China's financial system was increasingly vulnerable as threats such as worsening credit quality and a bursting property bubble were growing, the International Monetary Fund said in its first review of the country's financial system. Chinese banks, however, would be able to withstand a range of sector-specific shocks occurring in isolation, including rising bad loans in the property sector, local government financial vehicles, the export sector and other industries, the IMF said in the Financial Sector Assessment Programme review of China released yesterday. But stress tests showed the financial system could be 'severely impacted' if several major shocks happened at the same time. Such a scenario assumed economic growth of 4 per cent, sharply below the 9.1 per cent in the third quarter; M2 money supply growth of about 10 per cent; a 26 per cent drop in property prices; and a change in deposit and lending rates of 95 basis points. The report is in line with prevalent views that risks are growing in the mainland financial system and only reforms to further commercialise banks and liberalise financial markets can help address the underlying problems. 'China's banks and financial sector are healthy, but there are vulnerabilities that should be addressed by the authorities,' said Jonathan Fiechter, the IMF's Monetary and Capital Markets deputy director. '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.' The report was conducted with the World Bank in the second half of last year when analysts and regulators started to worry about credit quality after banks, responding to government calls, pumped an unprecedented 9.6 trillion yuan (HK$11.76 trillion) into the economy to fund stimulus projects in 2009. A sizeable portion went to local government financing vehicles (LGFVs) and property developers. While bad loans have now begun to rise as some LGFV projects fail to generate sufficient cash flow for repayment and the property market is cooling under government crackdowns, small exporters are grappling with lacklustre external demand and economic growth is decelerating. The stress test showed banks' non-performing-loan ratio rose by at least one percentage point for each one point drop in gross domestic product. While short-term risks stemmed from credit quality, drops in property prices and growing off-balance-sheet exposures, medium-term risks mainly came from the 'relatively inflexible macroeconomic policy framework and the government's important role in credit allocation', the IMF said. Robert Horrocks, chief investment officer of US-based fund house Matthews Asia, said the opaque nature of the mainland's banking system worried international investors. He said the definition of bad debt was heavily influenced by the political agenda of the government, which was keen to tell the market that the financial sector was doing fine. 'Mainland banking stocks are some of the cheapest in the region, but we don't like them because their balance sheet can shrivel up at the blink of the eye,' he said. Horrocks warned that banks' non-performing loans were likely to go up when local government projects went sour but these were unlikely to show on the books.