The International Monetary Fund on Wednesday urged China to embark on sweeping financial system reforms to shore up long-term growth, starting by freeing up its undervalued yuan.

The IMF praised market-oriented changes already underway, but said China needed to embark on a complex "rebalancing" plan that would take the country from an export focus to a more domestic-consumption model.

That would boost household incomes, help build the country's service industries, and strengthen China's role in -- and reduce its systemic threats to -- the global financial system.

"Chinas capacity to both transmit and originate real shocks is rising, implying an important stake for the world in its stability," the Fund said in a new report on the Chinese economy.

"Insofar as its export-oriented growth model is a source of stresses, economic rebalancing is crucial."

"A prerequisite for that financial reform will be to have a more appreciated renminbi," IMF China mission chief Nigel Chalk told reporters in a briefing on the report.

The IMF, as before, called the yuan, also called the renminbi, "substantially" undervalued.

It said that despite a simple 5.5 percent appreciation against the US dollar in the past year, in fact it had depreciated in both real and nominal terms against a basket of key currencies.

China's executive director at the Fund, He Jianxiong, took issue with that, saying the assessment "ignores the trend exchange rate movement" as well as coming, medium-term reforms already laid down.

Chalk said that simply floating the yuan, which closely tracks the dollar and underpins the huge power of Chinese export industry, would have only limited domestic and global benefits if not followed by other financial industry reforms.

The IMF mapped out a sequence of "risky" reforms necessary to adapt the country to shifts in its labor market, keep a strong hand on financial bubbles, and give the authorities better tools to manage the world's second largest economy.

It said that letting the yuan appreciate and float would open the door toward other key measures that would include developing more outlets for savings and investment; liberalized, market-based interest rates; better credit allocation; and eventually the dismantling of China's capital controls that prevent the yuan from being an internationally traded currency.

"A stronger renminbi would increase household income, boost consumption, make China's manufacturing products more affordable for the Chinese people, and help build a stronger service economy," said Chalk.

Not embarking on this sweeping rebalancing of the economy, the Fund warned, "would imply unprecedented increases in export market share, potential overhang in capacity, and adverse spillovers from resulting stresses on corporate and bank balance sheets."

"The stakes for the world in a smooth transition to a more domestically led growth model are thus significant."

"I think we have to recognize that this is a risky undertaking. It needs to be managed very carefully, it needs to be sequenced correctly," Chalk told reporters.

"This is an extremely complicated macroeconomic engineering exercise. As a result we think it needs to be handled quite carefully."

Chalk stressed that the goals, and many of the specific steps, were already included in Beijing's 12th five-year development plan, and so were not controversial.

"It's going to take certainly at least three to five years to move from the current financial system towards one that is much more market-based," he said.

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