* IMF releases report on stability of China's financial system
* IMF says regulators should reinforce primacy of financial stability over growth
* China should form financial stability sub-committee - IMF
* Under severely adverse scenario, banks may face capital shortfall equal to 2.5 pct of GDP - IMF (Adds details on IMF's stress tests for select banks)
BEIJING, Dec 7 (Reuters) - China should prioritize financial stability above development goals, as pursuit of regional growth targets and helping firms avoid heavy job losses had led to a surge in debt, particularly at local government level, the International Monetary Fund said.
Noting a lack of coordination and inadequate systemic risk analysis in a report released on Wednesday, the IMF also recommended the formation of a financial stability sub-committee comprising the central bank and three financial regulatory agencies, and an increase in staff for the banking watchdog.
Since the IMF's last assessment of the Chinese financial sector's resilience to shocks and contagion in 2011, two concerns remain - credit growth remains high and the expansion of wealth management products (WMPs), said Ratna Sahay, deputy director of the IMF's Monetary and Capital Markets Department.
"Risks are large," Sahay told reporters during an online briefing. "Having said that, the authorities are really aware of risks and they are working proactively to contain these risks."
The IMF report said that while China has been taking steps to address its debt risks, reining in excessive credit growth will require a de-emphasis on high GDP projections in national plans that have spurred local governments to set high growth targets.
But the near-term prioritization of social stability seems to depend on credit growth to sustain financing to firms even when they are non-viable, it said.
"The apparent primary goals of preventing large falls in local jobs and reaching regional growth targets have conflicted with other policy objectives such as financial stability," the report said.
"Regulators should reinforce the primacy of financial stability over development objectives," the fund said.
China's credit-to-gross domestic product (GDP) ratio is very high by global standards and consistent with a high probability of financial distress, the IMF said, citing an estimate from the Bank for International Settlements.
NEW PRODUCTS, NEW RISKS
The IMF specifically warned that the rapid development of financial products for investors could pose grave risks.
"We are also concerned that in a very innovative financial system such as China's, new products can emerge very quickly and very rapidly become large and popular, and potentially a systemic risk," said James Walsh, deputy division chief of the Monetary and Capital Markets Department.
"Better coordination among supervisors is therefore essential to make sure that these risks are contained, and that everyone understands what the risks to these products are," he said.
The China Banking Regulatory Commission (CBRC) was well-positioned to manage emerging risks, the IMF said, while adding that there was room for improvement.
"CBRC should be able to take decisions independently, and its budgetary autonomy should be preserved," said Alvaro Piris, deputy division chief of the IMF's Monetary and Capital Markets Department.
"In terms of resources, the CBRC as with the other supervisory agencies under (PBOC) have been working with a headcount that hasn't changed in 10 years, a period in which the Chinese financial sector has more than doubled in size," Piris told reporters.
The report said Chinese banks, while meeting Basel requirements, should hold more liquid assets and gradually increase their capital to create buffers to absorb potential losses that can be expected during China's economic transition as credit is tightened and assumed guarantees for investors are removed.
On its visits to China, the IMF conducted stress tests covering 33 banks with 171 trillion yuan ($26 trillion) in total assets and 20 trillion yuan in off-balance sheet WMPS. The IMF said the tests showed "widespread" and "large" under-capitalisation among joint-stock and city commercial banks under a severely adverse scenario, which includes both domestic and external financial shocks.
Under the scenario, the nonperforming loans ratio for the 33 banks would jump to 9.1 percent from 1.5 percent. The capital shortfall for the 33 tested banks amounts to 2.5 percent of gross domestic product, the IMF said. It said in a footnote the PBOC did not give it access to all the supervision data needed for its stress tests, without elaborating.
The PBOC reacted swiftly to the report's release, saying that while the report is objective and pertinent, the stress tests "do not reflect the whole picture."
China has a relatively strong ability to fend off any financial risk, the central bank said in a statement on its website.
($1 = 6.6135 Chinese yuan) (Reporting by Ryan Woo; Editing by Simon Cameron-Moore and Sam Holmes)