The International Monetary Fund (IMF) has warned that China’s banking and financial systems are highly vulnerable due partially to the Beijing government’s heavy involvement in the markets, as well as poor regulation and corporate governance.

The Washington-based organization called for Chinese officials to ease its control of the Yuan currency and permit the nation’s central bank greater latitude in making policy decisions.

“While significant progress has been made towards 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 uncertainties surrounding the global economy,” IMF said.

According to the fund, many companies and local government agencies in China are now burdened by heavy debts due to excessive lending since the global financial crisis of 2008. In the current climate, an economic slowdown and declining real estate values have prompted a wave of defaults.

Local governments in China had lent an astounding 10.7 trillion Yuan by of year-end 2010 – or about 27 percent of GDP for that year – according to reports.

The IMF also complained that a full evaluation of China’s financial sector is precluded by limited access to information and what it called”data gaps.”

Jonathan Fiechter, deputy director of the IMF Monetary and Capital Markets Department, noted that while China’s financial sector is “robust overall” it is nonetheless plagued by inefficient credit allocation and other problems.

Indeed, the IMF conducted stress tests on 17 banks and found them apparently able to withstand isolated shocks. Still, a confluence of negative events, including deteriorating loan quality, falling property prices and a global economic downturn, could conspire to pose serious risks to the country’s financial sector.

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, Fiechter said.

The cost of such distortions will only rise over time, so the sooner these distortions are addressed the better. China's banks and financial sector are healthy, but there are vulnerabilities that should be addressed by the authorities.”

Among the recommendations IMF offered to shore up China’s financial system, it suggested that state-owned banks should lend based on commercial risk parameters, rather than be dictated by government policy. The Fund also asked Beijing to set interest rates based on supply and demand.”