BEIJING (MNI) - The Chinese authorities need to move towards a more market-driven monetary policy environment, including allowing for greater exchange rate flexibility, the Organisation of Economic Co-operation and Development said Tuesday.

The Paris-based organisation noted in its latest economic survey of China the country's impressive performance of recent years, including the resilience displayed during the global economic crisis.

But it said that more reforms are needed on the fiscal and monetary fronts -- including an abandonment of the fiscal surpluses of the pre-crisis era -- if the government is to overcome pressing social and economic distortions that currently hinder growth.

Greater exchange rate flexibility is also an important part of this reform slate, the OECD said.

"Allowing greater exchange rate flexibility and putting more weight on an inflation objective -- while keeping a vigilant eye on asset prices -- would offer the central bank more scope to tailor monetary policy to domestic macroeconomic conditions and reduce the costs and risks of sterilising foreign reserve inflows," it said.

But it also said that the authorities may be "inclined to wait until inflation becomes a problem once again before allowing an appreciation," owing to the short-term output cost that a stronger currency would bring.

With the economy growing at over 10%, investment "very strong" and inflation picking up, OECD representatives said that higher interest rates will be needed this year.

"Mounting inflation risks are becoming a source of concern," Pier Carlo Padoan, the OECD's chief economist, said at a briefing for reporters here.

He added that Chinese authorities will need to remain cautious given signs of asset price bubbles in the housing and equity markets.

Richard Herd, head of the organization's China unit, said that a key indicator for a rate rise would be the increase of consumer price inflation to over the benchmark one-year deposit rate, which now stands at 2.25%.

"Some increase in interest rates will be needed during the year and... the effectiveness of monetary policy can be improved quite considerably by allowing gradual apprecaition of the exchange rate," he said.

Herd added that consumer price inflation for the year will come in at just under 2% but may peak during the upcoming Chinese New Year holiday.

The OECD left its forecasts for growth this year unchanged over its most recent report, published in November, which projected the economy to expand by 10.2% this year, with growth to ease to 9.3% in 2011 as the result of the government withdrawing crisis-period stimulus policies.

Chinese GDP grew by 8.7% last year, the government said in January, versus the OECD's forecast of 8.3% growth.

It noted the tremendous strides that China has made since its last survey published in 2005. It became the second biggest economy in the world on a purchasing power parity basis last year, and is on track to shortly overtake Japan on an exchange rate basis.

Within five to seven years, China could also take over the U.S. to become the world's leading producers of manufactured goods, the OECD said.

But more reforms are needed to ensure the quality and quantity of growth over the long-term.

It recommended that the government abandon its policy of running fiscal surpluses to ensure that spending can be provided for areas of the economy which would help to boost domestic demand, such as through the improvement of the quality and quantity of education in rural areas.

"It will be important not revert to budget surpluses," it said.

"China had an enviably strong fiscal position on the eve of the global economic crisis, and this will still be the case by 2010-11, even with higher levels of public spending."

More active government spending would also help to lower China's "uncomfortably high" saving rate and allow for a reduced reliance on investment to power the economy.

The OECD also called on the central bank to abandon its quantity approach to monetary management, arguing that more timely adjustments to policy rates would avoid the interest rate volatility of the current approach.

A more flexible exchange rate would allow for a greater scope of domestic monetary policy management owing to the reduced threat posed by capital inflows and the various sterilization operations surrounding them, the OECD said.

The PBOC should also be given greater independence in policy-setting by the State Council, and should set a flexible inflation target as the goal for its monetary policy, the OECD said.

In the area of financial market reform, the OECD highlighted now- common criticisms about the non-commercial basis of Chinese bank lending and the constraints imposed by an underdeveloped corporate bond market.

It said that the recent surge in lending carries "the risk of imprudent borrowing by local authority infrastructure companies and of a resurgence in non-performing loans."

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