Fed chairman says relative inflexibility of the exchange rate inhibits central bank's ability to keep inflation low US Federal Reserve chairman Ben Bernanke warned yesterday that China faced significant risks to its economy and stability, including high inflation, if it did not allow its currency to appreciate faster. In a speech to the Chinese Academy of Social Sciences in Beijing, Mr Bernanke gave a detailed assessment of the challenges facing the Chinese economy and offered his advice on how to deal with them. 'The principal risk [to China] arises from the likelihood that capital is not being allocated as efficiently as possible, the result of an undervalued exchange rate and of capital markets that, despite positive steps, remain distorted and underdeveloped,' he said. He added that 'the relative inflexibility of the exchange rate inhibits the central bank's ability to keep inflation low and to stabilise the economy'. But he backed off from calling China's yuan policy an 'effective subsidy' for exporters, a point that was included in the printed version of his speech given to the audience. In order to maintain the yuan's value in its targeted range relative to the US dollar, China's central bank must continually intervene in the foreign exchange market to buy US dollars with yuan. It must then sell bonds, mainly to commercial banks, in a process known as 'sterilisation', in order to manage the country's money supply and avoid inflation. 'To date, the [People's Bank of China] has been largely successful in its sterilisation operations' Mr Bernanke said. 'But further appreciation of the renminbi, combined with a wider trading band and with the ultimate goal of a market-determined exchange rate, would allow an effective and independent monetary policy and thereby help to enhance China's future growth and stability.' He added: 'If China invests too heavily in export industries whose economic viability depends on undervaluation of the exchange rate, a future appreciation of the renminbi could lead to excess capacity in those industries, resulting in low returns and an increase in non-performing loans'. US politicians have long called on China to allow its currency to appreciate more rapidly, a move they argue would make American exports cheaper and slow the flight of US manufacturing jobs offshore. Mr Bernanke did not mention China's US$1 trillion of rapidly expanding foreign exchange reserves, the majority of which are denominated in US dollars and decrease in value as the yuan appreciates. In addition to the currency, Mr Bernanke's advice to the central government covered a wide range of topics, including energy price reform, greater autonomy for the central bank and improving social services. 'Increased government spending on health, education, and other types of social services would raise both household consumption and government consumption,' he said. Reducing China's savings rate relative to investment would be the 'most effective way to reduce the external surpluses and increase the welfare of Chinese households', he said. Mr Bernanke's audience was made up of many of China's top scholars for whom most of the advice was undoubtedly old news. Questioned after his speech, Mr Bernanke acknowledged that record bilateral trade imbalances could also be addressed by the US increasing its savings rates and avoiding trade protectionism.