The Worst Is Yet to Come for China's Economy

A key private sector indicator on Thursday, which showed Chinese factory activity slumped to a nine-month low in August against expectations of a modest pickup, throws up the question whether the worst is yet to come for the world’s second largest economy.

A factory worker lays out strips of rubber to produce tires at the Pirelli & C SpA tire factory in Jining, Shandong Province, China.
Bloomberg | Getty Images
A factory worker lays out strips of rubber to produce tires at the Pirelli & C SpA tire factory in Jining, Shandong Province, China.

The second quarter, during which growth slowed to 7.6 percent, was regarded by many economists as the bottom for Chinese economic growth. However, experts say this view may have been overly optimistic.

“(While) we still believe the Chinese economy will pick up steam in the fourth quarter, this idea that the bottom has already passed in May-June is optimistic,” Frederic Neumann, Co-Head of Asian Economics Research at HSBC told CNBC after the release of the data.

“People jumped too quickly to the conclusion that China would fire everything at the economy to bring growth back up. What transpired is that policymakers have been cautious about over-stimulating growth,” he added.

Alistair Thornton, China Economist at Global Economics Group says while China is not in hard-landing territory yet, without aggressive response from the government – the economy will be “veering dangerously close.”

The HSBC Flash Purchasing Managers Index (PMI) - the earliest available indicator of manufacturing activity in China – fell to 47.8 in August from 49.5 in July. A reading above 50 indicates expanding activity and one below 50 signals contraction.

The most concerning aspects of the data, Neumann says are the fall in new export orders, which slumped to their lowest level since March 2009 on weak external demand, and the buildup in stocks of finished goods.

“Demand has declined more sharply than expected and firms are sitting on a lot of unsold inventory, which will weigh on production activity going forward,” he said.

Thornton adds that the data show an economy still “trawling for the bottom.”

“Current consensus view is that the second quarter marks the bottom…(but) it is looking increasingly likely that it will be the third quarter, not the second, that marks the bottom of the cycle,” Thornton said. He forecasts overall growth in China in 2012 will be 7.6 percent.

Economists say they are confident that authorities in the mainland will step up with adequate policy measures to support growth.

“Policymakers are aware of the latest developments…we continue to expect more monetary easing in August-September, as well as more fiscal support to stabilize growth,” Jian Chang, China Economist at Barclays wrote in a report.

According to Neumann, the weak PMI numbers puts the spotlight back on monetary stimulus.

“The market had scaled back expectations about easing in China over the last few days... this number proves that rate cuts and RRR (reserve requirement ratio) cuts are back on the table,” he said.

The impact of government stimulus measures will likely show up in the fourth quarter, said Neumann when growth should pick up to 8-8.5 percent.

By CNBC’s Ansuya Harjani