"China's banks and financial sector are healthy, but there are vulnerabilities that should be addressed by the authorities," Deputy Director of the IMF's Monetary and Capital Markets Department Jonathan Fiechter said in a statement.

Fiechter headed the team that conducted the IMF's first Financial Sector Assessment Programme (FSAP) review jointly with the World Bank.

"While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and the formation of bubbles, especially in real estate. The cost of such distortions will only rise over time, so the sooner these distortions are addressed, the better," Fiechter said.

While significant progress has been made toward developing a more commercially oriented financial sector and supervision and regulation are being strengthened, risks stem from the growing complexity of the system and the uncertainty surrounding the global economy, it said.

Further reforms are needed to support financial stability and encourage strong and balanced growth, the IMF said in its first formal evaluation of China's financial sector.

China is one of the systemically important countries that have agreed to carry out mandatory assessments of its financial system at least once every five years.

The FSAPs come as part of the IMF's financial surveillance activities for monitoring of the international monetary system.

According to the FSAP report, China's financial sector is confronted with several near-term risks: deterioration in loan quality due to rapid credit expansion; growing disintermediation by shadow banks and off-balance sheet exposures; a downturn in real estate prices; and the uncertainties of the global economic scenario.

Medium-term vulnerabilities are also building up and could impair the prospects for reorientation of the financial system to support the country's future growth, the IMF said.

Moving along this path will pose additional risks, so priority must be given to establishing the institutional and operational preconditions that are crucial for a wide-ranging financial reform agenda, the report said.

The IMF said the main areas of reform should include steps to broaden financial markets and services and develop diversified modalities of financial intermediation that would foster healthy competition among banks and expansion of the use of market-based monetary policy instruments using interest rates as the main instrument to govern credit expansion, rather than administrative measures.

There is also a need for reorientation of the role of government from merely using the banking system to implement broad policy goals and allow lending decisions to be based on commercial goals, it said.

The report also urged China to upgrade financial infrastructure and legal frameworks, including strengthening of the payments and settlement systems, as well as consumer protection and expansion of financial literacy.

The IMF said stress tests conducted jointly by the fund and Chinese authorities of the country's 17 largest commercial banks indicate that most of them appear to be resilient to isolated shocks, which include a sharp deterioration in asset quality (including a correction in the real estate markets), shifts in the yield curve and changes in the exchange rate.

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