Source:  The Wall Street Journal                       Date: 25 May, 2011

A business survey showing China's manufacturing in May expanding at its slowest pace in 10 months drove Chinese stocks down sharply, and added to concerns over a slowdown in the world's second-largest economy after months of inflation fears. The HSBC preliminary purchasing managers' index for China, an early read on manufacturing activity in May that was released Monday, fell to 51.1 in May from 51.8 in April. A reading above 50 indicates continued growth, but the decline in the index shows that the pace of growth is slowing.

Other recent data, including industrial production growth in April and manufacturer surveys from the last few months, have showed activity to be slowing more than many analysts predicted, even as inflation remains stubbornly high. "The market certainly is worried about growth slowing, that's been apparent, but it's also worried about inflation. Previously the worry was inflation alone. That's what's changed," said UBS Securities economist Wang Tao. She noted that even inflation concerns are ultimately about growth, as the real worry has been that the Government's anti-inflation tightening measures—a series of interest-rate increases, credit curbs and other measures—could lead to a sharp downturn in economic activity.

The lower preliminary reading in HSBC's survey on Monday "heralds further cooldown" in China "as both domestic tightening and external supply disruptions kick in," Mr. Qu Hongbin, HSBC chief economist for China, said in a research note. Still, Mr. Qu said there is no need worry about a "hard landing" for the Chinese economy. "Cooling growth is not all bad news as it also helps to tame inflation."

The preliminary China PMI figure is based on 85% to 90% of total responses to HSBC's PMI survey each month and is issued about one week before the final PMI reading for the month. The bank's final May China PMI reading is due June 1, as is the official PMI released by the China Federation of Logistics and Purchasing. The official PMI for April, released May 1, also showed a slowdown, falling to 52.9 from 53.4 in March.

Industrial-production growth also slowed more rapidly than expected in April, according to data released earlier this month, rising 13.4% in April compared with 14.8% increase in March. "In the next couple of months, we do expect some softness in the industrial-production numbers, and continued decline in the PMIs," said Ms. Wang. Inventories of finished goods have built up, and they aren't meeting the expected level of final demand in some sectors such as autos, she added.

Auto sales, a closely watched indicator of consumer activity in China, have been disappointing this year. In April, auto sales fell 0.25% from a year earlier, the first such decline in two years. The semiofficial China Association of Automobile Manufacturers now says its earlier forecast of 10%-15% growth in auto sales this year is in doubt, an especially underwhelming performance compared with 32% growth in 2010.

Still, economists don't see any serious risk of a damaging slowdown in China. HSBC's Mr. Qu said fighting inflation is likely to remain Beijing's focus in the coming months. Ms. Wang from UBS said she expects China's gross domestic product growth to come in at 9.3% this year, down from 10% in 2010, but still robust compared with most economies in the world.

In a survey of economists by Dow Jones last week, six out of 10 said they expect one more interest-rate increase this year, of a quarter of a percentage point, to both lending and deposit rates. The People's Bank of China is also likely to raise banks' reserve requirement ratio by half a percentage point next month, continuing its pattern so far this year of raising the ratio once a month, according to the survey.

To combat inflation, the central bank announced increases in its benchmark lending and deposit rates on April 5 and Feb. 8, following two similar moves in 2010, while also raising banks' required reserve ratio six times in 2010 and five times so far this year.

"It is likely that coming months will see a classic neurotic market mood swing towards China where investors stop worrying about inflation and start worrying about the opposite," said  a strategist at brokerage CLSA Asia-Pacific Markets. "Still the authorities have complete freedom to turn the liquidity tap back on should they want to."