(CFP)

The report indicates that near-term domestic risks include the impact of the sharp credit expansion on banks' asset quality, the rise of off-balance sheet exposures and lending outside the formal banking sector, the relatively high level of real estate and commodity prices, as well as increased imbalances due to the current economic growth pattern.

"While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and formation of bubbles, especially in real estate markets," said Jonathan Fiechter, Deputy Director of IMF's Monetary and Capital Markets Department.

"The current system has encouraged over-investment and fuelled asset bubbles," he added.

The report did not predict an imminent crisis, but it said China needed to act quickly given its vulnerability to risks. It called on China to move further toward using interest rates instead of administrative orders to regulate lending and allowing market forces to decide who can borrow. It said Chinese policymakers also should reduce their use of banks to carry out economic plans and instead pay for initiatives out of the government budget.

Banking concern

The IMF conducted a stress test over 17 Chinese commercial banks that account for 83 percent of China's banking system. The test results showed the banks appear to be resilient to isolated shocks such as a fall in real estate prices, exchange rate changes and a sharp slowdown in economic growth.

"If several of these risks were to occur at the same time, however, the banking system could be severely impacted," it said.

The IMF said the worst scenario assumed annual economic growth of 4 percent, sharply below the 9.1 percent posted in the third quarter; broad money supply growth of around 10 percent; a property price tumble of nearly 26 percent; and a change in deposit and lending rates of 95 percentage points.

"The banking system's non-performing loan ratio has been on a downward trend, reaching 1.1 percent at the end of 2010, thanks to strong economic growth and improvements in risk management," the IMF said.

But if credit increases more rapidly, it may cause bank assets to lose some of the flare in the coming years, it added.

The banks' non-performing-loan ratio would rise by at least 1 percentage point for each 1-percentage-point drop in the GDP growth rate, according to the stress tests.

Lu Zhengwei, chief economist at the Industrial Bank Ltd., downplayed the worries.

"The probability of liquidity strain, economic slump and property market meltdown occurring together is quite slim," he said. "As the policymaker fine-tunes monetary policies, market liquidity will become even more ample next year."

"The whole system is still robust enough to withstand major risks," Lu said.

Liu Mingkang, former Chairman of China Banking Regulatory Commission, said Chinese banks have built up strong capital reserves to weather even an acute crisis in case of a real estate market fallout and default of local government debts.

The risks looming over banks' property loans are totally controllable even in the worst-case scenario where property prices fall 50 percent, he added.

However, he cautioned that China faces destabilizing forces from shadow banking simmering underground borrowing activities. Shadow banking occurs beyond the reach of traditional banking system, and it includes entities such as hedge funds, money market funds and structured investment vehicles.

Sun Maohui, Director of Financial Engineering Research Center of Shanghai Normal University, also ruled out likelihood of deeper economic downturn.

"The economic slowdown is a result of government's rebalancing efforts, and will not necessarily lead to a surge in bad loans," he said.

"The banks have avoided reckless lending and raised requirements for borrowers since credit demands remain buoyant," he added.

"The IMF report obviously lacks in-depth probe into the Chinese economy," said Sun. "China should proceed with financial reforms in a reasonable manner and on its own pace."