Another Chinese interest rate increase in the first quarter is likely, a central bank adviser said on Wednesday, but a vice governor cautioned against raising rates too steeply for fear of luring in hot money.

Li Daokui, an academic adviser to the People's Bank of China, said a rate increase in the first quarter would be reasonable because inflation tends to be elevated for seasonal reasons during the opening months of the year.

Generally speaking, prices tend to trend up in the first quarter, and focusing on such a trend, to make some adjustments in interest rates is reasonable, Li Daokui told reporters at a forum.

The central bank, which raised interest rates twice and increased banks' reserve requirements six times last year, has promised to put the task of fighting inflation at the top of its 2011 agenda.

But deputy central bank chief Yi Gang said in published comments that China should focus on tackling the root cause of inflation by cutting the trade surplus rather than relying too much on monetary policy to fight inflation.

Yi said the origin of China's inflation pressure lies in the country's huge trade surplus, which exerts pressure on the yuan to appreciate.

Chinese officials have warned that monetary policy will be less effective because of excessive liquidity in global financial markets stemming from monetary easing in the United States.

Raising interest rates would curb inflation but it would also attract hot money inflows into China, where required bank reserve ratios have already been lifted to historic highs, Yi told the official Shanghai Securities News.

PRESSURE

The pressure on the central bank to contain liquidity is evident after data showed a record $199 billion surge in foreign exchange reserves in the fourth quarter to $2.85 trillion.

The central bank has to buy most of the incoming foreign currency to keep the yuan stable, pumping out huge amounts of local currency into the banking system as a result.

It has been sterilizing such funds by issuing bills and raising banks' reserve requirements, and Xia Bin, another central bank adviser, said the PBOC has done a good job in the area.

Although it was true that money issuance had been fast last year, the extent should not be exaggerated because the central bank was controlling it through sterilization, Xia said.

Li said the government does want to rein in bank lending, but that setting a full-year credit quota by itself was insufficient.

China's economic structure is complicated today, so it is not sufficient to only set a lending target this year to control the economic performance, Li said.

In the past, China used loan quotas to keep a handle on lending. This year, the central bank has pledged to refine that system with regular calibrations of reserve requirements and capital ratios targeted to individual lenders.

Banks lent 7.95 trillion yuan ($1.2 trillion) in 2010, overshooting Beijing's target of 7.5 trillion yuan, highlighting the need for more decisive policy tightening.

Banks extended a further 600 billion yuan in new loans in the first week of 2011, and lending in January could hit 1 trillion yuan, Caijing magazine reported on Wednesday.

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