China’s inflation at both the consumer and producer levels will ease further and the economy could see deflation early next year, Merrill Lynch said in a research note on Thursday.

Data released on Thursday showed the consumer price index (CPI),the main gauge of inflation, had fallen to 2.4 percent annually in November. The reading was the smallest rise since January 2007 and down from 4 percent in October.

“We expect the CPI to drop to about 1.2 percent in December and become negative no later than February 2009,” Merrill Lynch economists headed by Ting Lu wrote in the note.

Merrill Lynch also expected the producer price index (PPI) to move into negative territory before the CPI. The rate of increase in factory-gate prices slowed sharply to 2 percent last month from6.6 percent in October.

The investment bank said the PPI could fall further on weakened demand for commodities, energy and other producer goods. Some of the decline would reflect high year-earlier base prices.

Falling inflation leaves the government more room to implement the “moderately loose” monetary policy and to step up fiscal stimulus, it stated.

Merrill Lynch forecast the People’s Bank of China (PBOC, the central bank) would cut the benchmark one-year deposit and loan rates by another 1.08 percentage points before mid-2009, an upward revision from an earlier forecast of 0.54 percentage points.

The loan rate could even be cut by as much as 1.62 percentage points, it said. Given the situation, the PBOC would likely reduce the business tax for banks to compensate for the squeezed interest margin.

The PBOC has cut the one-year loan rate four times since mid-September, with the latest reduction by 1.08 percentage points, in a bid to stimulate the economy. It also has cut the deposit rate three times.

Merrill Lynch also said it expected another 2.5 to 3 percentage points reductions in the reserve requirement ratio by mid-2009.

Both exports and foreign direct investment (FDI) shrank in November, indicating that the global economic downturn hit China’s economy harder than expected, according to data released yesterday.

Exports in November fell by 2.2 percent to $114.9 billion, the first monthly decline in seven years, the Customs said on its website yesterday. Foreign direct investment dropped by 36.52 percent year-on-year in November to $5.3 billion, according to the Ministry of Commerce.

“It is like the economy went down the slide in 1998, but now it is going down at a speed of diving,” said Gene Ma, macroeconomic analyst for China Economic Business Monitor.

The decline in investment is mainly caused by two factors. Tight global credit has slowed down investment activity worldwide. And the once-guaranteed appreciation of the yuan has also stopped, removing one of the key motivations to tap into the Chinese market.

The decline in exports is consistent with the worsening trade performance of other exporters. China’s Taiwan this week reported its exports in November fell 23 percent, while South Korea said its exports last month fell 18 percent. Both declines were the biggest in seven years.

Ma said the bankruptcy of Lehman Brothers in October was the turning point, and since then global credit has been frozen. “Enterprises have no money to make investment, exporters have no money to ship their goods because orders have been cancelled, and that has led to a decline in FDI worldwide, especially in emerging economies,” said Ma.

Analysts estimate that the situation is going to last for quite a long time. “China’s monthly FDI inflows will continue to book year-on-year declines at least until mid-2009, as the global economy is expected to further deteriorate in the first half of next year,” said Sherman Chan, an economist with Moody’s.

But China is still attractive. “China’s FDI inflows should be one of the first economic indicators to rebound once global recovery begins,” Chan said.