China's economy grew at its weakest pace in 2-1/2 years in the latest quarter and it appeared headed for an even sharper slowdown in the coming months as export demand fades and the housing market falters.

The fourth-quarter year-on-year growth of 8.9 percent, although slightly stronger than the 8.7 percent that economists polled by Reuters had predicted, may give Beijing yet another reason to gently ease monetary policy, most likely by reducing the amount of reserves that large banks must hold.

The data released on Tuesday may not satisfy investors, who were looking for figures that were either weak enough to provide a clear-cut case for policy easing or strong enough to allay fears that the world's second-biggest economy might unravel.

The slowdown is not scary, so we are not going to get massive policy easing, said Kevin Lai, an economist with Daiwa in Hong Kong.

Shanghai stocks pared gains in low-volume, volatile trading after the data was released. The euro and Australian dollar both extended gains against the U.S. dollar as investors took some solace in the fact that China's growth rate was a bit faster than expected.

With Europe in danger of slipping into a recession and U.S. growth looking lacklustre, China's role in the global economy is magnified.

Although economists widely expect China's 2012 growth will be the weakest in a decade, a more pronounced slowdown would put a major drag on already shaky global growth.

The fourth-quarter growth rate was the slowest pace since the second quarter of 2009, when the global economy stumbled out of a deep recession. It also marked the fourth straight quarter in which growth slowed down.

Ma Jiantang, the head of China's statistics agency, said China's growth was likely to slow further as Beijing tries to restructure the economy away from exports and towards domestic consumption -- something the United States and other trading partners have long pressed China to do.

Tuesday's data showed net exports subtracted from 2011 growth while consumption contributed more than half.

Some analysts think China's first-quarter growth will be below 8 percent threshold seen as the minimum for assuring sufficient job creation.

Further weakness lies ahead, Mark Williams, an analyst at Capital Economics, said before the fourth-quarter data was released.

European demand for Chinese products has already slowed and is likely to remain subdued. The outlook for real estate construction -- a 10th of GDP -- is potentially an even greater concern.

Europe is China's top export market, and all signs point to much of the continent falling into recession in coming months, with no end in sight as governments push austerity programmes.

Mass ratings downgrades in the euro zone over the weekend and a breakdown in Greek bailout talks have added to financial market jitters.

NEW YEAR SKEW

An early Lunar New Year holiday on January 23-24 probably skewed the fourth-quarter data and the effect will likely linger through the first three months of the year.

Factories typically step up production to clear orders before the festive period, and then temporarily shut down as workers head home to visit family.

That means fourth-quarter growth probably benefited from the surge in manufacturing, while first-quarter activity will be even slower.

We are in a period where the early Chinese New Year is boosting activity ahead of the holiday, which is setting us up for a disappointment after, Ken Peng, an economist at BNP Paribas, said before the data release.

Peng sees China's annual economic growth slipping to 7.9 percent in the first quarter, the worst in three years.

A BOTTOM IN Q1?

Other Chinese data painted a mixed picture of the economy.

Retail sales grew 18.1 percent from a year earlier in December, faster than the consensus of a Reuters poll of 17.2 percent. Industrial output also exceeded expectations, up 12.8 percent year on year.

But housing investment dropped precipitously in December, and many property developers have warned that 2012 looks grim.

A booming housing market helped drive China's explosive growth in recent years, but Beijing has tried to cool prices in hopes of avoiding a devastating bubble and bust.

A modest housing market slowdown would be a welcome development, but a crash would be catastrophic, both for China and its trading partners around the world.

Some analysts think a more pronounced economic slowdown in the first quarter could be a blessing in disguise of sorts.

It may compel stability-obsessed Beijing to unveil more stimulus measures this year, giving the Chinese and world economy the lift that many investors are hoping for.

Possible stimulus could include further cuts in the levels of reserves that banks need to set aside at the central bank, and more aggressive state investment aimed at providing more public housing for low-income households.

Daiwa's Lai expects four cuts of 50 basis points each in bank reserves in 2012.

The central bank cut bank reserves in November for the first time in three years in a signal from Beijing of its concern about the economic slow down, reducing levels for big banks to 21 percent from a record 21.5 percent.

Beijing has also allowed the pace of bank lending to pick up and the central bank is injecting cash into money markets.

When growth dips to below 8 percent, the political consensus for protecting growth will be stronger. That helps to bring back activity, Peng from BNP Paribas said.

(Additional reporting by China economics team, Clement Tan in HONG KONG, Anthony Slodkowski in TOKYO; Writing by Emily Kaiser: Editing by Kim Coghill and Neil Fullick)