Weaker China factories argue for more policy support as stocks swoon

BEIJING (Reuters) - China's factory activity shrank more than initially estimated in July, contracting the most in two years as new orders fell and dashing hopes that the world's second-largest economy may be steadying, a private survey showed on Monday.

The report followed a downbeat official survey on Saturday which showed growth at manufacturing firms unexpectedly stalled, reinforcing views that the struggling economy needs more stimulus even as it faces fresh risks from a stock market slump.

Fears of a full-blown market crash have added a new sense of urgency for policymakers in Beijing, with many analysts expecting more support measures to be rolled out within weeks.

The final, private Caixin/Markit China Manufacturing Purchasing Managers' Index (PMI) dropped to 47.8 in July, the lowest since July 2013, from 49.4 in June.

That was worse than a preliminary reading of 48.2 and marked the fifth straight month of contraction.

New orders contracted after growing in June, while factory output shrank for the third consecutive month to hit a trough of 47.1, a level not seen in more than 3-1/2 years.

Deteriorating conditions forced companies to cut staffing for the 21st straight month, and factories had to reduce selling prices to a six-month low due to increasing competition.

Yet some economists warned against reading too much into the gloomy July data, arguing that the factory weakness may be transitory. For one, summer storms in the manufacturing hubs of Zhejiang and Guangdong may have dented output, they said.

And while companies that had invested in the stock market were shaken by the rout, history has shown that falling share prices don't affect real spending in China, they said.

"When stocks were rising rapidly, consumption did not pick up," said Julian Evans-Pritchard at Capital Economics, citing China's recent equity rally and that in 2007/08.

Instead, China's retail spending grew faster after share prices slumped in 2007/08, he said. "The wealth effect is not evident in China."

While soft global demand could continue to weigh on China's exports, market watchers like Evans-Pritchard believe increased government infrastructure spending and further policy easing should support domestic consumption in coming months, ensuring the economy meets the government's 7-percent growth target for the year.

Still, the factory outlook looks sluggish at best.

The official factory Purchasing Managers' Index (PMI) was also weaker than expected, falling to 50.0 in July from June's tepid growth reading of 50.2. The official survey focuses more on larger firms, which will likely benefit more from big infrastructure projects than smaller companies.

While growth in the services sector picked up slightly, offsetting some of the drag from persistent factory weakness, services companies rang alarm bells, too, reporting that new orders were cooling and they were cutting jobs at a faster pace.

A DIFFICULT SIX MONTHS

To be sure, even some within the Chinese government are less upbeat about the economic outlook.

Sheng Songcheng, director of the statistics division at the central bank, said that downward pressure on the economy will persist in the second-half of the year, adding that growth in exports and investment is not likely to pick up.

His guarded view resonates with some companies as well.

China Glass Holdings Ltd <3300.HK> on Friday became the latest in a growing list of firms to issue profit warnings due to weak demand, saying it expected a first-half loss.

China's slowdown is also forcing many Western companies to take a hard look at their businesses there, leading many to reduce investments and costs.

“We had five fabulous years in China where we grew strong double-digits, and it has been gradually slowing. Currently, in China we had negative order intake,” Frans van Houten, chief of Dutch electronics group Philips NV <PHG.AS> said last week.

“We need to be much more modest on expectations with regard to China growth; that's just being realistic,” he said.

Share markets across Asia including Shanghai <.SSEC> fell on Monday and global prices of commodities such as copper and crude oil skidded on worries about the Chinese economy.

MORE SUPPORT MEASURES

The People's Bank of China (PBOC) has already cut interest rates four times since November and repeatedly loosened restrictions on bank lending in its most aggressive stimulus campaign since the global financial crisis.

Beijing has also intervened heavily recently to stabilize stock markets, which has raised questions over its commitment to free-market reforms seen as essential for its transition from an export-led economy to one based on consumption.

While there is little evidence yet that the 30-percent stock market slump since mid-June has hit spending, analysts say wild price swings will rattle consumer and business confidence and could dampen activity in the financial services sector.

Buffeted by softening investment growth, unsteady domestic and foreign demand and a cooling housing market, China's growth is widely expected to grind to its lowest in a quarter of a century this year at 7 percent, from 7.4 percent in 2014.

After months of weakness, industrial output, retail sales and investment all grew slightly more than expected in June, raising hopes that earlier policy easing was finally starting to pay off. July data will be released over the next two weeks.

In an acknowledgement of difficulties ahead, the Politburo, one of the Communist Party's elite ruling bodies, promised last week to step up policy adjustments to keep growth stable.

Even if the stock market steadies, Tim Condon from ING Group in Singapore said Beijing will still need a continued housing market turnaround to hit its 7 percent growth target for 2015.

However, while home sales and prices are improving slowly in bigger cities after a year-long slump, a massive overhang of unsold homes could keep real estate under pressure well into next year, deterring developers from starting new construction and depressing demand for materials from cement to steel.

(Reporting by Beijing Newsroom and Koh Gui Qing; Editing by Kim Coghill)