China's Shaky Start to the Year of the Snake

China Year of the Snake Chinese New Year
Getty Images

The pullback in activity in China's key manufacturing sector in January highlights the fragility of the recovery in the world's second largest economy, experts told CNBC, following the release of the official manufacturing purchasing manager's index (PMI) on Friday.

China's official PMI, the government's first economic release of the year, unexpectedly fell to 50.4 percent in January, from 50.6 in December, led by a fall in new export orders and overall output. While the index - which focuses on larger, state-owned firms, a lot of which operate in heavy industry sector - remained in expansionary territory above 50, it was far below a Reuters poll, which had forecast a rise to 50.9.

(Read More: China Factory Activity Eases, Missing Forecast )

"If you look at the economic rebound since September, it was led by strong pick up in Chinese investments, which in turn spurred heavy industry activities in the last quarter. This current recovery is still narrowly based and fragile, it's predicated on more accommodative fiscal policy and monetary policy," Liu Li-gang, chief China economist at ANZ told CNBC.

In 2012, the government launched fiscal stimulus measures including a $150 billion-plus infrastructure spending package and incentives for exporters. Also last year, the country's central bank cut interest rates and the reserve requirement ratio (RRR) for banks twice each.

"Should monetary policy start to turn to the tightening bias, we think the recovery will not likely be sustained," Liu added.

IHS economists Xianfang Ren and Alistair Thornton agreed that the data reflect the "shakiness" in China's recovery, "the economy has yet to generate the type of self-perpetuating growth that is needed to put the recovery on a comfortable footing."

(Read More: New China Leaders Must Steady Economy in 2013 Before Driving Reform)

Economists also attributed the index's decline to the government's expansion of the survey's sample size. The survey comprised 3,000 firms in January, compared to 820 in previous months. While this makes it more difficult to compare this month's reading to December's it is a better indicator of the health of the manufacturing sector, analysts said.

Jian Chang, China economist at Barclays, however, argued that there is an element of seasonality contributing to weakness in the data, noting that there tends to be a pullback in the official PMI data when Chinese New Year falls in early to mid-February. This holiday period between February 11 and 15, alongside the colder than usual winter, typically leads to a slowdown in construction activity.

(Read More: China's Workers Endure New Year Without Parties )

Conflicting Signals

Contradicting the official data is HSBC's survey - which captures over 400 smaller, private sector firms. The bank's PMI rose to a 2-year high of 52.3 in January, climbing from 51.9 in December RIGHT?, boosted by a rise in new orders.

Liu of ANZ, who said he is not reading too much into the upswing, said the index tends to outperform when overall market sentiment is positive. The Shanghai Composite, for example, has benefited from this change in sentiment logging double digit gains since December, .

"This is a sentiment survey – with a large concentration of small and medium enterprises in the export sector, they are more prone to pro cyclical type of behavior when answering," he said.

Inflation Creeping Back

The two surveys, however, showed that input costs for factories were rising at a fast pace.

The official PMI's input price sub index, for example, jumped to 57.2 in January from 53.3 in December, while HSBC said input costs increased at a "solid pace."

"(The) input price index rose sharply in January again, it has been on an upward trend, there's a similar trend with food prices – next couple of months inflationary pressures will be on the mind for the central bank," Zhiwei Zhang, chief China economist at Nomura, said.

Nomura forecasts the People's Bank of China will hike interest rates twice in the second half of the year.