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China faces 'enormous challenges': Paulson

China's economy faces "enormous challenges," former U.S. Treasury Secretary Hank Paulson told CNBC, warning that exaggerating the country's economic strength was a mistake.

"This is a country that has some real strengths but some enormous challenges," Paulson told CNBC Monday.

"They have an economic model that's run out of steam, that they very much need significant reforms and at least as big a mistake could be made exaggerating China's strength as underestimating its potential," he warned.

Paulson's comments come a day after China's central bank implemented its third interest rate cut since November in a bid to stimulate the economy.

The People's Bank of China (PBoC) announced the cut in its benchmark lending rate and one-year deposit rates by 25 basis points on Sunday, as growth in the Asian economic giant slowed to levels not seen since the global financial crisis.


Henry Paulson, former U.S. Treasury secretary
Nelson Ching | Bloomberg | Getty Images
Henry Paulson, former U.S. Treasury secretary

Still, China's annual growth rate is still an enviable 7 percent, according to the latest statistics, although Paulson thought it was "optimistic" to believe China could maintain that growth rate.

"There's no doubt growth is slowing down, that shouldn't surprise anyone. The Chinese have talked about the 'new normal' of 7 percent (growth) but they may be optimistic," Paulson told CNBC.

"I think investors should really be looking at what are the sources of that growth. Are they (China) taking the reform steps they need so they're much more reliant on the private sector and opening up markets to competition? Are they taking steps to rein in their over-investment in infrastructure," he said.

Paulson should know what he's talking about when it comes to China, having built close business relations with the country during his role as chairman and chief executive of Goldman Sachs from 1974 to 2006, in which he played a part in opening up the country to private enterprise and visited the country around 70 times, he said.

Those experiences have served as a foundation for Paulson's latest book entitled "Dealing with China. An Insider Unmasks the New Economic Superpower" in which he discusses how Western business and political leaders can work with -- or compete with -- China.

"I step back and take a look (at China) on a longer term and China is facing some real structural issues with regard to its economy. They've been much too reliant not only on exports but on municipal investment and infrastructure which has led to a very rapid increase in municipal debt and that's not sustainable," he warned.

Read MoreThe risks behind China's growth gamble

"If the growth is coming the right way, then I think investors can be optimistic for the longer term, although there could be some bumps on the road. But if China continues to revert to overinvesting in infrastructure, then there's a much bigger risk that there will be real volatility and that this will spill over to the underlying economy."

- Written by Holly Ellyatt and reported by Julia Chatterley, follow them on Twitter @HollyEllyatt and @JChatterleyCNBC Follow us on Twitter: @CNBCWorld