China's foreign direct investment (FDI) in February shrank from a year earlier, a fourth straight fall, with anaemic inflows from debt-riddled Europe an additional sign that the People's Bank of China may act to ensure steady money supply growth.

The Commerce Ministry said on Thursday that the country drew $7.7 billion (4.9 billion pounds) in FDI in February, down 0.9 percent on the same month in 2011, while January and February combined saw FDI flows fall 0.56 percent from a year earlier to $17.7 billion.

Given that China's trade balance plunged to be $31.5 billion in the red in February -- the largest deficit in at least a decade -- analysts said there was a growing likelihood that to keep money supply steady, the central bank would cut the ratio of deposits it makes banks keep as reserves (RRR).

Falling FDI and the big trade deficit in February put pressure on capital flows. Capital inflows will be sluggish and there may even be net outflows. From this perspective, it supports the case for more RRR cuts, said Zhang Xinfa, economist at Galaxy Securities in Beijing.

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GRAPHIC on China FDI: http://link.reuters.com/tud27s

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The inflow of foreign capital is a basic component of money supply in the financial system. A fall in its level implies a need to expand domestic credit creation by easing monetary policy in order to keep money supply growth steady.

The central bank has cut RRR from a record high of 21.5 percent in two 50 basis point steps -- the first in November and a second in February -- to keep credit flowing.

China targets 14 percent growth in money supply this year.

The market consensus is for cuts of 150 bps more in RRR through the course of this year. Galaxy Securities expects three or four cuts of 50 bps each.

But any move by the central bank probably will be tempered by belief the trade position will change. Analysts think trade surpluses will return -- an assumption echoed by Commerce Ministry spokesman Shen Danyang.

Our judgement is that the trade deficit in February is unlikely to persist. Overall, we will still see a trade surplus this year, but it will gradually shrink and account for a smaller percentage of GDP, Shen told reporters at the monthly media briefing where the February FDI data was released.

The FDI data follows a raft of other reports which showed lower inflation and slower increases bank lending, retail sales and industrial output, which analysts say point to a gradual economic slowdown, not a hard landing.

SHRINKING SURPLUS

China's trade surplus has been shrinking in part as imports have been ramped up to help drive a rebalancing of the economy away from dependence on external demand towards the country's gigantic domestic market.

China's overall current account surplus, as a percentage of economic output, has fallen steadily in recent years. It dropped to 2.7 percent of GDP in 2011 from 5.1 percent in 2010.

Exports were a net drag on GDP growth in 2011, a fact that may placate some critics -- particularly those in the United States and the European Union -- who say China unfairly supports exporters, a charge Beijing rejects.

FDI from the U.S. rose a marginal 0.87 percent in the first two months of 2012 from a year ago, to $525 million.

Inflows from the EU, China's biggest trading partner, were down sharply at just $906 million in January-February combined, off 33.3 percent from that period of 2011.

The overall pace of decline from the 27-member EU slowed versus January, when flows plunged 42.5 percent to $452 million.

However, data showed China's more economically buoyant Asian neighbours were putting money to work in the country. Investment from 10 Asian economies including Japan, South Korea, Taiwan and Hong Kong rose 2.66 percent in the first two months from a year earlier to $15.4 billion.

Service sector FDI in the first two months was $8.0 billion, down 3.51 percent from a year ago. Manufacturing sector FDI was $8.4 billion in January-February, down 0.1 percent over the same period a year earlier.

Meanwhile, China's efforts to expand its own direct investments in foreign countries were revealed to be surging. Non-financial Chinese firms invested $7.4 billion abroad in the first two months of 2012, up 41.1 percent from a year earlier.

Despite a gloomy economic outlook thanks to Europe's festering debt crisis and under-spending U.S. consumers, China drew in a record $116 billion of FDI in 2011.

The Commerce Ministry targets an average of $120 billion in investment inflows in each of the next four years.

It has also unveiled new rules to encourage foreign investment in strategic emerging industries, particularly those that bring new technology and know-how to China.

(Additional reporting by Kevin Yao; Editing by Jacqueline Wong and Richard Borsuk)