June 19 (Bloomberg) -- China's monetary policy may be overwhelmed by inflows of speculative capital if it doesn't allow greater exchange-rate flexibility, the World Bank said.

``China is too large an economy not to have an independent monetary policy,'' Louis Kuijs, acting chief economist for China, said in Beijing today after the Washington-based lender released its quarterly report on the nation. ``To have that, you need more exchange-rate flexibility.''

The trade surplus, foreign direct investment and inflows of capital from investors betting on currency gains are flooding the world's fastest-growing major economy with cash that threatens to fuel inflation. Capital inflows in the first four months reached $324 billion, nearly double the amount a year earlier, according to Stephen Green, the Shanghai-based head of China research for Standard Chartered Bank Plc.

The World Bank raised its forecast for China's inflation to 7 percent this year from a February estimate of 4.6 percent. Gross domestic product will grow 9.8 percent, more than the previous estimate of 9.6 percent, it said, citing government revisions to data on the size of the service sector's contribution to growth.

The yuan has climbed 20 percent versus the dollar since the government scrapped a fixed exchange rate in 2005. It rose today to the strongest since the end of the peg, trading at 6.8762 against the U.S. currency as of 11:53 a.m. in Shanghai.

U.S. Treasury Secretary Henry Paulson urged greater yuan flexibility at this week's semiannual economic talks with China, in Annapolis, Maryland.

Asset Bubbles, Inflation

``China's monetary policy has not yet been overwhelmed by these inflows,'' said Kuijs. ``It would not be wise to assume that these problems will never overwhelm policy makers.''

The result would be that the central bank wouldn't be able to sell enough bills to soak up excess cash, increasing the risk of asset bubbles and inflation, he said.

There's a risk of a ``massive outflow'' of money if expectations of continued yuan appreciation turn around, the central bank said in a financial stability report released this month. The country's foreign-exchange reserves may rise to a record $1.8 trillion by the end of 2008, Trade Minister Chen Deming said yesterday.

China is trying to tame inflation without triggering an economic slump. Consumer prices rose 7.7 percent in May after inflation reached a 12-year high of 8.7 percent in February.

Reserve Requirements

The People's Bank of China has ordered lenders to set aside a record proportion of deposits as reserves, sold bills to soak up cash and allowed the yuan to gain 6.2 percent versus the dollar this year.

A stronger currency cuts import costs and may also reduce the inflow of money from exports by making China's goods more expensive and less appealing to overseas buyers. The World Bank advocated today more yuan gains.

China hasn't moved on interest rates this year, after six increases in 2007, because of U.S. cuts to borrowing costs. A widening of the gap between the two countries' rates may attract more capital inflows.

``Macroeconomic management would benefit substantially from greater room to increase interest rates,'' the World Bank said in the report.

It noted ``some spillover'' of food inflation, the main driver of China's consumer-price gains, into wages and some other prices, while the effects of industrial commodity and oil price increases are ``in the pipeline.''

China's economy expanded 10.6 percent in the first quarter as global growth weakened and the worst snowstorms in half a century disrupted production and transport. The May 12 earthquake in Sichuan province would likely have a ``modest'' impact on growth, the World Bank said.

To contact the reporters on this story: Nipa Piboontanasawat in Hong Kong at npiboontanas@bloomberg.net; Kevin Hamlin in Beijing on khamlin@bloomberg.net

Last Updated: June 19, 2008 01:20 EDT