Analysis | Debt and deflation darken China’s economic outlook

Debt and deflation are the two biggest risks facing the mainland economy and may take years to resolve as a slowdown looms.

While a Japan-style, demand-starved deflation cycle is unlikely - real economic growth of about 7 per cent, high by international standards, precludes it - China's high debt and massive industrial overcapacity are major impediments to healthy growth.

"Japan reminded us very clearly of a story we have seen many times before in history," Peking University professor Michael Pettis told the . "The combination of very high levels of debt and excess capacity can lock an economy into a self-reinforcing spiral in which high debt levels put downward pressure on both consumption and investment, causing a further increase in the real debt burden."

Yu Yongding, a professor at the Chinese Academy of Social Sciences - the mainland's top economic think tank - thinks it could take five years to eliminate the economy's excess capacity.

"The danger lies in financial areas," Yu said, noting that there are four major risks in the economy - a crash of the real estate market, runaway corporate leverage, default of local government debt and capital flight.

China has been suffering disinflation of late. Consumer prices are rising at their slowest in five years at 1.5 per cent, while prices at the factory gate have fallen for 34 consecutive months.

The ratio of corporate debt to gross domestic product rose to 137 per cent in the third quarter of last year from 92.1 per cent in 2008, according to JP Morgan.