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 when the Washington-based lender released its quarterly report on the nation. ``To have that, you need more exchange-rate flexibility.''

The World Bank today forecast inflation in the world's fourth-biggest economy of 7 percent this year, up from a February estimate of 4.6 percent. Record inflows of cash from trade, foreign direct investment and investors betting on more gains by the yuan threaten to fuel price gains.

``Excess liquidity is already a problem,'' said Huang Yiping, chief Asia economist at Citigroup Inc. in Hong Kong. ``The expectation of significant further appreciation of the yuan is encouraging more inflows.''

Gross domestic product will grow 9.8 percent, more than the previous estimate of 9.6 percent, the World Bank 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 6.8755 against the U.S. currency as of 3:49 p.m. in Shanghai.

Paulson's Call

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

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.

``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.''

If that happened, the central bank wouldn't be able to sell enough bills to soak up excess cash, increasing the risk of asset bubbles and accelerating 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.

Taming Inflation

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.

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

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.

Borrowing Costs

``Macroeconomic management would benefit substantially from greater room to increase interest rates,'' the World Bank said in the report. ``Speculative inflows have been a constraint,'' it said.

China must rebalance growth toward services and domestic consumption and away from industry and investment to reduce a current-account surplus which rose to 11.3 percent of GDP in 2007, the World Bank said.

China's economic expansion slowed to 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 04:07 EDT