The End of China Domestic Demand?

The HSBC flash China manufacturing PMI fell to a three-month low in August, dragging Asian stocks down with it, and it is only the latest in a series of bad data out of the world's second-largest economy.

It was the first fall in the index since March this year. The 50.3 value for August was significantly below a consensus of 22 analysts polled by Bloomberg, who had expected it to come in at 51.5 compared with July's final reading of 51.7.

Looking at the components of the flash PMI -- which is the earliest indicator of the operating conditions in China's vast manufacturing sector -- it is obvious that the weakness is pervasive. Output, new orders and new export orders all increased at a slower rate. Output and input prices both decreased, changing direction and signaling a return of disinflationary pressures. Worryingly, the employment component -- weak for most of the year -- decreased at a faster rate in August.

Other data, released earlier this month, pointed to continued weakness in essential sectors of the Chinese economy. Property and infrastructure investment were what pushed the economy forward, at least since the Great Recession curtailed global demand for Chinese goods. Eager to keep China's huge workforce employed, the government launched massive public investment programs, stimulated the construction sector and kept interest rates low to facilitate borrowing.

All this had led to more than four years of febrile activity in the property sector. But now the data point clearly to a slowdown, if not a downturn. The latest survey by the National Bureau of Statistics has shown home prices falling in 64 out of the 70 big cities it covers, the biggest proportion since records began in July 2005. There have been three months in a row when prices decreased, with July's 0.9% the sharpest fall so far.

Some developers are slashing prices in order to make sure they sell as many apartments as they can in the huge clusters of tower blocks that they built. But this sparked anger and protests from those homeowners unfortunate enough to have bought at higher prices when the times were still good.

Efforts by Chinese policymakers to encourage lending to first-time buyers "appear to have had the effect of stabilizing mortgage provision," Mark Williams, chief Asia economist at Capital Economics, a London-based economic think-tank, noted in research published recently. With household incomes still growing at around 10% year-on-year, affordability is improving, but developers "are already sitting on rising inventories of unsold properties," he added.

The property sector's weakness is a drag on growth, Capital Economics' China Activity Proxy shows. Cement output -- an indicator of the construction sector's strength -- remained weak. Growth in industrial production fell in July, with a deep decrease in electricity output pointing to weakness in heavy industry. Investment in real estate has slowed down, dragging down private sector investment, and infrastructure investment, one of the key drivers of the rebound in growth in the second quarter, has flattened.

No wonder then that China's biggest trade surplus on record, posted in July, is not all good news. Yes, it's true that exports doubled their pace of growth in July to 14.5% y/y compared to June's 7.2% advance. (Incidentally, exports to the U.S. grew at the fastest pace, by 12.3% from June's 7.5%; to the EU, they increased by 17% compared with June's 13.1%).

But imports shrank by 1.6% in July, reversing a healthy 5.5% increase in June and contrary to market expectations of a 3% rise. One factor contributing to the fall was the softening of commodities' prices such as iron ore, oil and copper, which make up a large part of China's imports. Weaker domestic demand also played a big part.

Could this be the end of growth for China's domestic demand? Not necessarily. According to Louis Kuijs, an economist with RBS, while Chinese domestic demand growth has slowed this year, "it has not collapsed." The sectors most likely to absorb imports -- property and the corporate sector -- have done "particularly badly" in recent months, but things are different for other areas. While overall demand growth was 6.3% in the second quarter y/y, real household consumption growth, which takes in fewer imported goods, was 8.4% over the period, he pointed out.

It is hard to say whether today's weak PMI number, crowning a month of bad news out of China, is the harbinger of a sharper slowdown. One thing is sure. The final PMI data, due on September 1, are likely to be watched with even more interest.