UPDATE 2-China central bank warns of inflation risk

Thu May 10, 2012 8:50am EDT

(Adds details, quotes)

By Aileen Wang and Lucy Hornby

BEIJING May 10 (Reuters) - China's central bank warned of continued risks of inflation, driven in part by rising labour costs, while pledging to increase two-way flexibility in its yuan exchange rate in a quarterly report released on Thursday.

The report's publication came ahead of April's data release on Friday, which is expected to show overall inflation moderating to about 3.3 percent but food prices rising by more than twice that amount, driven by higher vegetable prices.

"The overall price trend is falling, but it has not yet stabilized, and we need to closely watch the upside risk for prices in the future," the People's Bank of China said in the report.

The bank listed some favourable factors that are keeping prices under control, including "appropriate monetary conditions" and a relatively stable external liquidity environment.

"As the Lewis turning point approaches, domestic labor supply is tightening and the price of labor-intensive agricultural products, the service industry, and resource-based products will tend to rise further," the bank said, referring to a stage in a country's economic development when the economy fully absorbs rural surplus labor that keeps wages from rising.

"As demand climbs, it will drive a resurgence in prices. Moreover, imported inflationary pressures due to international commodity price volatility still exist."

By contrast, in the central bank's report for the fourth quarter of 2011, it pledged to prevent a rebound in inflation.

The central bank said it would step up yuan exchange rate reform and increase two-way flexibility.

The yuan had essentially only appreciated against the dollar since it was unpegged from the dollar in July 2005, but has flattened since late last year. Offshore yuan markets showed rare expectations of depreciation in the second half of 2011.

China widened its trading band in mid-April in what many analysts saw as an indication that market forces would play a bigger role in setting the value of the yuan.

April trade data released on Thursday showed that Chinese exports had risen by a surprisingly low 4.9 percent on year.

"It shows the over-strengthening of the Chinese yuan. That will show policy makers that they really need to resist any further strengthening of the yuan," said Darius Kowalcyzk, of Credit Agricole-CIB in Hong Kong.

The central bank said it would improve risk control for property loans and strengthen supervision of local government debt.

It will use multiple monetary policy tools to guide reasonable credit and money growth, the report said, mentioning reserve requirement ratios and open market operations.

It sounded a cautious note about international conditions, noting that the European debt crisis constitutes the biggest uncertainty for the global economy.

Loose monetary policy by developed countries could bring inflationary pressure and make capital flows more volatile, it warned.

The stand-off over Iran's nuclear program could push up global crude oil prices, it added. In the first quarter of this year, oil futures in New York returned to levels not seen since the previous May, but they have since fallen back to below $100 a barrel. (Reporting by Aileen Wang and Lucy Hornby; Editing by Nick Macfie and Ed Lane)