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China to Use Yuan, Interest Rates to Tame Inflation (Update1)

By Nipa Piboontanasawat and Li Yanping

Feb. 22 (Bloomberg) -- China's central bank said it will make the yuan more flexible and use interest rates to curb inflation that's projected to remain ``high'' in the first half of 2008.

The yuan's appreciation is helping to temper import prices while exporters have shown ``higher-than-expected'' tolerance to a stronger currency, the People's Bank of China said in a report today. It didn't give a forecast for inflation, which reached an 11-year high of 7.1 percent in January.

The yuan completed its biggest weekly gain this year and has risen 16 percent since the end of a fixed dollar link in 2005, as the government tries to prevent the world's fastest-growing major economy from overheating. China's economy grew 11.4 percent last year, the fastest pace in 13 years.

``The central bank needs to achieve a balance between growth and inflation,'' said Frank Gong, chief China economist at JPMorgan Chase & Co. in Hong Kong. ``The best way to curb inflation is to appreciate the currency faster and reduce import costs.''

The yuan closed at 7.1418 per dollar as of 5:30 p.m. in Shanghai, bringing its gain this year to 2.3 percent. The currency climbed 7 percent against the dollar in 2007, more than double the gain the previous year.

China will ``boost the exchange-rate's role in adjusting the balance of payments and in curbing inflation,'' the central bank said in the fourth-quarter monetary policy report. The bank ``needs to carefully use interest rate tools to control the expansion of demand and stabilize inflation expectations,'' it said.

Subprime Impact

China has raised interest rates six times in the past year and boosted the percentage of deposits banks must hold as reserves to a record 15 percent. The benchmark one-year lending rate is 7.47 percent.

Economic growth may slow ``moderately'' this year on ``domestic and global uncertainties,'' the central bank said in the report, posted on its Web site.

``As the subprime crisis causes persistent fluctuations to financial markets, aggravated by upward inflationary risks, central banks are in the dilemma of choosing between curbing inflation and maintaining necessary economic growth,'' it said. ``Monetary policy has become increasingly difficult.''

China's inflation accelerated in January as the worst snowstorms in decades disrupted food supplies. The annual inflation rate more than tripled in 2007 to 4.8 percent, exceeding the central bank's target of 3 percent.

Inflation may remain at a ``high-level'' for ``some time'', driven by more expensive global commodities, domestic supply shortages and energy price reforms, the central bank said. The bank is studying the introduction of a ``core-index'' for inflation that excludes seasonal and international price factors.

Export Jobs

China has resisted pressure from the U.S. and Europe for faster yuan gains on concern a stronger currency would make the nation's exports less competitive, causing job losses. China's trade surplus rose 23 percent from a year earlier to $19.5 billion in January, after surging to a record $262.2 billion in 2007.

``Most foreign trade-related companies have adjusted to volatilities in the renminbi and their production, operations and hiring have remained stable,'' the central bank said. The yuan is a denomination of China's currency, the renminbi.

Economists surveyed by Bloomberg News said last month that China may use currency gains to combat inflation instead of interest rates as the U.S. Federal Reserve cuts borrowing costs. A wider gap in rates between the two countries may attract more cash into China, boosting money supply and prices.

The central bank cautioned that international moves to limit the activities of sovereign wealth funds could hurt the global economy. China has set up a $200 billion fund to seek higher returns on part of its $1.5 trillion foreign-exchange reserves, the world's largest.