The World Bank raised its 2010 growth and inflation forecasts for China and recommended a tighter monetary policy as well as a stronger exchange rate to restrain inflation expectations and asset bubbles.

The bank revised its projection of gross domestic product growth this year to 9.5 percent from 8.7 percent in its previous China Quarterly Update in November and 9.0 percent in a regional report released in January.

For 2011 the bank penciled in GDP growth of 8.7 percent -- exactly the same rate China enjoyed in 2009 as the economy responded to massive monetary and fiscal stimulus.

In China the economy has held up very well during the global crisis and growth prospects for this year and next year remain quite good, Louis Kuijs, senior economist in the bank's Beijing office, told a news conference on Wednesday to issue the report.

Growth this year of 9.5 percent, which was the median forecast of economists in a recent Reuters poll, would vault China past Japan and make it the world's second-biggest economy.

UBS also raised its 2010 GDP forecast on Wednesday, to 10 percent from 9 percent, citing the momentum of domestic demand and a likely recovery in net exports back to pre-crisis levels.

The World Bank now expects consumer prices to rise by 3.7 percent on average this year -- it had forecast 2.0 percent in November -- and by 2.8 percent in 2011.

We think that inflation risks remain modest, in large part because of the global context. Nonetheless, the macro stance needs to be noticeably tighter than in 2009 to manage inflation expectations and contain the risk of a property bubble, the Washington-based lender said.

Meeting this year's target of 7.5 trillion yuan in new loans -- down from a record 9.6 trillion yuan in 2009 -- would be important to anchor inflationary expectations. Higher interest rates would make the tightening more convincing, the bank said.

The world economy is still very subdued, but China's growth has been strong and, unlike in most other countries, overall output in China is, according to our calculations, rather close to its potential -- which means there is not a lot of spare capacity, Kuijs said.

STRONGER YUAN

As for the yuan, a stronger exchange rate would help dampen inflation pressure by lowering the price of imports and toning down demand. It would also help rebalance China's growth toward services and consumption and away from industry and investment.

Over time, more exchange rate flexibility can enable China to have a monetary policy independent from U.S. cyclical conditions, which is increasingly necessary, the report said.

Yet the bank coupled its stress on the need to contain inflationary expectations with a warning that wrestling inflation down to very low levels might hinder the relative price changes required in such a rapidly growing economy.

For instance, China needs to increase administrative prices for resources and utilities that are necessary to adjust the structure of the economy. And higher prices for agricultural products and higher migrant wages can help boost rural incomes and reduce urban-rural inequality... the bank said.

It would be unfortunate if such desirable developments were suppressed because of concerns about moderate inflation.

China has set a 3 percent inflation target this year, but the bank said a rate of 4-5 percent is not a major problem in many emerging markets in the throes of reform and development.

The bank described the price risks facing China this year as relatively modest. The big dangers were higher asset prices and strained local government finances, stemming from unprecedented lending by state-owned banks unleashed to prop up growth.

Overall, China's prospects are much less uncertain than a year ago at the peak of the financial crisis, the report said.

As government-led investment slows, the bank expects the composition of growth in 2010 to shift markedly.

Total investment will expand at only half last year's rate, but real estate spending will provide a big boost. Consumption should remain strong. Overall, domestic demand will contribute 9.1 percentage points to this year's projected GDP growth.

Net exports will account for the remaining 0.4 percentage point as global demand for Chinese goods recovers. Last year, by contrast, net exports shaved 3.9 points off headline growth.

(Reporting by Alan Wheatley; Editing by Ken Wills)

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