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China needs to rein in runaway investment, raise borrowing costs and relax its currency to retain control over its booming economy, the International Monetary Fund said.


In its latest World Economic Outlook report, the IMF also said China was set to entrench its controversial dominance of the global textiles industry following the scrapping of quotas at the start of this year.



The Chinese authorities have been struggling to slow the economy, seeking to keep a lid on investment in key sectors such as steel, autos and construction by curbing bank lending.


Despite these measures, Asia's second-largest economy will continue to be the regional leader, the IMF said, predicting gross domestic product (GDP) growth of 8.5 percent this year and 8.0 percent in 2006.


Last year Chinese GDP grew an estimated 9.5 percent, the IMF said.


But the Chinese authorities need to better target investment, which accounted for an "extraordinary" 45 percent of GDP last year.


"We have been concerned about the quality of investment, and financial sector as well as public enterprise reform will be critical to improving it," IMF senior economist Raghuram Rajan told a news conference.


Inflation in China remains low despite the stellar growth levels. But the IMF said pressure on costs -- including wages and utility shortages, especially for electricity -- was now growing.


"Given the considerable economic momentum, further tightening of monetary conditions is likely to be required to prevent a resurgence of investment," the semi-annual report said.


With the yuan currency only likely to strengthen, "this would be facilitated by greater exchange rate flexibility", it said.


The Chinese yuan has been pegged to the US dollar at about 8.28 for a decade and has recently followed the greenback on its downward path against the world's major currencies.


As a result, China has come under intense pressure from foreign governments, especially Washington, who say the current value of the yuan gives Chinese exporters an unfair advantage globally.


Aside from the yuan, international trade tensions have intensified with China grabbing an ever-growing share of the world textiles pie since the quotas were eliminated.


China's textile exports soared 29 percent in the first three months of the year, and the country is already the world's largest exporter of clothing with 28 percent of the market, the IMF said.


That has caused anger among textiles workers in the United States and the European Union, whose governments have taken measures that could result in limits to Chinese textile imports being re-imposed.


"And indeed, dynamic growth in China's imports of textiles and clothing machinery suggests that production capacities are building up," the IMF said.


But it warned the developed world against taking action that would "distort" world markets, noting that textiles producers in South Asia were likely to step in to fill the gap left by any lessening of Chinese shipments.



With billions of dollars of trade at stake, China has reacted furiously to the EU and US measures, saying the moves smack of protectionism and are a blow to global liberalization.

Turning to China's budget, the IMF called on the government to maintain a "tight fiscal stance" to contain demand pressures.

The report also said that deeper progress on bank and public enterprises reforms was "critical", and called for greater labour market flexibility such as easing internal migration rules to manage a rising labour force.