China owes its stock market boom and bust to the one thing that is crushing the competitiveness of every part of the world's second biggest economy - debt. The nation's debt mountain is widely estimated to top 250 per cent of gross domestic product, roughly equivalent to US$26 trillion, and is unlikely to peak before 2018. Its rate of growth since the start of the global financial crisis in 2007 has been exceeded only by the euro zone countries that have required international bailouts to stave off bankruptcy. The mainland corporate sector is among the most indebted in the world and the drag on economic activity is made worse because most has been accumulated by state-owned enterprises that deliver a shrinking share of economic growth. The good news is that most of the debt is denominated in yuan, which helps insulate Beijing's US$3.7 trillion foreign reserves pile, and almost all the debt has been borrowed by, or is owed to, entities ultimately backed and owned by the government. The overarching bad news, however, is that cost of servicing the debt and the country's dependence on credit to drive the economy has become so acute that it now takes non-financial businesses around 1.6 units of leverage to deliver a one unit increase in GDP growth. "True, most of China's debt is owned by domestic investors and China has a huge foreign exchange reserve cushion, but it affects balance sheets, raises risk profiles and affects the application of economic policies," Paul Markowski, president of New York-based Falconridge/MES Advisers, told the South China Morning Post . "China's growth paradigm and the use of liquidity and fiscal policy measures to keep up growth in order to prevent unemployment risks, means that China is risking a sea of credit and balance sheet depletion," said Markowski, a long-time external adviser to mainland monetary and financial authorities. Digging itself out from under the debt pile could take a decade, according to Yao Wei, chief China economist at French investment bank Societe Generale, and the urgency to do so is rising - especially as economic growth has slowed further in the first six months of this year from the 24-year low it hit in 2014. "Debt by itself is not necessarily a problem, but if the borrowed funds go to finance investments that generate diminishing returns it is," Yao wrote in a recent note to clients in which she calculates that the ratio of investment required to generate one unit of output has rocketed to 5.5 from less than 2.5 before the global financial crisis. "As the growth deceleration intensifies and financial market liberalisation accelerates, denying the debt problem is becoming an increasingly unviable strategy," Yao wrote in a note. Not least because of deflation, a force that has had an unshakeable grip on the corporate sector since early 2012. Deflation only serves to make debt burdens bigger, which is doubly unhelpful to mainland firms facing the tightest real monetary conditions in at least a decade, according to an index devised by analysts at Bank of America Merrill Lynch. By this combination of currency, loan growth and real interest rates, mainland monetary conditions are as tight - if not tighter - than they were after the People's Bank of China announced a combination of cuts to interest rates and bank reserve requirements in response to plunging stocks in late June. Add in the effect of rising real corporate bond yields and it is clear that "monetary policy in China is still exceptionally tight," Bank of America Merrill Lynch analysts conclude. Private firms in the mainland are estimated, given fragmented and opaque reporting structures, to be carrying a debt load worth about 50 per cent of GDP. The average interest rate they pay is about 9 per cent, according to calculations by Yao. While she expects interest rates to fall in coming years - one-year lending rates are now at 4.85 per cent, below the 2002-04 level they were cut to when China last suffered from deflation - the fact that economic growth is slowing at the same time means that overall credit conditions will be no easier than they are today. "The average bank lending rate used to be much lower than nominal GDP growth for decades. These two have converged recently, almost entirely because of slowing growth," Yao wrote. The massive rise in corporate debt since the turn of the century compounds the problem for companies as well as skewing traditional valuation metrics so much that money managers and financial analysts are left groping for reliable figures on which to base estimates of further downside risk. Total corporate debt in the mainland stands at the equivalent of about US$12.5 trillion versus about US$1.4 trillion in 2000. It is so big that Bank of America Merrill Lynch analysts believe mainland A shares should be valued more on the basis of corporate bonds and calculated on the basis of enterprise value (EV) versus earnings before interest, tax, depreciation and amortisation. That valuation has A shares trading at 27 times EV/ebitda, leaving them languishing near the bottom of the heap in the 93rd percentile. US shares trade at 12.2 times EV/ebitda, Europe at 10.7 times and Japan at 8.4 times. "Our view is simple: China has a debt deflation on its hands - this requires corporate bond yields to be well below nominal GDP growth of around 5 per cent. This means the policy rate should head to around