The Chinese banking system could be severely affected if risks such as sharp deterioration in asset quality, shifts in the yield curve and changes in the exchange rate, were to occur at the same time, the International Monetary Fund said in a report on Monday.

However, the stress tests conducted on the country's largest 17 commercial banks by the Fund indicates that most of them are resilient to isolated shocks.

China should outline steps to broaden financial markets and services, and develop diversified modalities of financial intermediation that would foster healthy competition among banks, IMF said in its first-ever Financial Sector Assessment Program review of China, carried out jointly with the World Bank. The Fund also recommended a reorientation of the role of government away from using the banking system to carry out broad government policy goals and to allow lending decisions to be based on commercial goals.

It also wanted China to expand the use of market-based monetary policy instruments, and to use interest rates as the main instrument to govern credit expansion, rather than administrative measures.

Deputy director of the IMF's Monetary and Capital Markets Department Jonathan Fiechter said "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.

RTTNews