The International Monetary Fund (IMF) has said China's debt is "very high by international standards" and has warned that there was "a high probability of financial distress."

In a report released on Thursday, the global lender of last resort put the overall debt figure for China at 234 percent of gross domestic product (GDP) and predicted the figure to rise to 300 percent by 2022. Corporate debt was currently at 165 percent of GDP, the report said, while household debt had also risen quickly over the past few years.

Read more: OECD warns China on rising corporate debt

The report comes a day after regulators in Beijing drafted rules to strengthen bank funding and follows several alerts about a growing debt problem in the country. The Bank for International Settlements (BIS) — also known as the central bank of central banks — for example, warned that the Chinese banking sector could be facing an imminent blowout, raising worries about its effect on the world economy.

Banks the key risk conveyer 

"Credit growth is an important indicator of future financial distress, because lending standards often fall in the rush to make more loans," IMF experts warned in a blog post. 

The IMF said it had carried out stress tests on dozens of banks and that the big four banks had adequate capital but "large, medium, and city-commercial banks appear vulnerable."

It added that 27 out of the 33 banks tested — three-quarters of China's banking system assets — were "undercapitalized relative to at least one of the minimum requirements."

While the country's banking system meets the requirements of global banking rules known as Basel III, "current circumstances warrant a targeted increase in capital," the report said, adding: "This would create a buffer to absorb potential losses that can be expected during the economic transition as credit is tightened and implicit guarantees are removed."

Shadow banks

"The IMF has highlighted two critical issues in China's financial sector," Linda Yueh, Adjunct Professor of Economics at the London Business School, told DW.

"The existence of ‘shadow banking' loans outside the formal banking system, makes it challenging to assess the scale of private sector debt, and China's lagging regulatory system, which mirrors the slow reforms of its legal system, raises doubts over whether there is sufficient capacity to prevent and address a potential financial crisis that may drag the economy into a long slump," Yueh.

Read more: How dangerous are China's shadow banks?

Crony capitalism

The IMF report also noted that in some cases local banks face pressure to lend to politically important companies. Local government leaders were aiming to maintain high employment "even if that means cash-bleeding enterprises continue to operate."

China's loss-making often state-owned firms have come to be known as 'zombie' companies and banks and investors fund many of them as if they would not be allowed to fail.

"Part of the problem lies in high growth targets, which incentivize local governments to extend credit and protect failing companies," the IMF said, adding that the government had been prioritizing "social stability" in the near-term, appearing "to rely on credit expansion to continue financing firms even when they are not viable."

The introduction of increasingly complex and opaque financial products and banks encouraging excessive risk-taking by compensating investors for losses posed additional risks, the report added.

Ratna Sahay, deputy director of the IMF's Monetary and Capital Markets Department said in a statement that central government officials were aware of these risks and were proactively working to contain them. "We recommend the authorities to de-emphasize GDP growth," Sahay added, under efforts to "encourage local governments to strengthen supervision of risk."

Central bank downplays risk

However, China's central bank said in a statement following the release of the IMF report that it disputed "a few descriptions and views."

"The descriptions of the stress testing did not fully reflect the outcomes of the test," the People's Bank of China said on its website. 

China's economy beat expectations by growing 6.9 percent in the first three quarters of the year, though several international credit agencies have sounded the alarm about rising debt. Standard & Poor's in September cut China's credit rating, for example, leading to criticism from Beijing.

jbuhe (dpa, AFP)