I wrote in April and June about the Chinese slowdown. I thought that it would get worse but the Chinese economy fooled me again. The last time I made a dire prediction about the Chinese economy was in December of 2008. Why did I make these mistakes? I underestimated the Chinese government’s taste for risk.

I was wrong. I wrote in April and June about the Chinese slowdown. I thought that it would get worse but the Chinese economy fooled me again. It rebounded. Real estate prices rose. Retail sales increased. Both service and industrial production expanded. I say again, because the last time I made a dire prediction about the Chinese economy was in December of 2008. Why did I make these mistakes? The simple reason is that I underestimated the Chinese government’s tastes for risk.

Law gets in the way of the Chinese communist party. So they usually do quite well without it. But certain types of laws, those dealing with insolvency can be quite handy in clearing debts to encourage the creative destruction of capitalism. It is this destruction that governments around the world have taken enormous risks to avoid.

When the Chinese economy contracted rapidly in 2008, the government responded by allowing its banks to double and even triple the number of loans they made in prior years. One problem with this strategy was that they had not successfully dealt with the bad loans from the recession in 1999 to 2000. Yet neither the banks nor the government were that concerned. Chinese banks made 80% from the ‘spread’, the difference between the money they paid depositors and the amount they charged in interest. Since both were set by the government, the banks were guaranteed to make money. Bad debts were basically passed on to the depositors as a hidden tax. So without fear of the consequences, the Chinese economy sailed its way through the recession on a tide of debt, while the rest of the world’s financial system was stuck in insolvent mud.

You can stimulate your economy this way, but too much money eventually pushes up prices. In China this means real estate. Real estate makes up 15% of the Chinese GDP (gross domestic product); provides local governments with most of their income and is considered the only reliable investments. Incomes have increased in China, but real estate prices have grown up to four times faster. With the dream of a home outpacing most family income, the government became concerned with social unrest, to say nothing of millions of unoccupied apartments and a potential real estate bubble. So they solved the problem. In an economy driven by the state, the state slows the economy, not with market forces like interest rates, but with new rules and regulations.

The rules and regulations worked, but a bit too well. The real estate market slowed and along with it the Chinese economy. Growth in China fell from over 9% in late 2010 to 7.4% today. The slowdown was exacerbated by the recession in China’s major export market in Europe and marginal growth in the US. There are also other factors. Firms are relocating to cheaper locations and FDI (foreign direct investment) has slowed. The slowdown was a particular embarrassment in 2012 when China had its once-in-a-decade change of leadership. This is supposed to be a celebration of the Communist Party’s accomplishments and not evidence of failure.

Fortunately a new source of funding has appeared. As any Wall Street banker knows, rules exist to be circumvented. Chinese financial institutions are no different. They created trusts. These off balance sheet vehicles make or amalgamate loans and sell them to investors as wealth management products (WMP). In theory this system was illegal or at least a grey area. But it suited the banks which were looking for more profit and the local governments that were looking for more ways to borrow money. It also suited investors and depositors who were looking for safe ways to get a decent return on their money. Most recently it has suited the government who wanted to stimulate the slowing economy.

These products were wildly popular. They now have 12 trillion yuan ($1.9 trillion) under management—almost 13% of the banking system. They have grown over five times since 2009. They have provided the financing for the recent real estate recovery and the money for ambitious infrastructure projects along with continued heavy lending from the state banks. But there is one problem. These products can default.

Recently there have been issues with products issued by Huarong Financial, Huaxia Bank and even China’s largest financial institutions—China Construction Bank and CITIC. These products are until next year issued off the balance sheet of the issuing institution. They are unregulated with little or no transparency. Many go to very speculative projects, specifically real estate development whose land purchases support local governments. There is also a dangerous asymmetry. The products usually are issued for a few months, but the loans can be for years.

Two of these problems are especially interesting because they illustrate how these problems are resolved. Huang Financial is especially interesting because Huarong was originally set up as one of the AMCs, companies set up by the four major banks to get rid of the bad debts from the 1999 to 2000 recession. Not only did they fail to resolve the debts they never paid back the $250 billion bonds that they owed the banks, the bonds matured and were rolled over. Instead the AMCs like Huarong morphed into lending financial companies.

Huarong lent money to LDK Solar. When the loan went bad, LDK was bailed out by the Xinyu city government. Having a government entity pick up a company’s debt happened in the US as well. The problem is that like the US, the governments are already saddled with heavy debts from the last round of stimulus.

A similar problem occurred with Shandong Helon a rayon manufacturer in the city of Weifang. Helon has long been in trouble, not for its main business, but for real estate speculation. It borrowed $63 million in the form of commercial paper which it could not repay. In stepped the city of Weifang, a 16% owned of the company, and repaid the creditors of the commercial paper to avoid the major embarrassment of the imminent default. But the price was to stop payment to Helon’s other creditors like the large Chinese banks. This is not an isolated incident. Helon is a state-owned company and according to the World Bank, a quarter of them do not make any money. Despite the lack of profits they have almost exclusive access to loans from the state owned banks.

Both the PBOC (People’s Bank of China) and the CBRC (China Bank Regulatory Commission) have finally expressed concerns. The PBOC’s latest announcement speaks of “controlling risks” and the CRBC has asked for a list of all WMPs. But both have a major problem. If they draw too much attention to the bad products they may start a panic. Investors have been assured that these products are perfectly safe. Also if they shut down the industry they also stop the flow of money that is helping stimulate an increasingly inefficient economy. If the economy slows again, the problems will increase. So like the US regulators before them in the sub-prime crisis, their interest may be too little too late.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)