By Mark Magnier

BEIJING -- China faces mounting financial risk even as an innovation drive aimed at rebalancing the economy away from low-value manufacturing falls short, according to a report by the Organization for Economic Cooperation and Development.

Among the financial risks China should address "urgently" include excess production capacity in heavy industry and frothy prices in property and other asset markets that add to the risk of "disorderly default," according to the "OECD Economic Surveys: China 2017" report. The Paris-based research body forecast growth in China of 6.5% this year and 6.3% in 2018.

China faces a delicate balancing act this year as it tries to prop up growth in an important political year -- top leaders will be named at a Party Congress this fall -- while avoiding a potential financial crisis after years of stimulus and rapidly mounting debt.

China may need more than three years to work down excess housing inventory in small cities, according to the report, which looks at how the world's second-largest economy can foster more resilient growth. Housing prices rose 22.7% in the first two months of 2017 from a year earlier compared to a 16.8% increase in December, according to official data. This comes despite recent efforts by Beijing to dampen speculation in top markets.

China's financial stability also is jeopardized by mounting financial industry and corporate debt, particularly among state-owned companies, despite tax cuts enacted to reduce the burden on enterprises, the OECD said. Corporate debt stood at 170% of China's gross domestic product in early 2016, up from less than 100% at the end of 2008, it said. This is among the highest for major economies.

The OECD wasn't the first to issue such warnings. In mid-2016, the International Monetary Fund said soaring corporate debt is a serious and worsening problem in China that needs to be tackled quickly if Beijing wants to avoid potential systemic risk to itself and the global economy.

For much of last year, China propped up growth with accommodative monetary policy and stepped-up infrastructure spending to hit its growth target. In 2016, the economy grew 6.7%, its slowest pace in a quarter-century, and Beijing has set an "about 6.5%" goal for 2017. Using stimulus funds to bolster short-term growth will add to longer-term imbalances, the group said.

"China has undertaken substantial reforms," said Alvaro Santos Pereira, an OECD director. "A lot more can be done."

In a bid to shift from low-value manufacturing and exports to consumption, China has identified innovation as a priority to bolster growth. But the report says these efforts sometimes fall short.

China devotes 2% of its GDP to research and development -- more than some OECD countries -- and generous subsidies have driven a soaring number of new patent registrations. But most of these patents are incremental, not innovative, and have a declining impact on productivity, the report said.

While China registers 15,000 new companies a day, its business environment needs to be more entrepreneurial, the OECD added.

Innovation also is impeded by a system that inadequately protects intellectual property, despite special courts set up in recent years to protect patents, copyrights and trademarks, the report said.

The manager of Candy Intelligent Technology Co., a small maker of smartwatches based in the southern manufacturing hub of Shenzhen, said the government should provide more subsidies, tax cuts and enforcement protection for smaller, creative companies.

"Right now, intellectual property protection in China is really bad. It's as if there's no law at all," said Zheng Hanbo, Candy Intelligent's general manager. "It's like guerrilla warfare."

At a press conference marking the end of the annual National People's Congress, China's parliament, last week, Premier Li Keqiang said entrepreneurship and innovation are fueling national vitality. He called on the government to do more to encourage companies and regulate effectively.

Also impeding creativity and healthy growth is the lack of an effective bankruptcy system, the report said, which allows debt-loaded state firms to linger. "Too many firms are unviable," the report said.

The OECD report also called on China to improve transparency in a host of areas, from better financial data to improved corporate practices, and urged greater protection for whistle blowers to reveal corporate malfeasance.

China will remain themain driver of global growth -- last year it accounted for over one-third of the world's output -- but it needs to address inequities in education, healthcare, pensions and other parts of the social system that leave many people behind, the report said.

Write to Mark Magnier at mark.magnier@wsj.com

(END) Dow Jones Newswires

March 21, 2017 04:36 ET (08:36 GMT)

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