* Inflation risk is price to pay for last year's stimulus
* China needs to coordinate rate rise with major economies
* Yuan should be more flexible but must move gradually
By Benjamin Kang Lim and Simon Rabinovitch
BEIJING, May 6 (Reuters) - China will be doing well if it can keep inflation below 5 percent this year, influential former lawmaker Cheng Siwei said, one of the starkest warnings yet about price pressures facing the economy.
While it is "imperative" to increase interest rates, he said this might not be feasible, marking a rare admission about how Beijing feels that its hands are tied on monetary policy.
With expectations rising for yuan appreciation, higher rates would only serve to attract more speculative capital to China and add to the economy's excess liquidity, the former vice-chairman of the national parliament told Reuters in an interview.
As a result, Cheng said China must try to coordinate policy with other major economies, to increase interest rates at the same time as the United States, the euro zone and Japan. He said G20 meetings at the end of June would provide a good opportunity to discuss this coordination.
Economists argue that China's decision to peg the yuan to the dollar is what constrains its independence on monetary policy. Cheng acknowledged this line of reasoning, but said reform of the currency was not a simple matter and that the government should only gradually move to a freely convertible currency.
Although Cheng is no longer an official, he is still well connected in Beijing and has knowledge of thinking at the highest levels of government.
INFLATION RISK
The government is targetting an average of 3 percent consumer price inflation this year.
Officials have repeatedly stressed that managing inflationary expectations is a priority, but have, at the same time, maintained that price pressures are under control after inflation averaged 2.2 percent in the first quarter.
Cheng was less sanguine.
"Last year, China paid a heavy price in order to 'protect eight'," he said, referring to the stimulus spending and explosion of bank lending unleashed in 2009 to ensure that the economy would not slip below the government's target of 8 percent growth.
"The result is that we have an inflation risk," he said. "Last year, if we had not done this, the economy would have been in bad shape. It was necessary. So it is now a question of balance. This year, we are talking much less 'protecting growth'."
China will fully exit from its stimulus policies in the second half of 2010, he said.
An official with the National Bureau of Statistics told Reuters on Thursday that China should have no difficulty achieving 9 percent economic growth this year but needs to beware of mounting inflation. [ID:nTOE64502H]
The central bank raised banks' reserve requirements for the third time this year on Sunday and the government has already guided banks to rein in their lending.
"The impact of required reserve ratio increases is very small. Each 50 basis point rise absorbs just 300-500 billion yuan. Raising interest rates is not the same. Higher rates will translate to higher costs throughout society," he said.
"But we face a dilemma. If you raise rates, more hot money will flow in from abroad. You raise rates to combat inflation, but then you face this problem. So I believe that we must coordinate our policy with other major countries," he said.
YUAN FLEXIBILITY
Chen gave no specific timetable for when Beijing might let the yuan rise again, having frozen it against the dollar since mid-2008 to help cushion the economy from the global financial crisis.
Despite the de facto re-pegging to the dollar over the past 21 months, Cheng said the official policy of managing the yuan with reference to a basket of currencies was still in place.
"So I think the yuan might become a little more flexible in the near future, but its formation mechanism will still refer to a basket of currencies," he said.
"I advocate that we should increase its flexibility and allow more small fluctuations," he added, stressing that he was speaking in a personal capacity and not as a representative of the government.
With China's inflation rising and exports recovering, many in the financial markets think it is only a matter of time before Beijing resumes yuan appreciation. Investors expect a 2.5 percent rise in the yuan against the dollar over the next 12 months, according to the offshore forwards market. (Additional reporting by Shen Yan; Editing by Ken Wills)