In the recent past, there has been lot of discussion on where the Chinese economy is headed and on the country’s banking sector health. The Credit-to-GDP gap is a good early indicator of stress in the banking system and it indeed shows that there are big reasons to be concerned about China’s banking system. In particular, when economic growth remains sluggish and property prices are also muted.

The chart below gives the Credit-to-GDP for Asia, China and few other countries where the gap is high.

China leads significantly and this data implies that credit growth is meaningfully higher than the long-term trend. As economic activity remains muted, there is increasing risk of bad loans translating into a full blown crisis for the banking sector.

Policymakers need to understand that China’s slowdown is due to manufacturing and production excesses and this problem is unlikely to be solved through easy money. The transition from a production based economy to a finer balance between production and consumption will happen over time and involves prolonged period of sluggish growth. However, if credit growth continues, a potential banking sector crisis will only delay any recovery in the economy.

For now, I maintain my cautious outlook on China and I must mention here that India’s credit-to-GDP gap is negative 3.2 as of 3Q15 and the country is a good long-term investment destination. In the coming years, I see portfolio reallocation in Asia with investors likely to be overweight India.