Chinese inflation showed signs of cresting in a manufacturing survey on Thursday, an early indication that the government will be able to stick to its course of gradual rather than aggressive monetary tightening.
An easing of price pressures could also cap this week's jump the yuan to a record high against the dollar, which the central bank said had played an important role in taming inflation.
HSBC's China Purchasing Mangers' Index fell to a three month-low of 54.4 in December from 55.3 in November, suggesting that the pace of business expansion in the factories of the world's second-largest economy was moderating but still strong.
The headline figure offers an early clue about the direction of overall economic growth, but all eyes now are on Chinese inflation, which is running at its fastest in more than two years, and Beijing's policy response to price pressures.
In that arena, the HSBC survey offered a modicum of relief.
The input cost sub-index fell to a three-month low of 72.3 from 80.8 in November, while the output cost sub-index edged down to a four-month low. But both figures were still well in expansionary territory, indicating that firms were passing higher raw material costs onto their customers rather than absorbing them and taking a hit on earnings.
Inflation rather than growth still remains the top policy concern, despite the moderation in December's manufacturing PMI reading, said Qu Hongbin, HSBC's chief economist for China.
We expect Beijing to continue to rely on quantitative tightening measures to curb inflation and counter the impact of QE2 (U.S. monetary easing), while modest interest rate hikes are also needed to anchor inflation expectations in the coming months.
The People's Bank of China raised benchmark interest rates on Saturday for the second time in just over two months. Analysts polled by Reuters expect it to raise rates twice more in the first half of 2011.
Consumer price inflation raced to a 28-month high of 5.1 percent in the year to November.
The yuan rose to a record of 6.613 against the dollar on Thursday after a senior official from the central bank said gradual appreciation would help curb inflation and rebalance the economy.
China will continue to push forward reform of the exchange rate mechanism, Sheng Songcheng, head of the central bank's statistics department, told the Financial News, an official newspaper.
The positive impacts of China's yuan reform on the domestic economy have significantly outweighed negative impacts, Sheng said.
The yuan has gained just over 3 percent since its depegging from the dollar in June. But in the past two weeks alone, it has jumped 1 percent and traders think it is set for a new leg of measured gains.
The appreciation of the past half year had dragged down domestic inflation by around one percentage point, Sheng said.
He also said a survey of 5,000 manufacturers and 2,100 exporters had found that a stronger yuan was essential to rebalancing the economy toward greater reliance on domestic demand, a top objective of China's leaders.
If we allow the yuan to appreciate 3 percent a year against the dollar, it can boost imports by 0.3 percent, reduce exports by 0.6 percent and cut the trade surplus by 6 percent, he said.
HAWKISH CENTRAL BANK
An informal poll of China-based dealers over the last week showed that many expect the yuan to gain roughly 6 percent next year, hitting 6.25 per dollar in late 2011, as the exchange rate plays an increasing role in the battle against inflation.
The central bank is more hawkish than other state agencies on inflation, but it lacks policy independence when it comes to key decisions on interest rates and the yuan.
If inflation is indeed nearing a peak, then the central bank's push for heftier appreciation could soon run out of steam.
Nevertheless, Gao Shanwen, chief economist at China Essence Securities, warned that inflation could come unhinged next year if growth takes off.
Inflation has hit 5 percent even though the economy is not
overheating. We can imagine that inflation could easily shoot up to double-digits in a short span of time once China's economy becomes overheated, Gao was cited as saying by local media.
China will report its official PMI for December on Saturday, Jan 1.
Economists polled by Reuters forecast that it rose to a median 55.5, an eight-month high, underlining that the country's manufacturing sector is in robust shape.
(Writing by Simon Rabinovitch; Editing by Kim Coghill)