China Investment Corporation.

To see why a crash may be coming, it is worth examining the behavior of the China Investment Corporation- the $200 billion sovereign wealth fund set up by the Chinese government in September ... Six weeks ago, the power of sovereign wealth funds was celebrated and China Investment's moves into the market were awaited with bated breath.

A third of China Investment's portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks, and another third will recapitalize China Agricultural Bank and China Development Bank, to shape them up for privatization. $3 billion of the fund was invested in the private equity manager Blackstone Group in May - that may have bought China useful political contacts, but it is now worth $2 billion. And the remainder is being invested very carefully, primarily in U.S. Treasury securities - which are also losing money steadily in yuan terms.

The lackluster investment strategy of China Investment exposes a central flaw in the Chinese economy, its lack of a rational system of capital allocation. For more than a decade, Chinese state-owned companies have made losses, and have been propped up by the banking system. Since 2004, loss-making state-owned companies have been joined by overbuilding municipalities, erecting white-elephant office blocks in attempts to turn themselves into the next Shanghai. None of these losses has resulted in bankruptcy; instead the cash flow deficits have been covered by the Chinese banks. As a result, the Chinese banks have an enormous volume of bad loans $911 billion at May 2006, according to a later-withdrawn estimate by Ernst and Young, which must surely have ballooned to $1.2 trillion-1.3 trillion now ...

A $1 trillion problem in subprime mortgages has caused even the U.S. money market to seize up and has required frequent applications of sal volatile by the Fed. Since China's economy is around one fifth the size of the United States' the Chinese banking system's bad debt problem is in real terms about five times that of the United States, about 40% of its gross domestic product.

We have seen this movie before; the Japanese banking system's bad debts after 1990 totaled around $1 trillion, about 30% of Japan's GDP. The result was the bursting of the 1980s bubble and a period of little or no economic growth that lasted well over a decade.

Since China also has much of the corruption that bedevils Latin America and its government lacks any genuine understanding of the free market and is increasingly dominated by special interests, it may indeed be fated to follow a Latin American growth path for the next few decades, with a tiny entrenched elite enriching itself at the expense of the disfranchised masses.