(Adds stocks, paragraph 9; central banker, paragraph 17;
By Zhou Xin and Jason Subler
BEIJING, March 10 (Reuters) - China fell into deflation at the consumer level last month for the first time in more than six years, as ministers painted a gloomy picture of the economy's near-term prospects.
The 1.6 percent drop in the consumer price index (CPI) in the year to February, which was bang in line with a Reuters survey of 26 analysts, gives the central bank ample scope to cut interest rates further if need be to boost the economy.
Goldman Sachs said now seemed a "natural point" to lower borrowing costs to ease the financial burden on firms, which are battling a slump in overseas demand and in domestic construction.
Commerce Minister Chen Deming and Industry Minister Li Yizhong, speaking at a joint news conference, both used the word "grim" to describe the immediate outlook for Chinese exports and the manufacturing sector.
Li said he was encouraged that power consumption had declined at a slower pace in the first two months of the year. But he added, "The situation of industrial production remained grim."
The year-on-year drop in the CPI, reported by the National Bureau of Statistics, was the first since December 2002.
Economists worry that, unless China's 4 trillion yuan ($585 billion) stimulus plan kicks in soon, these deflationary pressures will intensify because the economy is saddled with excess capacity at a time of depressed demand.
Consumers who expect more price declines in future may delay their purchases, weakening the economy and undermining corporate profits.
"I think this is the first sign of deflation," Qing Wang, China economist for Morgan Stanley in Hong Kong, said of the CPI drop. "We expect an additional policy response, mainly to prevent deflationary expectations from getting entrenched."
Shanghai stocks recouped early losses and ended 1.88 percent higher as investors shrugged off the slide into deflation and took comfort from strong lending data.
DON'T PANIC
Wang expects consumer prices to decline 1 percent in 2009.
By contrast, the government of Premier Wen Jiabao, who has sought to bolster confidence by talking up the economy's fundamentals, expects inflation to average around 4 percent.
Mingchun Sun with Nomura in Hong Kong agreed the lapse into deflation was likely to be temporary. Inflation would return by the second half of the year and reach 2.8 percent in the fourth quarter. For all of 2009 the CPI was likely to rise 0.6 percent.
"Considering the inflationary nature of the stimulus package, we believe the People's Bank of China will hesitate in cutting rates. Therefore, we now expect just one more 27 bp (basis point) cut this year -- down from three in our earlier forecast -- and see that as more of a symbolic reaction to deflation," Sun said in a report.
Protracted deflation is also debilitating because it increases the real burden on companies of repaying debts. And, if the cost of money is already close to zero, deflation makes it impossible for central banks to set negative real interest rates.
The government in Beijing, and some private economists, say China's circumstances are different.
"The price falls are mainly caused by declines in international commodity prices; they do not mean that the Chinese economy is contracting," Su Ning, a deputy central bank governor, told reporters during the annual meeting of parliament.
The statistics office said the drop in the CPI was largely due to a high base of comparison: in the 12 months to February 2008, consumer prices were up 8.7 percent, near a 12-year peak, as the cost of food, oil and imported raw materials soared.
Even if prices had not changed last month from the end of 2008, the bureau said, the statistical effect of last year's high inflation rate would have been to drive the CPI down 2.5 percent.
Moreover, given rapid credit growth and ample liquidity in the banking system, it was not warranted to conclude that China had relapsed into deflation for the third time in a decade, the statistics office said.
Still, it drew attention to a sharp decline in prices of raw materials like crude oil, iron ore and metals due to the global economic slowdown.
This was the driving force behind an acceleration in the pace of decline in China's producer prices to 4.5 percent in the year to February from 3.3 percent in the 12 months to January.
"I worry about PPI. The sharp fall in PPI shows that the financial crisis is gradually spreading to the real economy," said Qi Jingmei, an economist with the State Information Centre, a government think-tank in Beijing.
In another ominous sign, Chinese urban property prices fell 1.2 percent in February from a year earlier, the steepest annual decline since official records began in 2005. (Reporting by Zhou Xin, Langi Jiang, Lan Wang, Jason Subler and Simon Rabinovitch; Writing by Alan Wheatley; Editing by Kim Coghill)