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.