Why Market Euphoria Over China PMI Data Might be Overdone

Official and private sector surveys on China's manufacturing sector suggest the economy is finally perking up, boosting stocks in Shanghai almost 2 percent on Thursday. But exports, the main engine of growth, are still struggling and that means the Chinese recovery is not on solid ground yet, economists say.

Why Market Euphoria Over China PMI Data Might be Overdone
ChinaFotoPress | Getty Images

China's official Purchasing Manufacturing Index (PMI) rose to 50.2 in October from 49.8 in September, pushing above the 50-mark that separates contraction from expansion, China's statistics bureau reported on Thursday.

Separately, HSBC said the final reading for its October PMI came in at 49.5 from 47.9 in September, with factories at their busiest in eight months, while new orders were at their highest in a year. The reading also deviated more than usual from an initial estimate released last week of 49.1.

The data had a clear impact on financial markets, which have been fretting about a sharp slowdown in China, the world's second biggest economy, for months now. The Shanghai Composite Index was up 1.8 percent in mid-day Asian trade.

But a closer look at the PMI data and the information they reveal about export orders tells a different story and points to continued weakness in China's main export markets, according to Louis Kuijs, Chief China Economist with RBS in Hong Kong.

"There's no rebound guaranteed," Kuijs told CNBC Asia's "The Call". "Things still depend very much on what happens in the United States, Europe, so while I think it will be more likely that the PMI stays above 50 than below, there's no guarantee."

Export Engine

Exports are a key component of the Chinese economy, making up about 35-40 percent of gross domestic product in 2011. The nation's biggest market, the European Union, has been mired in near-zero growth this year, while growth in the U.S. economy has also been weak.

(Read more: A Global Recession? The Warning Signs Are Everywhere)

The new export orders sub-index of the official PMI rose to 49.3 last month from 48.8 in September, but has been below the key 50-level for much of the year. The new export orders component of the HSBC PMI meanwhile declined for a sixth successive month in October.

Weak demand from China's key export markets throws into doubt a firm rebound in China's GDP growth, economists say.

"Externally, there are still a lot of challenges remaining," Donna Kwok, Greater China Economist with HSBC said. "We do see a pickup in domestic demand, thanks to Beijing's continued easing measures. We need those to continue to come through if domestic demand is to hold steady."

China unveiled a series of measures, mostly in the third quarter, to prop up an economy that was on track to expand at its slowest annual pace in 13 years.

Beijing said in late September it would allow faster payment of export tax rebates and an increase of loans to exporters to help the export sector. That was on top of approvals for infrastructure projects worth more than $150 billion earlier that month.

It has also eased credit conditions, cutting interest rates in June and July and slashing reserve requirement ratios for banks three times since November.

Bhaskar Laxminarayan, Chief Investment Officer, Bank Pictet & Cie, said more help needs to be directed to small and medium sized enterprises and to activities that will boost domestic consumption. That will reduce China's dependence on exports and ensure a more sustainable path to growth.

(Read more: Betting on a Spending Boost, Investors Eye China's Retail Space)

Until that happens, markets need to be "cautious" about any positive economic news from China, he said.

"We don't know how sustainable that (the PMI) is," he told CNBC. "It's early days in terms of saying that there's a complete recovery. The global recovery is not in great shape, so I think we need to monitor the situation. I don't think it's a sustainable reversal at this stage."

By CNBC's Jean Chua