government is getting more serious about doing so. However, it must be noted that the Chinese government is still on a capitalistic learning curve. That’s why the government’s economic edicts veer from one extreme to another extreme, which is pretty erratic (and authoritarian) relative to Western standards. There’s a chance that they may make a misstep and crash the economy.

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One very important development was reported yesterday: China is nullifying loan guarantees of local governments (see China to Nullify Loan Guarantees by Local Governments). To understand the implication of this, a little background is necessary. China’s local governments are not allowed to borrow directly. In order to raise funds for the stimulus infrastructure projects, they set up special investment vehicles to borrow from banks. Then they guarantee the debts of these vehicles. Through this means, Northwestern University Professor Victor Shih calculates that local governments have already accumulated RMB 11 trillion (US$ 1.7 trillion) in outstanding debt, with RMB $13 trillion (US$ 1.9 trillion) in available credit lines, belying China?s deceptively low reported levels of public debt (see Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?). In one swoop, the central government’s planned edict will nullify the loan guarantees and ban future ones.

Now, since many of the stimulus projects were not creditworthy by themselves in the first place, the removal of local government guarantees implies that many of these debts will become bad debt. According to Professor Victor Shih, a crackdown on such loans at the end of 2009 could trigger a ?gigantic wave? of bad debts as projects are left without funding. Not only that, ?By striking the fear of God into lenders, regulators hope to get them to turn off the [credit] tap,? said Patrick Chovanec, a professor at Tsinghua University in Beijing.

Since this is a serious systemic risk to the Chinese banking system, how will the central government deal with the likely gigantic wave of bad debts? We don’t know. But in 1998, it allowed Guangdong International Trust & Investment Corp (GITIC), a major bank, to collapse. According to Bloomberg,

The 1998 collapse of Guangdong International Trust & Investment Corp., which borrowed domestically and overseas on behalf of southern China?s Guangdong province, left creditors including Dresdner Bank AG of Germany and Bank One Corp. in the U.S. with $3 billion of unpaid bonds. It marked the first time that Chinese authorities failed to bail out one of the nation?s state-owned trusts.

Our guess is that, some of the hundreds of less important (or less well-connected) Chinese banks could be allowed to fail.

Only time can tell.