China is transitioning to a slower yet safer and more sustainable growth, which involves giving the market a more decisive role in the economy, the International Monetary Fund (IMF) said Friday.

The IMF expected the growth to slow to 6.8 percent this year, reflecting progress in addressing vulnerabilities, especially a needed moderation in real estate investment. It expected the growth to further slow to 6.3 percent in 2016, as the country continues to rein in vulnerabilities.

Economy on sustainable path but cahllenges still ahead

"The labor market has remained resilient despite slower growth, as the economy pivots toward the more labor-intensive service sector. This, in turn, has supported household consumption," the IMF said in its annual Article IV Consultation Staff Report for China.

The Washington-based institution further said in the report that China has made progress in reducing vulnerabilities, for example by slowing down credit growth, moderating investment, and passing a new budget law aimed at safeguarding fiscal sustainability.

Despite the data on slowing industrial growth, China's service sector is holding up well, IMF China Division chief Steve Barnett said at a conference call Friday. Now China's industrial sector has a smaller share of economy than before, while the service sector is taking up a larger share, Barnett said.

The trend of a continued slowdown in the manufacturing sector and continued resilience in the service sector will continue, he said.

According to the report, a key challenge facing China now is to ensure sufficient progress in reducing vulnerabilities while preventing growth from slowing too much.

In regard to managing the slowdown, the IMF suggested China should calibrate its macroeconomic policies to achieve an orderly adjustment by aiming for GDP growth of 6 to 6.5 percent next year.

"Going too slow will lead to a continued rise in vulnerabilities, while going too fast risks a disorderly adjustment," IMF mission chief for China Markus Rodlauer said in a press release. "The key to managing this trade-off is structural reforms to boost potential growth."

The IMF urged China to undertake "bold" structural reforms, such as moving to a more market-based financial system, improving the management of government finances, and leveling the playing field between state-owned enterprises and the private sector.

RMB no longer undervalued

In the report, the IMF said that the substantial appreciation of the Chinese currency, the renminbi (RMB), in real effective terms this year has brought the exchange rate to a level that is "no longer undervalued."

The IMF considers China's recent move to improve its exchange rate formation system as "a welcome step" to allow market forces to play a greater role in determining the exchange rate. It reiterated that China can, and should, aim for an effectively floating exchange rate regime within two or three years.

In the conference call, Rodlauer said that China's move to link the RMB's value to market forces is an encouraging step towards a flexible floating exchange rate system.

The official said as China is quickly moving towards an open capital account and integrating more and more into the global economy, it's increasingly important for China to have a flexible floating exchange rate, as the exchange rate can act as a shock absorber to capital flows that cannot be absorbed alone by other macroeconomic tools.

He believed China's move to improve the central parity formation system is just the first step towards a floating exchange rate system, and he expected China to further widen its exchange rate trading band in the future.

Following China's decision to adopt a more market-determined exchange rate, the Chinese yuan's central parity rate against the greenback has fallen 4.6 percent over the last four days.

"What has happened now over the past few days does not change our assessment (that the RMB is no longer undervalued)," Rodlauer said.