The Chinese financial system faces “a steady build-up in vulnerabilities” that require the government to relax its grip on banks, the exchange rate and interest rates, the International Monetary Fund said in its inaugural evaluation of China’s financial sector.

The IMF applauded the progress that China has made in giving freer rein to market forces and strengthening regulation but warned of a series of short-term risks facing the world’s second-biggest economy, from defaults on infrastructure projects to the rise of shadow banking.

“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,” said Jonathan Fiechter, head of the IMF team that conducted the analysis.