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 percent for 2017, which was up from 6.2 percent. The organization also said it expects China to average 6.4 percent growth between now and 2021, versus its previous estimate of 6 percent.
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 percent of GDP by 2022, up from around 240 percent 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.
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 percent in July versus the same period last year.
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.
WATCH: Should you be concerned about Chinese debt?
