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While most commentators have chosen to focus on the nefarious sounding "shadow banking" industry, the real problem is that banks are illiquid after having moved so much of this off balance sheet. It was only one year ago that the Chinese banking regulator publicly noted that state-owned banks' non-performing loan figures simply didn't add up. This should have provided them significant liquidity, but only reveals the depth of the bad loan problem on their books.

A recent Reuters article noted that banks are scrambling to "set aside additional funds with the central bank on Friday in order to meet the required reserve ratio (RRR) … because June was the end of the first half, banks that hope to window-dress their books strive hard to attract new deposits, meaning most banks will have to put aside extra reserves, traders said." Nor was this rush a one-off. As the People's Daily reported, 1 trillion RMB in deposits left Chinese banks the June 30 deadline to meet capital adequacy ratios.

The evidence that banks are hurting is growing rapidly. A recent China Banking Regulatory Commission report put non-performing loan growth at more than 20%. CITIC, Minsheng, and China Everbright reportedly have NPL rates of 4%-5%. Minsheng reportedly needs $11 billion in additional capital, and China Merchants Bank has been given the go ahead for a secondary offering. This is not the hallmark of a healthy banking system. So even after selling a lot of their loans -- including the bad ones -- off balance sheet into WMPs, Chinese banks are still facing a liquidity crunch saved only by central bank intervention. If Chinese banks sold even a slightly higher-than-average percentage of bad loans into WMPs, they should have ample liquidity. This only reveals how weak their loan book is and not that they have been skirting regulations (which they probably have been regardless).

The battle is between state owned banks and the Peoples Bank of China. The PBOC understands the enormous risks right now of the Chinese banking system because of the explosion of credit. The PBOC, however, is being given its political marching orders from the Party, prudent banking policy be damned. As Forbes put it, "In the absence of effective regulation, therefore, they (the PBOC) leak stories to the Shanghai Securities News."

The banks and the politicians see the solution to this problem as throwing more money at the problem and crossing your fingers that they will grow their way out of this mess. Recent statistics reveal that the supposed Chinese economic rebalancing is a mirage similar to economic liberalization. According to the most recent monthly data, fixed-asset investment grew at 20.4% year on year while consumer sales growth clocked in at 12.6%. Even assuming these numbers are legitimate, which is a dubious proposition at best, it shows that investment, surplus capacity, and housing continue to grow extremely rapidly, extending the coming hangover.

One more worrying number in this data is the difference between central and local government investment. Central government investment increased by a more prudent 7.7% while local government investment increased by 21.1%. The PBOC is much closer to trying to execute central government policies than local government chieftan policies. State-owned banks are controlled much more by their provincial and local branches than Beijing headquarters, and this is as much a fight between central and local governments as it is between the PBOC and state-owned banks. The PBOC sees declining impact of investment on GDP, enormous amounts of surplus capacity, and rolling over loans to pay back the old ones.

The PBOC has fired a shot across the bow of banks and politicians hoping to borrow their way out of this problem and has stepped back, hoping the message has been received by the markets. The PBOC is trying to push prudent (read: non-political) lending. The banks and their local political masters that seek to maximize public off-balance sheet lending are scared this gravy train will come to an end. The PBOC can see the flood of bad loans coming due and is seeking to manage the defaults, while the banking system and politicians are seeking to keep throwing money at the white elephant projects, staving off the inevitable.

The reason this financial game of chicken matters is the underlying matter of running an authoritarian state. The Party in Beijing is terrified about what happens if it can't maintain breakneck growth. Many outsiders, and even China based reporters, have not focused on the near-boiling discontentment with Party rule. Recently, when a Beijing man blew himself in the airport, Weibo (the Chinese Twitter) exploded with expressions of sympathy over his grievance. Even the official news agency Xinhua urged the government to help people people feel justly treated.

In how many countries do people side with an airport bomber? In another instance, when a watermelon seller was killed by police, a prominent blogger compared him to the Tunisian fruit seller who lit himself on fire, setting off the Arab Spring. This is not a populace that is willing to be patient. If growth drops and unemployment goes up, China will be one bank collapse away from real political unrest.

This returns us back to the original dilemma. Politicians and the central bank are at loggerheads. There is serious infighting about what to do with technocrats trying to tackle the problems and the Party, politicians, and banks trying to spend their way out of an impending debt crisis. Despite all the talk of restraint, land sales are exploding and developers have been spending money at enormous rates. While occupancy rates in most cities top out at 60% and while land is being sold and money is being given out, the party will continue a little while longer as politicians spend what's left to keep growth buoyant. The entire system depends on it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.