* Stock index posts biggest daily percentage fall in 5 years
* Yuan falls by most since 2008, bond yields surge
* Volatility increase follows PBOC rate cut last month
By Pete Sweeney
SHANGHAI, Dec 9 (Reuters) - Chinese shares plunged on Tuesday, sharply reversing course from a two-week rally fuelled in part by speculation the central bank would further ease policy, with a key stock index recording its biggest fall since the depths of the global financial crisis.
Volatility also gripped the currency markets, where the yuan posted its biggest one-day decline against the dollar since 2008 on talk of a possible cut in banks’ reserve requirements by the central bank - which could flood the market with renminbi and so dilute its value versus the dollar.
The gyrations follow the People’s Bank of China’s surprise November interest rate cut in response to a steady drumbeat of weak economic data.
Recent months have seen weaker-than-expected trade data, signs of looming deflation and a housing market - a major internal driver of growth - that has failed to pick up despite easing of administrative restrictions.
“More market volatility will be the new normal,” said Zheng Weigang, head of investment at Shanghai Securities. But he added that regulators may not necessarily be pleased with the outcome.
“The recent sharp rally in the stock market indicates that money freed from the PBOC’s recent rate cut has not flowed in to the real economy, and that is worrying regulators.”
In the stock market, the Shanghai Composite Index started the day rising to a 3-1/2-year high, before collapsing in the afternoon to lose more than 5 percent, the biggest single-day percentage drop since 2009, as investors took profits in sectors such as banking and property.
China looks set to miss its growth target this year for the first time since 1999, and full-year growth is likely to be the weakest in 24 years.
Some influential advisers are recommending the country’s leadership, which was meeting on Tuesday to map out economic and reform plans for next year, should cut 2015’s economic growth target to 7 percent.
Turnover in Chinese shares has not only blown past domestic records but is also setting global volume records, according to Reuters analysis. That makes the market susceptible to a sharp fall.
Valuations in the brokerage sector, which has been one the biggest beneficiaries from the latest rally, are now hovering at lofty levels, with their price-to-earnings ratio fetching around twice of their historic mean.
“If you are sure the next two years are going to be a boom market then securities firms are OK, but the problem is you just don’t know,” said Jiahe Chen, chief strategist at Cinda Securities.
In currency markets, the spot yuan slid nearly half a percent to 6.2007 per dollar, accelerating a decline that began after the Nov. 21 rate cut.
However, the increase in volatility should not come as a surprise to investors as Beijing has repeatedly said it would allow greater freedom for the markets to decide on pricing.
“We have long believed that RMB volatility needs to rise and the recent price action is a clear sign of this,” wrote HSBC economists in a research note.
In a key move towards liberalising the foreign exchange market, the PBOC earlier this year allowed the spot price to rise or fall by 2 percent away from the daily fix, up from 1 percent previously.
Traders have also noted state-owned banks have so far held off from behind-the-scenes intervention to prop up the yuan, a sign that the PBOC is actually following through on promises to reduce meddling in the market.
In the bond market, a benchmark corporate bond yield spiked more than 30 basis points and government bond future prices dropped more than 1 percent after regulators restricted the ability of low-rated issuers to raise short-term funds through bond-repurchase agreements.
The surge in yields prompted the China Development Bank and State Grid Corp of China, two major issuers of debt, to cancel their planned issuances.
Additional reporting by Jake Spring in BEIJING; Lu Jianxin, Chen Yixin, Engen Tham and the Shanghai Newsroom and Tu Lianting of IFR in SINGAPORE; Editing by Kazunori Takada and Alex Richardson