China deflation fears grow as producer prices sink most in 6 years

By Pete Sweeney and Winni Zhou

BEIJING (Reuters) - China's manufacturers slashed prices at the fastest rate in six years in August as commodity prices fell and demand cooled, signalling stubborn deflation risks in the economy and adding to expectations for further stimulus measures.

The producer price index (PPI) fell 5.9 percent in August from the same period last year, its 42nd consecutive month of decline and the biggest drop since the depths of the global financial crisis in late 2009, data showed on Thursday.

The market had expected a decline of 5.5 percent after a drop of 5.4 percent in July.

"The change in PPI is very worrying. It could affect corporate profitability, which in turn could affect consumption and the economy," said Li Huiyong, economist at Shenyin & Wanguo Securities.

"We must step up policy support."

Economists believe China's surprise currency devaluation of nearly 2 percent in mid-August will have little impact on inflation in the near term, in comparison with the effect of sharply lower commodity prices.

The consumer price index (CPI) rose 2 percent from a year earlier to a one-year high, the National Bureau of Statistics said, but the gain was due largely to soaring food prices, not an improvement in economic activity.

Analysts polled by Reuters had predicted CPI would rise 1.8 percent, compared with 1.6 percent posted the prior month.

Indeed, non-food inflation remained subdued at 1.1 percent, unchanged from July.

"The risk for China is still deflation, not inflation. PPI deflation will eventually filter down to affect CPI, and aggregate demand will continue to be weak," said Kevin Lai, chief economist Asia Ex-Japan at Daiwa, adding his firm had just cut its 2016 CPI forecast to -0.5 percent from 0.5 percent.

"In addition all the capital outflows (due to the slowing economy) will force the PBOC to continue purchasing yuan, which is hugely destructive to the monetary base," he said.

VICIOUS CYCLE

Continuously falling producer prices are eating into profits at many Chinese firms and raising the relative burden of their debts. Official and private factory surveys last week also showed manufacturers laid off workers at a faster rate last month as their order books shrank.

The central bank has cut interest rates five times since November and more reductions are expected in coming months, but many economists believe real rates are still too high, discouraging new investment.

Economists at ANZ said further policy easing is needed soon to head off the risk of a vicious cycle of slower growth and deflation. They expect the central bank to cut banks' reserve requirements (RRR) by another 50 basis points by year-end.

Data earlier this week showed imports tumbled more than expected in August while exports shrank again, pointing to persistently weak demand both at home and abroad.

Other data from China this week - including industrial output and investment on Sunday - are likely to be downbeat, keeping financial markets on edge. Fears of a China-led global slowdown have grown in recent weeks after a series of grim factory activity surveys.

The government is also still struggling to stabilise the yuan after its surprise devaluation of the currency on Aug. 11 and halt a stock market rout that has seen the country's share indexes plunge 40 percent since mid-June.

Analysts say weak data over the summer is putting Beijing's official 7 percent growth target for this year at risk.

That level would mark China's weakest expansion in a quarter of a century, but some economists believe current growth levels are already much weaker than official numbers suggest.

The chairman of the National Development and Reform Commission (NDRC) said on Wednesday that China's economic fundamentals are healthy while still facing relatively large downward pressure.

Separately, the finance ministry said on Tuesday that it will strengthen fiscal policy, boost infrastructure spending and speed up reforms to support the economy.

(Additional reporting by Nathaniel Taplin and Kevin Yao; Editing by Kim Coghill)