China is edging towards "financial calamity" and must wean itself off its debt addiction and reform if it is to avoid a crisis, the International Monetary Fund has warned.
Markus Rodlauer, deputy director of the IMF's Asia-Pacific department, said the world's second largest economy was approaching a tipping point where its rapidly growing financial sector and surge in shadow credit could undermine the state's ability to contain the fallout from a crash.
"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," he 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 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."
Data show credit and financial sector leverage in China has continued to rise much faster than economic growth. The IMF's latest World Economic Outlook said debt in China was rising at a "dangerous pace", while its Financial Stability Report showed small Chinese banks were heavily exposed to shadow credit as a share of capital buffers, with exposure reaching nearly 600 per cent at some banks.
Rodlauer, who served as the IMF's China's mission chief for five years, said stronger trade ties and financial linkages between China and other countries meant the impact of a hard landing on the global economy could also be huge.
IMF analysis shows a 1 per cent decline in Chinese growth in translates into a 0.2 per cent decline in global output, with the biggest impact felt in neighbouring countries and its closest trading partners.
"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," said Rodlauer.
The Bank for International Settlements raised alarm bells last month over China's "credit to GDP gap". The key gauge of banking risk is currently at a record high of above 30, and much higher than levels seen in the run up to the 1997 Asian financial crisis.
Mr Rodlauer said the level was not immediately alarming, but could become more troublesome over time. "China's sovereign balance sheet is very strong, and so is the capacity for the government to move around resources and to address issues," said Mr Rodlauer.
The IMF chief added that the risk of a "sudden stop" in capital flows was also unlikely as foreign funding in China remains limited.
"These are elements of strength that lead us to believe that even though these measures clearly indicate a warning, they are not signalling an imminent crisis as they might on the eve of Thailand before the Asia financial crisis."
Rodlauer said it was more likely that an "accident" would materialise if state enterprises and local government continued to plough money into unproductive investments or if China's shadow banking system became much larger and more complex.
"The more this happens the more it becomes difficult for regulators to supervise that and to control it, and if there is an accident to coordinate a rescue or resolution of that." Rodlauer said he remained optimistic that Chinese policymakers would be able to steer the country away from investment led growth towards consumption.
While Mr Rodlauer said steady progress was now imperative, he said labour market reforms and opening up the services sector could help the country to maintain a growth rate of between 6 per cent and 7 per cent in the longer term, even if growth in the short and medium term is slower.
He added that empowering the private sector could generate huge productivity gains, which would help to raise living standards. "Just look at Alibaba. In a couple of years they have unified the goods market in China.
They have invented their own transport system to deliver goods from one country to the other. That provides a huge boost to productivity in of itself. "And that potential exists in hundreds of other areas."