Ray Dalio, the founder of Bridgewater Associates, believes that China is going to experience a big financial bust because of its escalated domestic debt problem.
A private note from Dalio said, "This rapid expansion in credit looks like it has created significant vulnerabilities in the Chinese financial system at a time when the economy is still near the front end of a material loss cycle."
The note was published by Larry Cofsky and Matthew Karasz and summarized findings of stress tests conducted on China's banking system conducted this year. The findings focused on second-tier banks and shadow banking.
"One of the largest risks to the banking system is its exposure to off-balance sheets non-standard shadow banking products such as wealth management products and trusts," the note said.
The hedge fund also issued a warning on the escalation of loan products offered by second-tier banks that is worsening the debt problem in the country.
Dalio wrote, "These banks look vulnerable to us; they are large (more than 30 percent of bank assets), growing rapidly with increasing reliance on wholesale funding, and they are responsible for much of the growth in opaque on-balance sheet assets as well as off-balance-sheet wealth management products."
Shadow banking is another problem that the Chinese government is attempting to stop. Shadow banking is a form of financing outside the banking system.
Michael Pettis, a professor at Peking University's School of Management, said that shadow banking is harmful to the economy.
He said, "It (shadow banking) continued increasing investment into manufacturing capacity to the point where we have excess manufacturing capacity in a wide variety of industries, it increased infrastructure spending and real estate development well beyond the needs of China, so basically what that means is that an increasing amount of capital has been allocated to projects in which the real economic value of the project is less than the cost of the investment. In other words, it's a waste of investment, particularly in the real estate sector."