Annual export growth of 13.4 percent in December was in line with expectations, albeit the slowest since November 2009 except for a February distortion caused by Lunar New Year holidays.

But it was a big downside surprise for import growth that caught investor attention, sinking to a 26-month low of just 11.8 percent year-on-year versus the 17 percent forecast by economists in the benchmark Reuters poll.

"We thought imports would surprise quite a bit on the downside and generally the implication is negative. Domestic demand is slowing down very quickly," Zhang Zhiwei, chief China economist at Nomura in Hong Kong, told Reuters.

Zhang said the scale of drops in annual import growth for domestic consumption, at 13.5 percent in December versus November's 27.4 percent, and imports for processing trade at 6.2 percent versus about 11 percent in November, were crucial.

"That means going forward for the next couple of months exports will decline with a very high certainty," he said. "This trade data basically confirms our view that the first quarter is going to be very tough."

The December trade data is a key link in a series of activity indicators to be published by China over the next two weeks, including fourth-quarter gross domestic product that is likely to show the world's second-largest economy suffering its worst quarter in 2- years.

Financial markets took the data in their stride, with hopes that it will prompt a relaxation of monetary policy offsetting fears over slowing growth.

Gains in Chinese stocks accelerated modestly after the data, with Shanghai's main index up around 1.6 percent by 0515 GMT, broadly in line with other Asian markets outside Japan, while the yuan strengthened to 6.3122 per dollar.

TRADE SURPLUS

Despite easing growth rates, the total value of China's imports and exports finished 2011 at an all-time high of $3.6 trillion. But the overall trade surplus shrank to a three-year low of $155 billion from 2010's $183.1 billion.

The narrowing trade surplus for the year may help China argue that it is reforming its currency policy, countering foreign critics who accuse it of holding the yuan artificially low to give its exporters an unfair competitive edge.

But the pace of slackening trade is disconcerting for Beijing as exporters are mainstay employers in China, even though their output accounted for only around 7 percent of China's 2010 GDP.

The softening domestic demand revealed by the data also complicates plans by China's ruling Communist Party to rebalance the economy towards more internal demand and consumer imports and tilt it further away from exports.

"The main disappointment is with imports, which show a much weaker number compared to November and are way below consensus," said Kevin Lai, an economist at Daiwa Capital Markets, in Hong Kong. "That means the boost in November was temporary, the domestic economy is slowing sharply. China will have to continue to relax policy to protect domestic demand."

POLICY FINE-TUNING AHEAD

To counter patchy demand in the United States and Europe, China's top two export markets, Beijing cut banks' reserve requirements by 50 basis points in November to 21 percent, the first such cut in three years to boost corporate credit lines.

Economists see more cuts to required reserve ratios (RRR) coming, further tweaks to fiscal policy and quite possibly intervention to slow the steady appreciation of the yuan, which gained about 4.5 percent against the dollar in 2011.

"I think the authorities will intensify the fine-tuning. I think we will get an RRR cut pretty quickly, and I think the slowdown in the pace of RMB (yuan) appreciation will continue," Tim Condon, head of Asian economic research at ING in Singapore, said.

M2 money supply data published on Sunday showed money growth hitting a four-month high in December, suggesting Beijing is adding cash to the financial system to ease credit strains and stimulate the economy.

Economists see slowing trade and tight domestic credit conditions dragging China into its worst quarter in 2- years between October and December, with GDP growth easing to 8.7 percent, down a full percentage point from the first quarter.

A Reuters poll in December showed analysts thought China could lower banks' reserve requirements by another 200 basis points in 2012, but that a cut in interest rates was only likely if economic growth slips below 8 percent.

Many economists believe China needs to grow its economy by about 8 percent, at least, if it wishes to create enough jobs to sustain current employment rates.

China does not release any reliable jobs data, and its only measure of unemployment is an urban jobless rate that has hovered between 4.1 and 4.3 percent since June 2009.

The thing economists are sure about is that, even allowing for seasonal factors that could smooth some of the more disturbing trade numbers -- an earlier than usual Lunar New Year in 2012 and reasonably steady exports -- China faces serious economic headwinds in the months ahead.

"Half of China's export markets are slowing in the first half of the year so that's why expectations for growth remain downbeat," said Li Wei, an economist at Standard Chartered, in Shanghai.

"It's not the end of the slowing down part of the story. That will probably last another quarter or four or five months before momentum recovers along with other emerging markets."

(Additional reporting by Beijing Economics Team; Writing by Nick Edwards; Editing by Alex Richardson)

• A Permanent Economic Emergency