By Kevin Yao

BEIJING (Reuters) - To date, China has been wary of leaning heavily on interest rate rises to combat inflation. But to tackle what Beijing just called its "most prominent" economic problem, that's likely to change.

China will not toss out other tools in its policy kit but would make rate increases a bigger part of the mix. Authorities have largely run out of room to keep wielding the main instrument so far -- raising banks' required reserve ratios (RRR) -- while imposing lending limits would spark a backlash from commercial banks.

More importantly, it's becoming clear that the Chinese economy needs higher rates to fix the damaging effects of negative real interest rates.

Last Wednesday, China raised rates by 25 basis points --the third such increase this year -- which took the one-year bank deposit rate to 3.5 percent.

On Saturday, China reported annual inflation for June of 6.4 percent, the highest level in three years. Retail prices for pork, which has central role in Chinese diets, were 65 percent above one year earlier.

Premier Wen Jiabao, who last month said China will struggle to meet its 2011 inflation target of 4 percent, on Monday reiterated that the top priority is stabilizing prices.

Also on Monday, People's Bank of China Governor Zhou Xiaochuan named as the most prominent problem "the relatively big inflationary pressure and still strong inflationary expectations."

A Reuters poll found a median projection for the latest quarter of 9.4 percent.

Zhou, in an article the central bank published, said that PBOC will work to "avoid big fluctuations" in growth while implementing "prudent monetary policy in a pro-active and safe way."

So what is Beijing most likely to do to try to beat down high price pressures while not intensifying a credit crunch that's cutting loans to small businesses?

Xia Bin, a central bank adviser, told the China Securities Journal that Beijing needs to use a combination of tools -- including interest rates, currency moves and open market operations as well as changes in banks' required reserve ratios (RRR).

And indeed if China continues to rack up huge trade surpluses and attract capital inflows, merely raising rates won't be sufficient and authorities would have to uses other tools to mop up cash.

But it can be argued that there isn't much scope for more RRR hikes. In 2011, there have been six increases of 50 basis points each, taking the level to 21.5 percent. Those increases have drained about 2.2 trillion yuan ($341 billion) from the banking system.

LIQUIDITY PRESSURE

"The scope for further RRR rises is small because the liquidity pressure on banks is already very large," said Tang Jianwei, senior economist at Bank of Communications in Shanghai.

China could impose sectoral borrowing limits, but many analysts say this is unlikely because there would be resistance from commercial banks. The increased RRR levels have already prompted big banks to scramble for liquidity, rolling out high-yielding wealth management products to lure deposits.

Yuan-lending by Chinese banks in June exceeded market forecasts, which some analysts say showed that open market operations helped ease liquidity for banks. Still, authorities need to maintain tightening policies to battle inflation.

Zhu Baoliang, chief economist at State Information Center, a top government think-tank in Beijing, said the "focus of policy may be shifting toward interest rates as the scope for further bank reserve rises is limited."

Policymakers are convinced that higher rates are needed to correct the deeply negative real interest rates, which can fuel inflation expectations and complicate the efforts to control price rises, analysts say.

With the one-year bank deposits paying 3.5 percent after the July 6 rate rise, rising inflation will push real rates deeper into negative territory, prompting more Chinese to channel their savings into property and high-yielding investments.

"The authorities are likely to rely more on interest rates as the tool for monetary policy normalization going forward," Dong Tao, an economist with Credit Suisse in Hong Kong said in a note to clients. Tao expects at least two more interest rates in 2011.

Many analysts expect June's 6.4 percent or the July figure to be inflation's peak, but there are many uncertainties stemming from soaring wages and utility costs. While food costs, a key driver of inflation in the past, could lose steam in the second half, non-food inflation is picking up due to rising wages and utility costs.

TOO OPTIMISTIC?

"Most people are too optimistic about inflation," said Lu Zhengwei, senior economist at Industrial Bank in Shanghai. "I think inflation will hover near 6 percent during the third quarter."

The cost of services makes up for 50 percent of China's CPI basket while food accounts for 30 percent of CPI weight, according to analyst estimates.

One main reason authorities have raised interest rates much less frequently than the reserve ratio is worry about hot money inflows and increased debt burdens for local governments.

Analysts argue that higher interest rates could add to debt burdens of local governments but won't push local financing vehicles to the wall given the pace of rate rises has been modest. Rate rises could help Beijing achieve its goals in trying to restrict fresh borrowings by local financing vehicles, they say.

Also, they contend that it's been China's red-hot property market, and not an interest rate differential, that has been a magnet for speculators. More rate rises could help cool property speculation, they add.

Banks have concentrated their credit on large state firms and restrict lending to many small companies, forcing them to borrow at exorbitant rates on informal credit markets that have shot up to 6-10 percent per month.

Many Chinese analysts argue that higher bank interest rates could curtail demand for loans by cash-rich state firms and make more credit available for small businesses.

(Editing by Richard Borsuk)