Debt ratios have reached extreme levels across all major regions of the global economy, leaving the financial system acutely vulnerable to monetary tightening by the US Federal Reserve, the world's top financial watchdog has warned.
The Bank for International Settlements (BIS) said the wild market ructions of recent weeks and capital outflows from China are warning signs that the massive build-up in credit is coming back to haunt, compounded by worries that policymakers may be struggling to control events.
"We are not seeing isolated tremors, but the release of pressure that has gradually accumulated over the years along major fault lines," said Claudio Borio, the bank's chief economist.
The Swiss-based BIS said total debt ratios are now significantly higher than they were at the peak of the last credit cycle in 2007, just before the onset of global financial crisis.
Combined public and private debt has jumped by 36 percentage points since then to 265 per cent of GDP in the developed economies.
This time emerging markets have been drawn into the credit spree as well.
Total debt has spiked 50 points to 167 per cent, and even higher to 235 per cent in China, a pace of credit growth that has almost always preceded major financial crises in the past.
Adding to the toxic mix, offshore borrowing in US dollars has reached a record US$9.6 trillion, chiefly due to leakage effects of zero interest rates and quantitative easing (QE) in the US.
This has set the stage for a worldwide dollar squeeze as the Fed reverses course and starts to drain dollar liquidity from global markets.
Dollar loans to emerging markets (EM) have doubled since the Lehman crisis to US$3 trillion, and much of it has been borrowed at abnormally low real interest rates of 1 per cent.
Roughly 80 per cent of the dollar debt in China is on short-term maturities.
These countries are now being forced to repay money, though they do not yet face the sort of "sudden stop" in funding that typically leads to a violent crisis.
The BIS said cross-border loans fell by US$52 billion in the first quarter, chiefly due to deleveraging by Chinese companies.
It estimated that capital outflows from China reached US$109 billion in the first quarter, a foretaste of what may have happened in August after the dollar-peg was broken.
China and the emerging economies were able to crank up credit after the Lehman crisis and act as a shock absorber, but there is no region left in the world with much scope for stimulus if anything goes wrong now.
The venerable BIS - the so-called "bank of central bankers" - was the only global body to warn repeatedly and loudly before the Lehman crisis that the system was becoming dangerously unstable.
It has acquired a magisterial authority, frequently clashing with the International Monetary Fund and the big central banks over the wisdom of super-easy money.
Borio said investors have come to count on central banks to keep the game going but this engenders moral hazard and is ultimately wishful thinking.
"Financial markets have worryingly come to depend on central banks' every word and deed," he said.
Financial markets have worryingly come to depend on central banks' every word and deed.
A disturbing feature of the latest scare over China is a "shift in perceptions in the power of policy", a polite way of saying that investors have suddenly begun to question whether the emperor is wearing any clothes after all, following the botched intervention in the Shanghai stock market and the severing of the dollar exchange peg in August.
The BIS "house-view" is that the global authorities may have put off the day of reckoning by holding interest rates below their "natural' or Wicksellian rate with each successive cycle but this merely stores up greater imbalances, drawing down prosperity from the future and stretching the elastic further until it snaps back.
At some point, you have to take your bitter medicine.
The BIS report said the rich countries have failed to right the ship over the last seven years or bring leverage back down to manageable levels, as the Nordic states succeeded in doing after the banking crises a quarter of a century ago.
Instead they seem to be caught in a Japanese trap.
"Aggregate private debt has barely stabilised, let alone started to correct downwards, even in the corporate sector.
And government debt continues to rise steadily, in a manner reminiscent of Japan's trend deterioration in the 1990s," it said in its quarterly report released over the weekend.
Britain, Spain, and the US have cut household debt ratios but this is still not enough to offset the massive jump in public debt since the Lehman crisis.
France has suffered the worst deterioration of any major country in the developed world, with total non-financial debt levels spiraling upwards by 75 percentage points to 291 per cent, overtaking Britain at 269 per cent for the first time in decades.
The concern is what will happen as the Fed prepares to raise interest rates for the first time since 2006, perhaps as soon as this week.
A study on financial spillovers in the BIS report found that much of the global financial system remains anchored to US borrowing rates, whether or not countries have fixed exchange rates or floating currencies, and regardless of normal theory on trade links and business cycles.
On average, a 100-point move in US rates leads to a 43-point move for emerging markets and open developed economies, with powerful knock-on effects on longer-term bond rates.
"We find economically and statistically significant spillovers," it said.
The grim implication is that emerging economies may face a monetary shock as rates ratchet higher, even if the liabilities are in their own currencies.
What remains unclear is whether QE by the European Central Bank will delay the denouement yet again.