China's latest move to raise interest rates and allow the yuan to trade more freely is a positive step, but its economy may overheat if further steps do not follow, the International Monetary Fund said on Saturday.
Speaking at a meeting of finance ministers from the Group of Eight (G8) industrial nations near Potsdam in Germany, IMF Managing Director Rodrigo Rato said Friday's announcement by China was a "step in the right direction". "First of all because it introduces more flexibility into the exchange rate system," he told reporters.
"Second, because it relies more on tightening monetary policy, which we believe is the key question for China's macroeconomic stability right now. And both are interlinked." The yuan will now be permitted to rise or fall by 0.5 percent each day against the dollar, up from a 0.3 percent margin, the Chinese central bank said on Friday.
The bank also raised its one-year lending rate by 0.18 percentage point and the one-year deposit rate by 0.27. "It would be very difficult for the Chinese to apply the tighter macroeconomic policy they need without a more flexible exchange rate system implemented," Rato added.
"If that's not the case, there are risks of overheating in the Chinese economy, especially in the growth of investment." Rato added that efforts to increase private consumption in China required structural changes, safety nets, changes to labour laws, and a bigger role for the financial sector.
"But it certainly requires a better and more efficient use of monetary policy," he said. "A stronger implementation of a more flexible exchange rate system is very important."
Rato added that financial markets should be wary of the risks of carry trades, where investors seek to take advantage of differences in interest rates by borrowing in low-yielding currencies and re-investing in higher yielding ones. "In some cases, especially in carry trades, markets and ... investors should be very aware that sudden changes can occur, and usually do," he said.