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Official data to signal more pain for Chinese factories

Stringer | AFP | Getty Images

China's closely-watched official manufacturing purchasing managers index (PMI), due out on Thursday, is expected to show factory activity contracted for the first time in 10 months as the world's second largest economy suffers a deepening slowdown.

The government's official PMI, which tracks large and state-owned firms, is forecast to fall below the key 50 threshold that demarcates expansion from contraction to between 49.2 and 49.8 in July, according to four economists polled by CNBC. The PMI stood at 50.1 in June.

"Businesses in China are increasingly cautious on the growth outlook, and this is being driven by a lot of factors: the perception that the government will allow weaker growth, the strong currency, deteriorating financing conditions and policies to curb excessive consumption of high-end products and services by government officials," said Dariusz Kowalczyk, senior economist, Asia ex-Japan at Credit Agricole.

(Read more: Relax - China may weather Fed tapering, after all)

"The official PMI will reflect this and we expect manufacturing to slow for the remainder of the year," he added.

A key drag on the manufacturing sector is tighter liquidity conditions, say economists, which is making it more difficult for businesses, particularly small and medium sized enterprises (SMEs), to raise working capital to invest and fund their operations.

This could explain why the official index has lagged HSBC's China PMI - which focuses more on SMEs and has been in contractionary territory for three straight months. The bank's flash estimate of the index for July fell to an 11-month low of 47.7 from 48.2 in June.

(Read more: China's growth plan 'pretty persuasive': O'Neill)

"Given that the small-and-medium sized enterprises are prominently represented in the HSBC sample and they are more affected by liquidity squeezes, the slide in the official PMI should be more moderate," said Societe Generale in a note released earlier this week.

There have been some concerns that the tight credit conditions suffered by local lenders in June could spill over into the broader economy, contributing to a further slowdown in economic growth.

The manufacturing sector is expected to remain under pressure in the coming months as Beijing seeks to cut back on production in a range of sectors suffering from overcapacity.

(Read more: China risks following Japan into economic coma)

Last week, the government ordered hundreds of companies in 19 industries ranging from steel to cement and glass to cut production capacity.

"This shows the government is serious in its efforts to restructure the economy and is prepared to tolerate the necessary pain," said Zhiwei Zhang, chief China economist at Nomura. "This reinforces our view that growth should trend down, dropping to 7.4 percent in the third quarter and 7.2 percent in the fourth quarter."

—By CNBC's Ansuya Harjani; Follow her on Twitter: @Ansuya_H.

Contact World Economy

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