China deflation risks grow, foreign central banks on alert

By Pete Sweeney and Charlotte Greenfield

BEIJING/WELLINGTON (Reuters) - The risk of deflation in China is growing, data suggested on Thursday, as policymakers tried to reassure markets that the economy can stay on track and state banks were suspected of intervening in offshore markets to bolster the yuan.

Some foreign central banks are increasingly worried about the impact falling Chinese prices and a weaker yuan could have on their economies, following a surprise devaluation in the currency last month.

Since then investors have been betting the yuan, or renminbi, could fall further, reflected in a wide spread between the offshore and more-tightly controlled onshore rates.

On Thursday afternoon though a surge of buying sent the offshore rate up more than 1 percent, in what market sources said was a move by Chinese state-owned banks to curb speculation against their currency.

Sliding Chinese stock prices and currency have rattled global markets and prompted a flurry of policies and intervention by authorities to steady the world's second-biggest economy.

Earlier, New Zealand's central bank governor Graeme Wheeler said the yuan devaluation had left them concerned about the risk China may let it slide further.

"We've seen authorities basically say they want to stabilise the renminbi, but if there were to be a very substantial depreciation in the renminbi it would certainly export deflation around the rest of the world, so everybody is looking closely at China," he said at a press briefing following an interest rate cut in New Zealand.

The deflation threat was underlined by data showing that Chinese manufacturers cut prices at their fastest rate in six years, with the producer price index (PPI) down 5.9 percent in August from a year earlier, though consumer prices are rising for now.

"The risk for China is still deflation, not inflation," said Kevin Lai, chief economist for Asia, excluding Japan, at Daiwa.

"PPI deflation will eventually filter down to affect CPI, and aggregate demand will continue to be weak," he added.

A growing worry for overseas central banks like the Reserve Bank of New Zealand (RBNZ) is that falling Chinese factory gate prices coupled with a weaker yuan mean the price of exports from China will fall sharply, feeding downward price pressures into their economies.

Wheeler's comments came despite attempts by Chinese policymakers to reassure global markets that the yuan will remain stable and China's economic growth, whilst slowing, is still set to be around 7 percent this year.

"The RBNZ...verbalised it but this is probably an underlying concern shared by policymakers around the region," said Sim Moh Siong, foreign exchange strategist at Bank of Singapore.

REASSURANCE

Since the devaluation, China has scrambled to keep the yuan steady, running down its foreign exchange reserves by a record amount in August to stabilise the onshore rate.

Thursday's rise in the offshore yuan was the clearest indication to date that China will also try to stop speculation against its currency outside of the mainland.

"The big picture is that policy makers are doing everything they can do to dampen expectations that the yuan will depreciate much," said Mark Williams, an economist at Capital Economics in London.

The offshore yuan spot rate strengthened more than 1 percent to 6.39 per dollar from 6.4698 earlier in the day.

Chinese Premier Li Keqiang, for the second day running, used a speech to tell business leaders and investors on Thursday that China does not want a currency war and that the slowdown in its growth rate will be modest. The economy grew 7.3 percent last year.

"China's economy will not see a hard landing" he told a gathering of the World Economic Forum in Dalian in northeastern China.

"Once there are signs of economy slipping out of the reasonable range, we will be fully capable of handling (the situation)."

The economic signs are gloomy. After Li spoke, a report showed auto sales in China were flat in the first eight months of the year, raising the spectre of the market's first contraction since the late 1990s.

Global markets' worries about Beijing's handling of the economy and its currency have been exacerbated by China's attempts to stem the slide in its equity markets. Despite a barrage of policies to support stock prices and push out speculators, its equity markets have fallen around 40 percent since June.

The past two days though have seen Chinese stocks push higher, with the positive sentiment feeding into other major equity markets around the world. Still, that optimism was waning on Thursday, with share prices back in the red.

The CSI300 index <.CSI300> of the biggest stocks listed in Shanghai and Shenzhen ended down 1.23 percent, while the Shanghai Composite Index <.SSEC> was 1.45 percent lower.

(This version of the story corrects throughout to show that the events happened on Thursday, not Wednesday)

(Additional reportying by Winni Zhou, Xiaoyi Shao and Kevin Yao in Beijing, Nathaniel Taplin in Shanghai, Masayuki Kitano in Singapore, Ian Chua in Sydney, Gerry Shih in Dalian; Michelle Chen in Hong Kong; Writing by Rachel Armstrong; Editing by Neil Fullick)