A year since China untethered the yuan from the dollar, arguments are intensifying whether to let inflation rise in order to bring about the real exchange rate appreciation needed to adjust the country's lopsided economy.

Wary of endangering export-related jobs, Beijing has let the yuan rise just 1.4 percent against the dollar since the initial 2.1 percent revaluation that accompanied the end of the dollar peg. In real terms the gain has been even smaller.

But the case for a stronger exchange rate remains compelling as China's trade surplus continues to swell, with the proceeds fuelling a credit and investment boom that has Beijing worried.

There is a debate now whether to allow inflation to rise or to allow the currency to appreciate, said Qing Wang, an economist with Bank of America in Hong Kong.

Economic theory, in the form of the Balassa-Samuelson effect, dictates that a rapidly growing economy will have an exchange rate that appreciates in real terms.

That can come via a higher nominal rate, faster inflation than the country's trading partners', or a mixture of the two.

One way to bring about higher inflation is to raise the cost of labor, and last week Guangdong, China's main exporting province, ordered a 17.8 percent increase in minimum wages.

Andy Xie with Morgan Stanley in Hong Kong says double-digit increases in minimum wages for 5 years would not only remove all pressure for nominal appreciation but would also contribute to Beijing's policy goal of boosting consumption.

But given the political difficulty of cutting wages, Wang, a former International Monetary Fund official, said a higher nominal exchange rate would provide much greater policy flexibility: in the event of an economic downturn, the authorities could always push the exchange rate back down.

Ultimately, policy is a combination of economics and politics. If politicians decide they'd better protect the poor and sacrifice efficiency, that might be the policy of choice. But as an economist, I don't believe that's the way to go, he said.

What's more, both theory and the experience of other countries suggest that correcting an undervalued currency through higher domestic inflation takes a long time and is more costly to the economy as a whole, Wang added.

For one thing, if the central bank opts for the higher inflation route, it would need to raise interest rates, Ba Shusong, vice head of the financial research institute at the cabinet's Development Research Center, told Reuters.

BOTTLED-UP PRICES

For now, inflation remains well under control. Producer prices rose 2.4 percent in the 12 months to May, while consumer prices were up 1.4 percent.

The Chinese economy is still under heavy pressure from excess capacity in many sectors, said Beijing University economics professor Justin Lin.

But the pipeline pressures are unmistakable. Goldman Sachs expects headline consumer prices to be rising at a 3 percent rate by the end of the year.

Brokerage CLSA's monthly poll of Chinese purchasing managers showed output prices rose in June at the fastest pace in the two-year history of the survey as firms strove to protect profit margins in the face of climbing input costs.

It will not be long before the price pressures in the Chinese economy spill over into local and global inflation, said Jim Walker, CLSA's chief economist.

As well as raising wages, the government has increased administered prices of oil products and electricity.

Other measures to increase the cost of producing tradable goods could be in the works. Scrapping export tax rebates would be the equivalent to a 3.5 percent revaluation of the yuan, the official China Securities Journal said last Wednesday.

Andrew Smithers of London consultancy Smithers and Co. said he suspected China's imbalances, reflected in a record trade surplus and record reserves, would be addressed through higher inflation without much of a change in the nominal exchange rate.

But whichever route is taken will produce problems for the world economy, he said: if prices of Chinese exports rise, the inflation rates of domestic services in rich countries will have to fall for central banks to keep overall inflation in check.

As domestic services' prices depend largely on domestic wages, lower inflation of service prices will require slower growth in domestic wages. This, in turn, is likely to produce below-trend growth in developed economies, he said in a report.

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