China's Manufacturing Sector Remains Stagnant

Steel and Auto Still Contracting

Although the headline manufacturing purchasing managers' index (PMI) of China remained above the critical reading of 50 in July, the index for two key industrial sectors, steel and automobile, were already well under it. Steel and auto are just two of the 11 sectors that have recorded lower-than-50 PMI. In July, the steel PMI retreated by another 4.7 points to a five-month low of 44.5, as the new orders sub-index was pared by 13 points—a record low since December 2008, according to data released today (2 August) by the steel logistics professional committee of China Federation of Logistics and Purchases (CFLP). The drop is much larger than the 0.1 point decline of the headline manufacturing PMI. The total manufacturing PMI, released yesterday by the CFLP, still indicates continued expansion, even though coming in surprisingly lower than expected.

PMI for the automobile sector, a key downstream sector of steel, also indicates continued contraction. After hitting a high of 60.4 in March, auto PMI has nosedived into the contraction zone for four straight months, according to the CFLP. New orders, production and imports of the auto sector are all contracting, according to the CFLP. Data released by the China Automobile Logistics Association have also revealed high inventories. According to the association's survey, one-third of the auto dealers surveyed are reporting significant rise in inventories. The inventory coefficient—the ratio between inventory and current month sales—had climbed from 1.49 in January to 2.09 in June, well above the 1.5 warning threshold.

Guangdong's PMI Down for Four Straight Months

In the meantime, provincial manufacturing PMI has shed light on distress on the regional level. The manufacturing PMI for Guangdong, the largest economy in China and the first Chinese region reporting its own PMI, softened further to 50, from 50.4 in June—a retreat also larger than the national PMI. The production sub-index has already hit a six-month low, and the decline of new orders, raw material stock and employment has widened. The downward trend of Guangdong's PMI started in March, and traditionally the provincial PMI reading has been more volatile and weaker than the national one. Given that the economy of Guangdong is weighed more heavily towards the export sector and private sector than the national index, the weakening of Guangdong's PMI is a good indicator of headwinds facing the country's export sector and private sector, the most vulnerable links in the country's economy.

Outlook and Implications

Other than poor sector and regional PMI data, the employment sub-index of the broad manufacturing PMI is also to be watched. Employment in the CFLP PMI has dropped below 50 since June, and that in the HSBC/Markit PMI has come down for five straight months. Anecdotal reports have confirmed burgeoning labour market problems, with bankruptcies reported for contract manufacturers in coastal regions such as Guangdong, Fujian, and Zhejiang. Labour disputes have also arisen in capital-intensive sectors, such as construction machinery, which was recently manifested by Sany Group's forced transfer of young engineers from research units to blue-worker assignments. Hidden redundancy has also been reported in many other businesses, where employees have been working fewer hours or put on non-voluntary vacation. If revenue and profits remain distressed, some of the hidden redundancy may start showing up as outright redundancy over time.

The manufacturing sector's current distress has reflected serious problems with demand and supply. Demand has weakened while supply capacity has ballooned in the previous boom cycle. The outcome is huge amounts of inventories need to be worked off, and large amounts of redundant capacities to be retired. The inventory cycle could be turning more positive in the next couple of months after about one year of destocking, further helped by the demand-side stimuli. This shall help engineer a rebound of the manufacturing sector later this year. Nonetheless, it is far from assured that the rebound will turn into a sustained recovery, as the underlying structural problems will take much longer to be resolved.