China may slow its pace of interest rate increases and reserve requirements and instead rely more on open market operations and exchange rates in the second half of this year as it tries to tame stubbornly high inflation and ensure the economy continues to expand, analysts said. [Related coverage: price hike]

The People's Bank of China announced it would drain 83 billion yuan (US$12.9 billion) from the economy through a 28-day bond repurchase yesterday, after suspending repurchase auctions last week. The central bank also auctioned off 2 billion yuan worth of one-year note yesterday, one billion yuan more than last week. The PBOC has kept the yield for the bill unchanged for the seventh consecutive week at 3.498 percent.

A total of 192 billion yuan in central bank bills and bond repurchases will mature this week, the largest amount seen so far this month, said Li Huaiding, an analyst with Guosen Securities.

Analysts said the central bank may increase withdrawal of liquidity through open market operations, a measure that has a milder impact on the macro economy than increasing interest rates and reserve requirements.

"Liquidity was so tight in the first half of the year that the cost of borrowing soared at the end of the month and the quarter," said Lian Ping, chief economist at the Bank of Communications. "Liquidity will be generally easier in the second half of the year to maintain stable economic growth. Open market operations will be the major tools and raising reserve requirements ratios and interest rates may gradually fade out."

China yesterday reported the Consumer Price Index, a general gauge of inflation, rose 6.5 percent in July from last year, the fastest in 37 months.

The Producers' Price Index, which measures rising output costs, climbed 7.5 percent from last year, 0.4 percentage point higher than in June.

"China's July CPI and PPI both came in higher than expected, posing challenges to policymakers at a time when escalating external risks further complicated the tasks in balancing growth and inflation risks," a Barclays Capital report said. "A significant weakening of the global economy will substantially reduce the probability of one more interest rate hike in the third quarter."

Barclays Capital said that inflation may have peaked in July and expects the CPI to trend lower from August to around 6 percent before falling to about 5 percent in October due to lower food and pork prices as supply picks up as well as slower commodity price increases and a slowing economy.

China should also allow yuan to appreciate more to tame imported inflation, analysts said. A higher yuan makes imports cheaper.

"Under the current situation, China should allow a more flexible yuan exchange rate to curb inflation," said Teng Tai, chief economist with Minsheng Securities. "The turmoil in Europe and the US markets may shift investor interest to China."

Xia Bin, an advisor to the central bank, said last week that the yuan's exchange rate will be more market-oriented in terms of floating range and frequency.

But the yuan is unlikely to be floated freely in the near term as China's economy faces internal difficulties as it reforms, and uncertainties in the global economy, he said.