The risk of China’s economy collapsing and causing global contagion is becoming an increasing risk, according to the French bank Societe Generale’s latest quarterly investment strategy report.

In the report, the firm notes three main downside risks, including an oil shock where prices spike, an interest rate shock due to US rates and lastly, a potential China collapse, causing emerging markets to drop even further and increasing global volatility.

According to Societe Generale's estimates, China’s debt level has risen sharply to 200 per cent of GDP from less than 140 per cent only six years ago, a 20 per cent growth per annum. Corporates and local government financing vehicles have accounted for nearly all the increase in China’s overall leverage, as this sector’s debt load is approaches 150 per cent of GDP – an undeniably high level by any standard, the report said.

Accompanying this rise in debt is growing capital misallocation, resulting in a trend of declining investment returns.

“A key issue for China’s debt risk is the increasing role of non-bank lending, i.e. the corporate bond market plus the shadow banking system,” the report said, highlighting issues with the lending form comprising off-balance-sheet trust loans, entrust loans, nonbank financial institutions’ lending and formal banks’ lending.

“Credit supplied by these channels is now equivalent to over one-third of formal loans and nearly half of GDP, becoming an important short-term credit provider for corporates. [It] can pose a material liquidity risk to the entire financial system. The new leadership seems well aware of the debt risk and has started trying to deflate the credit bubble in a controlled manner,” added the firm.

As such, the Societe Generale analysts highlighted three key steps that China’s politicians must take in order to slowly deleverage the Chinese economy. This includes efforts to slow new credit growth so the debt risk will accumulate at a slower pace; speeding up financial innovations in order to lower the debt service burden on corporates and alleviate some of the rollover pressure on banks; and lastly, to start writing off non-performing assets so that the economy can become more efficient and more able to pay back debt.

However, the way back from the credit debt crisis will prove to be a bumpy ride for the Chinese government, the report said.

“The aforementioned strategy to deflate the credit bubble has a chance of helping China avoid a full-blown banking crisis in our view. Nevertheless, the fiscal cost will not be low and the execution will be prone to downside risks. The deleveraging process that China will have to go through will be painful no matter what scenario unfolds,” read the conclusion.