China's Manufacturing Activity Shows Cracks

China's factories unexpectedly contracted in May, ending a two-month period of growth and casting doubt on the country's export-driven strategy to rejuvenate its struggling economy.

  • This downturn surprised many economists, despite long-standing warnings that the current growth rate was unsustainable.
  • Indicators such as production outpacing new orders and an increased dependence on exports foreshadowed potential issues, especially as U.S. consumers have shown growing reluctance in recent months.

The National Bureau of Statistics reported that China's official manufacturing purchasing managers index (PMI), a critical measure of economic momentum, dropped to 49.5 in May from 50.4 in April. This figure fell below the 50 mark, which distinguishes growth from contraction, and missed the Wall Street Journal's forecast of 50.4.

A Delicate Act

A significant concern is the sharp decline in new export orders, which could trouble Beijing's efforts to bolster high-end manufacturing and exports as a counterbalance to the struggling property sector.

  • One factor affecting exports is the noticeable decline in U.S. consumer sentiment and spending, as the U.S. remains China’s largest export market.
  • According to a University of Michigan survey, U.S. consumer sentiment reached its lowest level since last November in May. U.S. retail sales stagnated in April, and job growth slowed considerably.
  • Historically, China’s new export orders have mirrored the overall trend in U.S. consumer sentiment, highlighting the importance of American consumers to China’s economy, despite its recent pivot towards Russia and other emerging markets.

The output and new export orders components of the PMI fell by 2.1 and 2.3 points respectively, surpassing the overall index's decline. Throughout late 2023 and April, output growth had consistently outpaced new orders, exerting downward pressure on prices and margins, and indicating that factory growth exceeded actual demand. The latest data slightly corrected this imbalance, reducing the gap between output and new orders from 1.8 points in April to 1.2 points.

Not All News Was Negative

Large manufacturers, particularly those producing transport equipment like trains and planes, computers, communication gear, and general industrial equipment, managed to expand for a third consecutive month. This could suggest that Beijing's recent "trade-in" policies for outdated equipment, implemented over the past half year, are still having a significant effect, noted Bruce Pang of JLL, a property and investment management firm.

  • China’s service sector PMI also saw a slight increase to 50.5 from 50.3 in April. However, the construction PMI dropped to 54.4 from 56.3, its lowest level since February.
  • This data follows Beijing’s new measures to support the ailing property sector, whose downturn has weakened market confidence and consumer spending.
  • The more supportive policy stance, combined with better-than-expected economic growth in the first quarter, has led many institutions to upgrade their forecasts for China’s economic growth.
  • Earlier this week, the International Monetary Fund raised its projection for China’s economic growth this year to 5.0% from 4.6%, aligning with Beijing’s target.

If the poor data trend continues next month, it will increase pressure on Beijing to more aggressively tackle the struggling property sector. The Communist Party’s Central Committee will meet in July for the Third Plenum, a meeting that has historically introduced significant policy changes.


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