Awaiting China PMI: Things Could Get Even Worse

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Activity in China's vast manufacturing sector may have decelerated further in June, the flash estimate of the HSBC China purchasing manager's index (PMI) is expected to show, exacerbating worries about a downturn in the world's second largest economy.

The closely-watched flash PMI survey due on Thursday could fall to as low as 48.7, according to estimates by Credit Agricole and Nomura, worse than the final reading of 49.2 in May when the index moved into contractionary territory for the first time in seven months.

A reading above 50 indicates expanding activity and one below 50 signals contraction.

"The manufacturing sector is going through a soft patch driven by the inventory cycle, where companies are holding back from growing inventories too much, that's why they haven't been producing a lot," Dariusz Kowalczyk, senior economist, Asia ex-Japan at Credit Agricole told CNBC on Wednesday, adding that June has historically logged a decline in the index.

"Consumption by households has decelerated and manufacturers are concerned about the demand outlook. For now, business sentiment will remain subdued because domestic demand isn't that strong." Kowalczyk, who expects the flash PMI to decline to 48.7, added.

Weakness in demand is reflected by the extended slump in China's producer prices, which fell 2.9 percent in May from a year earlier, steeper than a 2.6 percent decline in April. Deflation in producer prices has persisted for 15 straight months.

(Read More: This China Downturn May Be the 'Most Drawn-Out' )

On top of a softer domestic demand picture, weakness in external demand and tighter liquidity conditions are also weighing on manufacturing activity, said economists.

"The policy tightening that started in the second half of March is starting to hurt liquidity, so interbank rates rising sharply this will have a negative impact on growth," said Zhiwei Zhang, chief China economist at Nomura, who forecasts the flash PMI will fall to 48.8.

Tightness in liquidity makes it more difficult for businesses to fund operations and dampens sentiment.

Fears over a hard landing in the world's second largest economy have resurfaced in the recent weeks, driven by a slew of disappointing economic data alongside concerns over financial instability.

The latest Bank of America Merrill Lynch fund manager survey, published late Tuesday, showed investors identifying a hard landing in China as the biggest tail risk at the moment. 31 percent of fund managers surveyed expect the mainland economy to weaken over the next 12 months, compared with 8 percent in May.

(Read More: This Worries Us Most About China, Says World Bank)

Reflecting growing worries over the outlook for the economy, the World Bank last week downgraded its 2013 growth projection for China to 7.7 percent from 8.4 percent.

By CNBC's Ansuya Harjani