Property prices in most of these cities have risen well beyond those in Tokyo and Singapore, it noted.

'Housing affordability (in China) is becoming an increasingly prominent social issue,' the IMF said in releasing the full staff report accompanying its annual 'Article IV' consultation with Chinese authorities, an outline version of which appeared earlier this week and which suggested that China's economy should grow by 10.5 per cent this year.

The report drew attention to an 'unprecedented' expansion of bank credit - especially to local government financing vehicles - in China, but suggested that 'at this point the banking system looks well-placed to withstand a significant deterioration in credit quality'.

Chinese authorities are 'acutely aware of the underlying risks of asset price inflation, not least due to lessons learned from Japan's experience in the 1980s', said the IMF report, which was based on the findings of an international team of experts from the Washington-based organisation.

The central government has 'deployed a range of regulatory tools to contain unwarranted inflation in asset markets', it noted. These include regulatory controls on lending, increased transaction taxes and increases in mortgage rates for second and third homes.

But these attack the symptoms of the problem rather than the causes, which include the low cost of capital in China and the prospects property investment offers for capital gains, owing to strong economic growth and rapid urbanisation. There is also a lack of other savings vehicles in China, the IMF pointed out.

Chinese authorities offered assurances they will expand investment in low-income housing in coming years, which should help to defuse some of the social tensions that can accompany fast-rising residential property prices, the IMF noted. They are also studying the introduction of a property tax.

The IMF has urged China to make greater use of interest rates to offset asset price rises and what IMF economists believe could be more generalised Chinese inflation in future as the output gap narrows.

But China's central bank sees the inflation outlook as 'benign' and fears that 'higher interest rates could risk fuelling capital inflows', the report said.

Credit expansion in China has taken place on an 'unprecedented' scale since authorities moved aggressively in 2009 to ward off the danger of recession in the wake of the global financial crisis, the IMF said.

'Experience both in China and abroad would suggest that this could soon be accompanied by a worsening in average credit quality.'

In order to prevent this, authorities have tightened prudential regulation, demanding that banks make higher reserves against non-performing loans, requiring higher capital adequacy standards, limiting bank guarantees for corporate bonds and encouraging banks to raise new capital.

The IMF is currently conducting a detailed assessment of financial system health in China but current indication are that banking 'profitability is solid', most banks are well capitalised and provisioning levels are being increased and loan to deposit rate margins are improving, the report said.

But if the banking system appears to be in relatively good shape, the same cannot be said of the myriad corporate vehicles used by local governments in China to borrow money for purposes such as infrastructure development, according to the IMF.

Their debt to the banking system has soared since credit restrictions were abandoned as part of China's crisis response.

Some part of this 'quasi fiscal' lending is likely to end up as non-performing loans with negative implications for local government finances, bank balance sheets or potentially, central government finances, the IMF report said.

It called for greater transparency in the accounting of these nationwide entities and noted that 'only now (are Chinese authorities) putting in place systems to identify and measure the level of recourse to these financing arrangement'.

- The Business Times, 30 July 2010