SINGAPORE, Nov 15 (Reuters) China needs to tackle inflationary risks by raising interest rates to rein in demand and letting the yuan rise faster to curb its huge trade surplus, a key source of easy money, the World Bank said on Thursday.
China's buoyant domestic economy makes it well-placed to weather the impact from the U.S. subprime market crisis, the development lender said in its semi-annual report on East Asia.
In fact, a moderate global slowdown would help Beijing tackle its biggest challenge: the swelling trade surplus that boosts liquidity and drives up asset prices, it said.
''The authorities are rightly aiming at avoiding excess demand and the spill-over of high food prices into generalised inflation, and mopping up liquidity and raising interest rates will continue to be needed,'' the World Bank said.
''However, the main macro-economic task remains to contain the rising trade surplus, and a stronger real exchange rate is the most obvious tool.'' Consumer inflation bounced back to a nearly 11-year high of 6.5 percent in October from 6.2 percent in September, data showed on Tuesday, strengthening the case for further monetary tightening.
The World Bank said, however, China's inflation was driven by food prices and should lose steam if global commodity prices moderated.
To ward off inflationary overheating, the central bank has raised interest rates five times this year and ordered banks nine times to set aside more of their deposits as reserves.
Milan Brahmbhatt, the World Bank's regional economist, said China's stock markets may be heading towards ''significant corrections'', despite rapid economic growth that has helped fuel the stock market boom.
''Given an economy that is growing rapidly, there is a lot of room for strong stock market increases. On the other hand, the price-earning ratios are very high,'' he told reporters.
Chinese firms were trying to cope with higher production costs by pushing up export prices in dollar terms, but they still had a competitive edge over foreign rivals, the World Bank said.
The yuan has gained about 5 percent against the dollar so far this year, but it has fallen almost 6 percent against the euro .
''As a result, prices of China's exports are now rising in U.S. dollar terms, but they are still rising by less than those of other countries. In other words, China is still gaining competitiveness,'' the bank said.
China reported on Monday that its trade surplus hit a record .05 billion in October and the World Bank said government's mainly tax-based measures to curb exports were not sufficient.
''Given the size of the surplus and the drivers behind the surplus, significantly more policy action is likely to be needed,'' it said.
The bank listed a more flexible exchange rate, higher fiscal spending on health and education and further financial sector reforms as long-term measures needed to rebalance the economy.
REUTERS BJR DS1133