And given the extent that these local banks are connected with China’s new economy — local institutions have been the key lenders to private enterprises and small and medium-sized companies that power the new economic sectors —the representative warned the potential risks of local bank failures will increase and cause disruption across the whole financial system. That may bring greater capital flight and endanger China’s rebalancing efforts to transition to a high value-added economy, especially under China’s new regime that is allowing some companies go under.

“We are now looking at a long-term decline in productivity capacity for China. We are not just looking at a decline from 10 per cent growth to 6.7 per cent right now but potentially a much lower figure going forward,” said Sally Chen, resident representative at the IMF’s office in Hong Kong who arrived in the eye of the storm of yuan-led global market turmoil in January. She said the current decline in growth in China is not just cyclical but also structural.

“We are now looking at a sizeable credit gap. The amount of excess credit given to firms running over capacity and that are no longer productive is now crowding out the productive sectors.”

Chen said the time Chinese companies take to pay bills has risen from a median of the already-long 53 days five years ago to 72 days now — even up to a year in some industries, pushing the country to the absolute longest cash flow cycle in the world.

This problem is burdening a whole swathe of even more companies in the Chinese economy with distressed balance sheets because they do not generate sufficient income between the pay cycles to cover interest on their debt, which in turn becomes potentially uncollectibles on banks’ balance sheets.

Looking beyond the official non-performing loans figures, which Chen said banks have much leeway to interpret under the banking regulator’s murky guidelines, 14 per cent of Chinese corporate debt is now “at risk”, equivalent to 7 per cent of China’s GDP, she said.

“It matters not just because corporates are having a harder time to pay their creditors and suppliers. It matters because the downstream too is spread out to other sectors. You can see it not just in state-owned dominant industries but also at some firms in the super high new economy. High productive industries have also seen a deterioration in revenue.”

According to Chen’s charts, surprisingly, technology companies saw the greatest reduction in their ability to cover interest — by an astounding 20 per cent and that puts the sector in worse order than mining, the second-worse industry.

“If you looked at what happend in the late 1990s, the problem was with the large banks and there was a sense of crisis back then. the government got very actively involved and there was a very thorough reform of state-owned enterprises,” Chen said

“This time around there is no sense of crisis - because you have these concentrated risks in these smaller funds that didn’t put systemic pressure in the broader economy. The sense of urgency is really not there,” Chen said.

“When we look at non-performing loans, to what extent do we have good information on these local banks? And to what extent could we accurately assess the real problems there?” she said.

Having previously covered Spain, Chen said of her arrival that for a moment, the ballooning debt problem in China reminded her of the troubled European nation. The new head of China at the IMF was also previously at the institution’s helm in Spain.

“When we looked at China, one of the legacy problem in terms of the real estate cycle and the corporate balance sheet, the ballooning of the bad debt on balance sheets — what that means and how it spills onto the sovereign — I thought Ah, there are some similarities here,” Chen said. “China presents yet another challenge.”

“The financial market volatility was striking. For a while, we thought we were heading into another financial crisis. The changes in volatility underscored the sensitivity that we had and the lack of confidence in what we see. If that kind of volatility persists, it will affect investment decisions and it’s a problem,” she said.

The IMF is paying more attention to what goes on in China and how it goes about resolving its debt problems because since that last bout of global market volatility caused by transitions in the yuan, just about any knock-on effects stemming from China’s policy transition efforts have now become the biggest disruptive factors weighing on the IMF’s scorecards for their global growth outlook, second only to the problems created by the sustained low performance of the euro economies.

“If China does not address this debt overhang and overcapacity issue, we are looking at a very punishing prospect going forward. And that has implications,” Chen said. “We are at a point that a greater effectiveness of monetary policy stimuli are reaching their limit.”

“The punchline is if these risks materialise, it could result in a reduction in risk appetite, an increase in risk premiums and an increase in funding rates for corporates and sovereigns — what that really means is that at the end of the day, it is a loss of global output by four percentage points over the next five years,” Chen said.

Chen’s warning about the four percentage points disruption to global growth comes at a time when the IMF is forecasting only a feeble 1.5 per cent and 3 per cent growth on average for advanced economies and emerging markets respectively.

This article has been amended to remove the unnecessary words ‘a reduction of’ in the second paragraph and to change the incorrect ‘average’ to ‘median’ in the ninth paragraph. The IMF has provided an updated GDP figure of 6.7 per cent in the sixth paragraph.