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China's third interest-rate increase in 11 months may slow import growth, exacerbating tensions with Europe and the US over its swelling trade surplus.

The interest-rate increases and other measures are cooling investment, reducing demand for imported steel and cement for factories. At the same time, the trade surplus -- which has pumped cash into the economy, fueling inflation and asset bubbles -- is ballooning as exports surge.

"It's difficult to reduce both investment and the trade surplus," said Huang Yiping, chief Asia economist at Citigroup Inc. in Hong Kong. "You can do one but you'll see a rebound in the other."

Premier Wen Jiabao is concerned that building too many factories will leave the world's fastest-growing major economy vulnerable in a slowdown. The central bank has increased the amount of money lenders must set aside as reserves five times in eight months, sold bills to soak up cash, and restricted property investment.

The People's Bank of China raised the benchmark one-year lending rate by 0.27 percentage point to 6.39 percent on March 17. The deposit rate climbed the same amount to 2.79 percent.

"Risks remain skewed toward another 27 basis point rate hike this year," said Sue Trinh, a currency strategist at RBC Capital Markets in Sydney. "Yuan appreciation is part of the tightening policies that we expect."

Global Trade

The US and Europe want the yuan to strengthen faster to make China's exports more expensive and global trade more balanced. The currency has gained 7 percent since the end of a decade-long peg in July 2005. China's leaders are concerned quicker gains will cost jobs and cause social unrest in a country with 200 million migrant workers and an average rural income of $465 a year.

Japan's yen rose today against the dollar on speculation a stronger yuan would make Japanese goods cheaper for consumers in China, its largest trading partner, and make Chinese exports more expensive. The yen traded at 116.28 per dollar at 8 am in Tokyo compared with 116.73 in late New York trading on March 16.

"Most investors are focusing on the export competitiveness of the yen versus the Chinese yuan," Trinh said.

Cooling measures in China are working. Growth in spending on factories and real estate slowed to 23 percent in the first two months of the year from a peak of 31 percent in the first half of 2006.

Investment Growth

Slowing investment growth means imports of raw materials such as steel and copper for factories grow less quickly. The trade surplus jumped ninefold in February from a year earlier to $23.76 billion after exports soared 52 percent. Imports rose just 13 percent.

"This is a policy dilemma," said Wang Qing, an economist at Bank of America Corp. in Hong Kong. "The currency needs to appreciate more, but the government worries that it might not be effective and job security among Chinese is also an important factor to consider because exports have created so many jobs."

China needs to create at least 9 million new jobs for urban residents this year, Wen said on March 5.

China's economy expanded 10.7 percent in 2006, the fastest pace in 11 years. The stock market has reached record highs this year, and also had the biggest drop in a decade, underscoring government concerns about boom-and-bust cycles fueled by the cash from a trade gap that last year widened to $177.5 billion.

Steel, Coal, Cement

The government last year began to shut inefficient plants and curb investment within 11 industries including steel, coal cement and aluminum to avoid overcapacity, according to Wen. China is also taking steps to boost domestic demand and curb a reliance on exports and investment for economic growth.

At the two-week meeting of China's legislature ended March 16, leaders pledged to strengthen the implementation of minimum wages, supply more low-cost housing, and increase rural spending. Retail sales rose 14.7 percent in the first two months from a year earlier.

"Encouraging people to spend more money will eventually boost imports," said Kent Yau, an economist at Core Pacific- Yamaichi International Ltd. in Hong Kong. "Increasing domestic demand is the most effective way to solve this problem."

As the trade surplus widens, lawmakers in Washington are considering a measure that would allow US companies to petition for sanctions against nations that manipulate their currencies. Another proposal is to add duties to some Chinese imports to compensate for government subsidies to industries.

Graham, Paulson

The Chinese currency, allowed to move 0.3 percent against the US dollar each day, is undervalued by as much as 40 percent, according to US Senator Lindsey Graham.

US Treasury Secretary Henry Paulson again tried to coax China into making the yuan more flexible during a visit there this month.