The International Monetary Fund (IMF) has cautioned China that it is moving towards "financial calamity" and must keep away from debt to avoid a crisis, according to a report by the Telegraph.
The country is moving closer to a tipping point in which the shadow credit surge from the growing financial sector could affect the country's ability to manage the outcome when finances crash, Markus Rodlauer, deputy director of the IMF's Asia-Pacific department, said.
"The level of financial and corporate debt and the complexity of the financial system and rapid growth in shadow banking is on an unsustainable path," Rodlauer said.
"While still manageable in its size given the size of the public assets under public control, the trend is dangerous and if it's not corrected it will lead to a correction, "the official explained. "The longer it lasts ... the more serious the disturbance and the disruption might be. The reaction could range from a mild growth slowdown, to a sharp slowdown in growth to potentially a financial crisis."
According to recent data, the country's credit and the financial sector leverage is rising faster than economic growth at a "dangerous pace," the IMF's latest World Economic Outlook said while its Financial Stability Report showed small banks in the country were exposed to shadow credit as part of capital buffers, which, in some banks, reach nearly 600 percent.
Rodlauer, who worked as IMF's China's mission chief for five years, added that China will have a huge impact on global economy, as well as with countries where it has trade and financial ties.
According to IMF analysis, a 1 percent decline in Chinese growth resulted in a 0.2 percent decline in global output.
"All eyes are on China because of [the stock market turbulence last August]. Over the past year, we've seen shocks to the stock market being correlated quite quickly with global financial markets. So there is no doubt that a calamity or a problem in China would have very serious repercussions for the global economy, both real and financial," Rodlauer said.
Last month, the Bank for International Settlements expressed concern over China's "credit to GDP gap". Currently, the banking risk gauge is at a record high of above 30, higher than levels seen prior to the 1997 Asian financial crisis.
Rodlauer said that although it was not immediately alarming, it could become a problem in the future. "China's sovereign balance sheet is very strong, and so is the capacity for the government to move around resources and to address issues," Rodlauer said.
The IMF official, however, said that the "sudden stop" in capital flows will not happen since foreign funding in China is limited.
"These are elements of strength that lead us to believe that even though these measures clearly indicate a warning, they are not signaling an imminent crisis as they might on the eve of Thailand before the Asia financial crisis," Rodlauer said.
Rodlauer, however, remained optimistic that the government would be able to lead the country away from investment -led growth towards consumption. He added that market reforms and the services sector could help maintain the country's growth rate of between 6 percent and 7 percent in the longer term.
He said that empowering the private sector would help generate productivity and raise the living standards of people.