SHANGHAI - Mainland stocks fell, erasing earlier gains, on speculation the China's central bank will accelerate increases in interest rates after boosting borrowing costs over the weekend. Bonds dropped and yuan forwards climbed.

The benchmark Shanghai Composite Index declined 1.9 percent to 2781.40 at the close on Monday, the lowest since Oct 8. Commodity and consumer companies ranging from Aluminum Corp of China Ltd to Kweichow Moutai Co slid more than 2 percent on concern that monetary tightening will slow economic growth. Chinese currency forwards rose to a five-month high on prospects the government will allow further currency gains to contain consumer prices that reached a 28-month high in November.

"Investors were initially relieved as this interest-rate increase had been priced into stocks for a long time," said Dai Ming, a fund manager at Shanghai Kingsun Investment Management & Consulting Co. "However they're now thinking about the future; that one increase won't be enough to bring inflation under control and more rate hikes will be needed. That will keep depressing valuations of stocks."

The People's Bank of China increased key one-year lending and deposit rates by 25 basis points on Christmas Day in its second move since mid-October. The benchmark lending rate rose to 5.81 percent, compared with 7.47 percent before cuts from late 2008 to counter the global financial crisis. The deposit rate increased to 2.75 percent, compared with the 5.1 percent annual pace of inflation in November, the highest in 28 months.

Premier Wen Jiabao's government aims to limit asset bubbles in the real-estate market and prevent rising prices from leading to social problems after pumping large amounts of liquidity into the economy from late 2008 to drive a recovery.

Rate outlook

China's monetary tightening in 2011 may be mainly in the first half, JPMorgan Chase & Co and Morgan Stanley said. China may raise rates as many as three times in the first half of next year, according to Morgan Stanley, while JPMorgan forecasts two increases in that period.

The Shanghai Composite rose as much as 1.5 percent before slumping in the last hour of trade. Aluminum Corp of China and Zhuzhou Smelter Group Co, the nation's biggest producers of aluminum and zinc, slid more than 2 percent. Kweichow Moutai, a spirits maker, and GD Midea Holding Co, a manufacturer of home appliances, dropped more than 3 percent.

The central bank raised rates for the first time since 2007 in October, and on Dec 10 ordered lenders to set aside more money as reserves for the third time in five weeks. The policy tightening has contributed to a 15 percent decline in the Shanghai Composite this year, the biggest drop among the world's 15 largest equity markets, including a 2 percent loss last week.

Cash crunch

Related readings:  Stocks fall after PBOC's weekend rate hike  China's interest rate raised second time in 2010  Wen: We are beating inflation  Reserve ratio may rise to record high

Chinese new bank loans have fallen for two straight months, to 564 billion yuan ($85 billion) at the end of November from 596 billion yuan in September, government figures show. The seven-day repurchase rate, which measures lending costs between banks, has more than doubled in the past two weeks and reached a three-year high of 5.67 percent on Thursday.

Twelve-month non-deliverable yuan forwards strengthened 0.4 percent to 6.4765 per dollar as of 3:34 pm in Hong Kong, reflecting bets the currency will strengthen 2.4 percent in one year, according to data compiled by Bloomberg. The contracts touched 6.4740, the highest level since Nov 23.

The yuan's spot rate declined 0.12 percent to 6.6347 per dollar, from 6.6270 on Friday, according to the China Foreign Exchange Trade System.

The yield on the 3.67 percent note due October 2020 climbed nine basis points to 3.90 percent, and the price of the security dropped 0.76 per 100 yuan face amount to 98.13, according to the China Interbank Bond Market.

Bond prices

"Investors are worried about the timing of interest rate hikes next year after the earlier-than-expected rate increase," said Yang Yongguang, a bond trader at Sealand Securities Co in Shenzhen. "The 10-year bond yield won't rise much because banks have a strong demand for bond assets at the beginning of the year."

The rate increase "is more a signaling tool than anything else", Yu Song and Helen Qiao, analysts at Goldman Sachs Group Inc, wrote in a report. "We still expect the government to take a combination of measures to control inflation, including further rate hikes and possibly slightly faster currency appreciation, and believe the heavy lifting of controlling inflation will still fall on quantitative measures."

Premier Wen Jiabao reiterated his goal for home prices to return to a "reasonable level" during his term. The government will also increase the supply of affordable housing and introduce more measures to curb speculation, he said on China National Radio on Sunday.

Bloomberg News