Things continue to look absolutely awful on the Chinese public sector front. Not only is China already one of the most heavily indebted economies in the EM universe, with a huge pile of formal and contingent quasi-fiscal liabilities, it also runs ever-widening public deficits - and, completely unheard-of in any major country, with a massive skew in the debt burden towards bankrupt local governments as well.

And all of this is before we take China's looming pension crisis into account, driven by collapsing birthrates, one of the lowest average retirement ages on the planet and the world's largest pool of aging retirees. In short, this appears to be a disaster in the making.

But if that is the case, then why haven't things, well, exploded? Where are the spiraling yields and spreads, the defaults, the collapsing deficits and forced austerity? And what would it take for us to get there?

The broad answer here is two-fold.

On the one hand, as regular China watchers know there are already growing austerity pressures in the economy, as local governments hike levies and fees on businesses and push for higher pension contributions. I.e., the fiscal mess is already becoming a drag on activity and growth.

At the same time, however, there is no sign of budgetary funding stress today - nor will there likely be going forward. Why? Because the government completely controls both funding costs and flows via its state-owned monopoly in the commercial banking system, which in turn holds virtually all fiscal and "quasi-fiscal" debt. And as long as this is the case, China can continue to run wide deficits and let debt levels spiral up forever.

Put another way, the real question in the mainland is about the health of banks, not budgets. And we will tackle that issue in our follow-up installment.