zero per cent," Bank of America Merrill Lynch equity analysts wrote in a recent report. "Yes, it sounds radical, but so is the scale of China's impending debt deflation and the magnitude of its debt binge." Avoiding a debt deflation trap may already be too late. The virtuous growth cycle associated with China's entry into the global economic and financial system in 2001 and the high growth period that was driven by a generational shift to new technologies that created fast growth and expanded wealth is over. "China has downshifted to a vicious cycle of debt deflation as it comes to grips with the vagaries of indebtedness and over-leverage that was part of that cycle of growth," is Markowski's analysis. That vicious cycle is nowhere more apparent than in the structure of China's overleveraged stock market. The mainland's tumultuous US$3.9 trillion equity market unwind has been blamed on the need to repay excessive levels of margin finance - money borrowed in order to buy shares - that helped drive the doubling of the benchmark Shanghai Composite Index in less than a year. Retail investors, many of whom were late to the rally and borrowed money to get in, have been convenient scapegoats to blame for a run-up in official margin financing to 2.3 trillion yuan (HK$2.9 trillion) and another two trillion to three trillion yuan's worth of grey market, unofficial margin lending. But more important are the executives at listed companies who pledged their holdings of shares in companies they controlled as collateral for loans - much of which was needed to fund the working and investment capital the state-controlled banking system starves them of. So-called stock pledge lending has soared in the last four years. HSBC analysts calculate the loans have leapt to 1.5 trillion yuan so far this year - more than was borrowed through that channel for all of last year - and that the total outstanding market value of such transactions is now about 2.5 trillion yuan. Repay that, add it to the one trillion yuan or so of unofficial margin finance estimated to be still outstanding, and the 720 billion yuan that Morgan Stanley analysts estimate must be trimmed from official margin accounts to bring the debt back to a sustainable level, and the stock market rout of late June could be barely halfway through. This is particularly grim, considering the financial sector - including the profits earned from stock market lending - provided 1.7 percentage points of China's second quarter GDP growth. Economists at UBS estimate that contribution will fall by 0.5 percentage point in the second half of the year because of fallout from the stock market volatility. That is not necessarily because of a so-called wealth effect on households crimping consumer spending, which is widely considered by economists to be minimal given the small proportion of household savings invested in equity markets, but because it cuts off a funding channel for private sector firms. It is a staggering turn of events, given that during most of the first decade of this century, corporate investment in China relied upon retained earnings - the portion of profits put aside to finance new projects without increasing debt. Data reviewed by the Peterson Institute for International Economics last year shows that between 2000 and 2008, retained earnings financed 71 per cent of all fixed-asset investment. By 2011, the most recent data available to Peterson, such investment financed by retained earnings had fallen to 54 per cent. It has likely dropped further since. Much of this drop is explained by the fall in SOE competitiveness and the consequent drop in earnings growth in the years since 2009 in particular. Analysts conservatively estimate that about 20 per cent of all SOEs in the industrial sector are habitually loss-making. The average SOE - combining the typical returns for central and local government SOEs - delivers a return on equity at about half the broad A-share market average rate of 13.7 per cent. Broadly speaking, expanding equity finance and ending state monopolies is the key to lifting profitability and improving the efficiency of resource allocation - the latter being a stated policy goal of President Xi Jinping. Raising equity levels helps lower leverage, but there is a wrinkle in that solution right now, says Bill Adams, senior international economist at PNC Financial Services Group and former resident economist at The Conference Board's China Centre, where he helped design the widely watched China leading economic index. "The moratorium on new share issues in Shanghai makes it even harder for China to manage its debts, since it prevents new equity financing - non-debt capital - from being injected into the highly levered corporate sector," he told the Post. In the meantime, policymakers are most likely to rely on the tool most readily available to them to keep corporates afloat, though it is the one that is doing the most damage - debt. "The PBOC can add liquidity; but for what end - more speculation and rubble that will follow? China built its engine on being a low-cost economy that is no longer as competitive and cannot transition to the hi-tech world to compensate for the losses in low-value SOEs in an era of slow global growth," Markowski said. "This is the single most critical threat to China's social and political structure that also puts its national security at risk."