IMF: China Must Tackle Debt-Fueled Growth

China's economy is looking good enough that the International Monetary Fund is raising its outlook, but the organization is doing so with a strong warning over growing debt in the world's second-largest economy.

The IMF issued its annual review of China on Tuesday, and has revised its growth forecast to 6.7% for 2017, which was up from 6.2%. The organization also said it expects China to average 6.4% growth between now and 2021, versus its previous estimate of 6%, CNBC reported.

Still, the organization warned that things were far from peachy. "The growth outlook has been revised up reflecting strong momentum, a commitment to growth targets, and a recovering global economy," the IMF said. "But this comes at the cost of further large and continuous increases in private and public debt, and thus increasing downside risks in the medium term."

What Beijing needs to do is to seize its current strong growth momentum "to accelerate needed reforms and focus more on the quality and sustainability of growth," said the report.

At the top of that list is working to tackle the debt issue: Going forward, the IMF sees China's non-financial sector debt to hit nearly 300% of GDP by 2022, up from around 240% last year.

Debt-fueled growth, the IMF warned, is a short-term solution that isn't sustainable in the long run unless China tackles deeper structural issues.

Alarm Bells Ringing

Experts have been sounding the alarm bell over this issue for years, urging China to rein in its old model of opening credit lines to fuel investment and spending and to find a better balance between supporting growth and controlling risks to the economy.

Chinese banks extended 825.5 billion yuan (about $123.44 billion) in new loans in July, down from 1.54 trillion yuan in June. Outstanding total social financing—a broad measure of credit and liquidity—came in at 1.22 trillion yuan last month versus 1.78 trillion yuan in June.

Part of the drop is seasonal, and it's "masking an uptick in underlying credit growth," wrote China economist Julian Evans-Pritchard at Capital Economics. A better way to look at credit creation is to gauge growth in outstanding bank loans and total social financing, both of which rose roughly 13% in July versus the same period last year.

Risks Increase

“The near-term growth outlook has firmed but at the cost of higher medium-term risks. Policy support, recovering external demand, and reform progress have helped keep growth strong. Amid strong momentum and an expectation that the authorities will do what it takes to achieve their medium-term growth target, staff have increased their medium-term baseline growth projections,” the IMF said.

“However, risks around this baseline have also increased. The main cost of this stronger growth outlook is further large increases in public and private debt. Such large increases have internationally been associated with sharp growth slowdowns and often financial crises. Staff thus recommends replacing precise numerical growth targets with a commitment to reforms that deliver the fastest sustainable growth path.”

Aside from dealing with debt, the IMF also said China needs to address overcapacity and increase productivity in inefficient sectors, including those featuring China's "zombie" state-owned enterprises.

It's not all red flags: The IMF applauded China's efforts to boost oversight and regulation of financial sector risks, to control a run-up in corporate debt, to better manage capital outflows and to stabilize fluctuations in the yuan.

Banking Sector

The IMF also highlighted its worries about the rapid growth of China’s banking sector, now one of the largest in the world. “China now has one of the largest banking sectors in the world. At 310% GDP, China’s banking sector is above the advanced economy average and nearly three times the emerging market average.

“The sharp growth in recent years reflects both a rise in credit to the real economy and intra-financial sector claims. The increase in size, complexity and interconnectedness of these exposures have resulted in sharply rising risks.”

Beijing rejected the IMF’s criticisms, saying that the stronger growth outlook for 2017 was the result of a rebalancing of the economy and the government’s reform program rather than a reliance on debt.