Even the go-for-broke gamblers on the Shanghai stock exchange are getting worried. On July 29 rumors that the Chinese central bank was going to step on the brakes sent that market down 5%.

The next day stocks made up part of that loss by tacking on 1.7% as the People’s Bank of China, the country’s central bank, said it would keep the cash taps open.

The Shanghai Composite index is now up 82% for the year.

Traders and speculators in Shanghai are right to be worried. Efforts by the Beijing government to get the Chinese economy growing again have more than done their job—the economy grew by nearly 8% in the second quarter of 2009—but they’ve also inflated another asset bubble in China.

China is back to the go-go days of 2007. Chinese investors opened 565,000 new accounts last week, the biggest increase since January 2008. China State Construction, China’s biggest home builder, raised $7 billion in its July 29 initial public offering (IPO). Shares jumped 56% in the first day of trading. The offering was the biggest in China since the October 2007 IPO of Petrochina (PTR).  That deal marked the top for Chinese stocks.

This isn’t sustainable, folks. The bubble will keep inflating for a while (my guess is into 2010), but these soaring stock and real estate prices, and the Chinese economic recovery itself, is built on a flood in 2009 of  bank loans, many—probably most—of which will never be repaid. This wave of cash has further unbalanced an already dangerously unbalanced Chinese economy by encouraging a wave of investment in the export sector at a time when the world isn’t exactly rushing to buy.

Who will lose when the bubble bursts?

Chinese investors who poured life savings—or borrowed money—into Chinese stocks, of course. Certainly, Chinese banks, who will, as in 1997, wind up with a mountain of bad debt.

But the biggest losers are likely to be those companies in the global economy who bet that China would pull the world out of recession and who invested in new capacity or borrowed money to expand production. These companies won’t get bailed out by Beijing—as Chinese banks will be—and they can’t count on flexible accounting rules that kept bankrupt companies in business.

The bubble is being inflated in China. The bust will be felt more powerfully outside China’s borders.

What got this all started? A stimulus package that went further than anyone initially imagined.

China initially announced its 4 trillion Yuan–$586 billion—stimulus package to a chorus of skepticism. Yes, on paper a stimulus package of this size is huge, equivalent to a $2.25 trillion stimulus for the much bigger U.S. economy. That’s about three times the stimulus the U.S. Congress finally passed in the early days of the Obama administration. Doubters asked “How effective would it be? And how much of it was actually new money?

What no one realized back in November 2008 was how massively the Chinese financial and political system would leverage any spending by the central government.

So China’s state run banks have made $1.08 trillion in new loans in the first half of 2009. That’s three times the new loans banks made in the first half of 2008 and 50% more than banks lent out in all of 2008

Local governments rushed to submit stimulus projects even before the ink on the stimulus package had dried. That added more money to the total since in the Chinese system, projects approved by the central government are often only partially funded by the national treasury with local government units kicking in the rest. Local governments in China aren’t any more flush with cash than their counterparts in the U.S., however, so they borrowed much of their contribution to the stimulus.

China’s money supply, as measured by M2, was up a huge 28.5% in June.

Drenching the economy with cash worked to get GDP numbers up again. In the second quarter China’s economy, by the official numbers, grew by 6.9%. That reversed an ominous decline. After growing by 13% in 2007, the Chinese economy gradually slowed. Growth went from 9% in the third quarter to 6.8% in the fourth quarter to 6.1% in the first quarter of 2009. Those last two numbers worried Beijing where it’s accepted wisdom that the country needs growth of better than 7% to create enough new jobs to keep the domestic peace (and to keep the Communist party in power.)

But all that cash had some unfortunate consequences too.

Lending standards at banks went out the window and much of this money went to the least efficient, least viable part of the Chinese economy, the state-owned businesses. According to McKinsey & Company, large, usually state-owned companies get 84% of all bank loans, but account for only 45% of GDP. In the mean time, small and medium-sized companies are often shut out of the lending market altogether—in the first quarter just 5% of all direct lending went to small and medium-sized companies–or have to pay 10 times the official interest rate to get an underground loan.

Much of the stimulus went to investment in fixed assets such as railways (up 127% from 2008), roads (Up 55%) and irrigation and public works projects up 55%).  Whatever the rate of return on these investments, the surge of new money into these sectors increases the imbalance in the Chinese economy between investments in fixed assets and consumer spending. These fixed asset investment will only pay off for China if the world is ready to recreate the China makes and the world takes pre-recession model.

If you add state to corporate investment, that’s a lot of money betting that Chinese companies will be able to export even more to the world in the future.

Many of these loans will never be repaid putting the banking sector in danger again. Let’s not pretend that China’s banks managed to lend out 3 times the 2008 money and keep anything resembling loan quality standards in place. We’re looking at a replay of the bad-loan debacle of the late 1990s. Using a variety of accounting tricks and massive state subsidies, China managed to restructure more than $300 billion in bad loans—that would be equal to about $1.2 trillion in the larger U.S. economy. The restructuring got them off the books at state-owned banks (It helps if you own the banks and make the accounting rules), but the bad debt is still floating around the system somewhere. And China’s banks look like they’re about to add to the bill.

And finally, a lot of this cash looks like it has gone into China’s asset markets. Loans to the tune of $170 billion went into stocks in the first five months of the year, for example, according to the Development and Research Center of China’s State Council.

We all know what happens eventually to stock markets where rising prices are built on borrowed money, right?

“Eventually,” though, is the key word. Beijing has shown only very limited interest in taking away the punch bowl so far in either the financial markets or the real economy.

Oh, there have been some steps to raise reserves and a bit of rhetoric but nothing that’s done more than give pause to a few revelers. My guess is that loose money stays this loose in China until growth gets back in the double-digits. The hope, I think, among Chinese officials is that by that time the world economy will have kicked in and be ready to buy enough stuff to get China’s export machine running on its own.

What we’re witnessing then, is a race, between to see which happens first: Will the bubble burst before the global economy can pick up enough so Beijing can step on the brakes?

Of course, every day that the Chinese government lets money supply grow at 25% or better makes the bubble bigger, creates more export capacity for the world to absorb, and raises the risk that the drivers in Beijing will overreact when they do put on the brakes.

I don’t see this ending tomorrow–one of the things teh last two bubbles should have taught us is that they stay inflated longer than we thought and longer enough to cause maximum damage. But I don’t see this ending well.