China's stuck between a rock and a hard place on reforms, Ex-IMF Prasad says

China has a significant debt problem: Eswar Prasad

China has a "significant problem" from its gigantic debt load, but its reform options could make it worse, Eswar Prasad, the former chief of the IMF's China division, said.

The scope of China's debt problem has risen "enormously," since Prasad was the IMF China division chief from 2002-2004, with corporate debt alone at 150 percent of the mainland's gross domestic product (GDP), he told CNBC's "Squawk Box."

But China may not be able to extricate itself, said Prasad, who is currently a senior fellow at think tank The Brookings Institution.

"If they do slow down credit growth very substantially, that's going to mean a slowdown in overall growth. That could mean even more problems in the banking system," he said.

Last year, China's economic growth decelerated to a 25-year low, as improvements in consumption failed to offset a marked slowdown in traditional economic drivers.

While China may be trying to tackle the problem by reforming the banking system and retrenching the economy simultaneously, "it's going to be very difficult to fix the banks and fix the bad debt problem unless they begin at the root, which is the state-owned enterprises (SOEs)," he said, noting China has made little progress on reforming SOEs.

China's banking sector has long spurred concerns that its non-performing loans (NPLs) were grossly underreported and that lending too often was politically directed into industries with too much capacity.

During the global financial crisis, China's government used the banks to inject stimulus into the broader economy. As a result, debt levels rose sharply among local governments and state-owned companies and the banks now hold high volumes of non-performing loans — a problem that is worsening as industrial profitability falls and debtors struggle to service interest payments.

Skittishness over the health of Chinese banks has also undermined the country's creditworthiness. Earlier this year, rating companies S&P and Moody's lowered the outlook on China's debt rating to negative.

Last week, the IMF warned in its annual review of the country that China needed to put the brakes on unsustainable credit growth and stop providing financing to weak companies, Reuters reported.

The report noted that China's non-financial SOEs accounted for half of bank credit, but just a fifth of industrial output, Reuters reported.

Those loans to SOEs remained a key barrier for China's reforms, Prasad said.

"Even if they want to get the banks moving in the right direction, the banks have a legacy problem: That is a stock of loans they made to the state enterprises, some of which are not going to be paid back," he said. "But if they stop financing those state enterprises, then those turn into non-performing loans on their books right away."

Even recapitalizing the banks and spinning off the bad loans may not help out the banks much, he said.

"Banks still have a very strong incentive to lend to the relatively weak state-owned enterprises and unless that incentive structure is changed, recapitalizing the banks and taking the bad loans off their books is not going to solve the problem," he said.

To be sure, there are some signs of slowing credit growth in China: new renminbi-denominated total social financing came in at 488 billion yuan ($7346 billion) in July, well below analysts' expectations. Deutsche Bank said in a note Monday that it expected credit growth would continue to slow in the second half of the year as shadow financing has tightened. The bank estimated that new credit to corporate borrowers actually shrank on month, but it noted that households and government borrowers continued to borrow.

Workers sit on the pavement near a construction site in Beijing, China, on Wednesday, March 2, 2016.
Qilai Shen | Bloomberg | Getty Images

There's another problem with China's reforms: Market-oriented doesn't necessarily mean free market, Prasad noted.

"When they speak about market oriented reforms, they mean having the market work well in terms of allocating resources in terms of acting as a price mechanism," he said. "But when they talk about making the state-owned enterprises more market-oriented, they don't mean giving up state control. What they mean is making the state-owned enterprises behave in a more corporate-like manner."

That's similar to Beijing's efforts to make the stock and markets would according to market principles while still maintaining stability and control, he said.

"It's a fascinating experiment in the making: Whether you can in fact have these two fundamentally contradictory impulses coexisting," Prasad said.

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1