Speaking days after China posted its biggest trade deficit in at least a decade, People's Bank of China (PBOC) Governor Zhou Xiaochuan Zhou said monetary policy moves would respond to liquidity conditions determined by the balance of payments, demand for yuan in markets and international capital flows.

"The closer the yuan is to an equilibrium, the bigger role market forces will play in the yuan exchange rate. We will allow and encourage market forces to play a bigger role, and the central bank's participation and intervention in the market will decrease in an orderly manner," Zhou said.

Zhou did not comment on speculation that China is ready to widen the yuan's trading band to create more flexibility, even as Beijing pushed the yuan sharply lower on Monday.

It has set a weaker trading midpoint for the currency in five of the last six trading sessions, fueling some speculation in financial markets that Beijing may rely more on foreign exchange policy to stimulate exports and broader growth.

Zhou's remarks support well-entrenched investor views of an imminent reduction in the amount of cash commercial lenders must keep with the central bank, following cuts of 50 basis points each in November and February that brought the required reserve ratio (RRR) down from June 2011's record high of 21.5 percent.

"There is a lot of room for RRR cuts," Zhou told the central bank's annual conference held on the sidelines of China's annual meeting of parliament, the National People's Congress.

"But we need to look at whether it's necessary... and look at market liquidity. We cannot raise or cut RRR at will when we think there is room. We need to look at the liquidity condition, which is related to FX purchases and our international balance of payments.

Data over the weekend showed China's trade balance plunged $31.5 billion into the red in February as imports swamped exports. It followed reports on Friday that inflation eased in February while bank lending, retail sales and industrial output fell below forecast, all pointing to a cooling economy.

The trade data "means a bigger need to stimulate domestic demand -- via fiscal stimulus and monetary easing," said Dariusz Kowalczyk, senior economist and strategist for Asia ex-Japan at Credit Agricole CIB, in a note.

"So we expect 200 bps more in RRR cuts and 50 bps in interest rate cuts later this year."

The central bank's cuts so far ease back some of the tightening to rein in inflation that hit a three-year high in July 2011, helping foster economic growth by easing credit strains that are exacerbated by a shrinking trade surplus and slower foreign capital inflows.

RRR CUTS ANTICIPATED

A recent Reuters poll showed analysts expect Beijing to cut the RRR by a further 150 basis points this year when the world's No. 2 economy is set to clock its slowest full year of growth in a decade of between 8 and 9 percent.

Zhou was more nuanced about whether markets should be anticipating a move in outright interest rates.

"The PBOC has always paid attention to price tools. It raised the benchmark interest rate five times from the fourth quarter of 2010 to the third quarter 2011. But when we use the tool, we need to consider some constrains. One consideration is the impact on capital flows," he said.

China is reluctant to encourage speculative inflows of money to its closed capital account financial system as they require sterilization by the issuance of yuan-denominated bonds that can drive up money supply and increase inflationary pressures.

Substantial inflows generated by China's huge export-focused factory sector are problematic enough. The country ran a current account surplus of $201.1 billion in 2011, though it has been shrinking steadily as a proportion of GDP since around 2007.

The foreign reserves China earns will continue to be diversified to ensure safe, stable returns, the head of the State Administration of Foreign Exchange (SAFE), told the same news conference.

The portion of China's $3.2 trillion of reserves invested in euro zone assets had increased in value, making returns above the rate of inflation, and more would go into yen-denominated assets if the timing was right, SAFE chief Yi Gang said.

Yi repeated the long-standing official backing for Europe's efforts to resolve a festering debt crisis that began rumbling in 2009 and has rocked the foundations of the monetary union that underpin the single European currency.

But he gave no clear indication of whether the process of reserve diversification had seen SAFE -- which administers the world's largest stash of foreign wealth -- increase or decrease the portion that it allocates to euro zone assets.

YUAN CLOSE TO EQUILIBRIUM

SAFE chief Yi said China's trade performance last month was evidence that the yuan was close to a "balanced level.

The yuan's value has been a lightning rod for disputes between China and its biggest trade partners including the United States, who accuse Beijing of deliberately holding down the currency for trade advantage.

China has always denied those allegations, and increasingly says it is allowing market forces to have a bigger sway over the yuan as it nears its fair value, an argument reiterated by Zhou.

China wields tight control over the yuan through regular market interventions, and by having the central bank set its daily mid-point before the start of trade. It can rise or fall a maximum of 0.5 percent against the dollar from the mid-point.

But Beijing wants to relax its grip on the yuan, also known as the renminbi, to have it basically convertible by 2015 so as to expand its influence on global financial policymaking.

China de-pegged the yuan from the dollar in a landmark move in July 2005 and it has since appreciated some 30 percent against the U.S. currency, though some critics in the West say Beijing is still keeping too tight a grip on the yuan in order to aid the country's exporters.

"Steady progress will be made to promote capital account convertibility," the central bank said in a statement before the news conference, adding that Beijing would work to get more firms to settle cross-border trade in yuan and expand the type of yuan investment products available.

Many analysts argue much work still needs to be done, saying China needs to free its interest rate market before it frees its currency. Some also are skeptical that China has the political will to push through rate reforms that may hurt the health of its giant state-owned banks.

(Writing by Koh Gui Qing; Additional reporting by Kevin Yao; Editing by Ken Wills & Kim Coghill)

• A Permanent Economic Emergency