China’s official PMI for July fell 0.9 pp to 51.2, its fourth consecutive decline and the lowest reading since February 2009. The forward-looking PMI new orders reading was down 1.2 pp to 50.9. The output index fell sharply by 3.1pp, reflecting the ongoing inventory correction.

Credit Suisse’s economist Dong Tao noted that weakness almost across the board in the latest PMI data. This set of data suggested that the inventory correction had been quite aggressive across many sectors, while infrastructure construction had continued to soften. Dao believed this data suggested that China was probably growing at around a low-9% or high-8% year-on-year rate in 3Q. Tao expected the authorities to keep monetary policy, interest rates, and the property tightening policy unchanged, suggesting recent investor expectations that Beijing might loosen tightening grip remained intact.

Bank of America-Merrill Lynch economist Lu Ting had a positive interpretation, he said it “might be positive to markets today” as many had anticipated contraction in activity. Lu said the PMI was closely watched by markets because it was the first indicator to show “v-shaped” recovery for China in wake of financial crisis. The weak PMI helped enhance recent investor expectations that Beijing may loosen tightening grip.

China stock markets rose on the “good news”. Shanghai Composite rose 0.5% at 2650 in early morning trading and Hong Kong HSI opened up 1% at 21,221 overnight Monday.

Shortly after the China stock markets opened on Monday, Hong Kong Bank also announced that its HSBC China manufacturing PMI fell to 49.4 from June’s 50.4. “China manufacturing PMI came in at 49.4, the first sub-50 reading in 16 months. This suggests that manufacturing production growth continued to decelerate last month, reflecting the combined effect of credit tightening, property cooling measures and Beijing’s measures to cut capacity in energy-intensive sectors.” said Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC. “However, there is no need to panic because this is just a slowdown, not a meltdown. We still expect the economy to rely on continued investment into ongoing infrastructure projects, public housing construction and resilient private consumption to grow by around 9% in 2H 10 and 2011.”, Qu added.

Notwithstanding the above big players’ positive analyses, Jun Ma, Chief Economist, Greater China Head of China/Hong Kong Strategy Deutsche Bank Hong Kong has done a thorough analysis of the July PMI and his observations directly from the official PMI report, posted on ETnet, is cited as follows:

First, the PMI report shows a broader-based weakening of industrial outlook compared with the previous month. In June, only five (out of 20) sectors (ferrous metal, non- ferrous metal, petroleum and coking, chemical materials, timber & furniture, and paper) reported PMIs below 50, which indicate contractions in activities. In July, the number of sectors that reported sub-50 PMIs rose to seven, and they now include transport equipment (mainly auto), chemical fibers & plastics, pharmaceutical, and tobacco, in addition to ferrous and non-ferrous metals. Looking at the new orders index, the number of sub-50 sectors also rose to eight in July from six in June.

Second, the domestic-oriented sectors continue to fare worse than export-driven sectors. Specifically, the new orders sub-index fell 1.1ppts to 50.9 in July, while the new export orders sub-index dropped 0.7ppts to 51.2. As we pointed out in several notes recently, the key reasons for the domestic sectors’ weakness are mostly related to policy tightening on real estate, local financing platforms, and production cuts in energy intensive sectors. And we do not think the current political environment will allow an immediate policy relaxation in response to these leading indicators.

Third, the two worst performing sectors measured by the new orders index are timber & furniture (reflecting the recent sharp fall in demand for properties) and transport equipment (reflecting mainly weakness in auto demand). For auto, its July reading of 38.3 is the lowest since the inception of this index in January 2005 (excluding the crisis period). This is consistent with our view that yoy auto sales growth will likely fall into the negative territory in the coming months, down from 20-30% yoy in past months. In other words, the 70% drop in property transactions in the past three months and sequential decline in auto demand will present a double whammy to consumer demand, in addition to the government-led FAI deceleration and production cuts in heavy manufacturing sectors.

Fourth, taking the difference between the new orders sub-index and the inventory sub- index, which measures the aggregate outlook for underlying demand and inventory recovery, the worst hit sectors are chemical fibers & plastics (-20), ferrous metal processing (- 20), and timber & furniture (-16). In other words, inventory destocking will remain a serious drag on these three sectors in coming months.

As for economic and policy implications, we see the following points:

(1) These PMI reports suggest further downside risk to our already conservative IP and GDP growth forecasts for Q3. We will not be surprised to see qoq (saar) GDP growth falling to 6.5% in Q3 (vs our previous expectation of 7%). IP growth can come off to 11% yoy in Q3 (another 1 ppt off from our earlier expectation of 12%) compared with 16% in Q2.

(2) The weak PMI reports per se will not be sufficient to lead to policy relaxations in the near term. For the moment, there are still strong hawkish voices in the policy circle arguing that the on-going GDP deceleration is desirable, policy stimulus has been costly, and property bubbles are yet to be deflated. For example, both PBOC and the Ministry of Housing reiterated today that the tightening measures for the real estate market would not be changed. And a Vice Minister of the Housing Ministry even stated that “definately no policy relaxation until the government’s objective is achieved”. Only when the officially reported GDP growth falls below 9% (which we expect to occur in mid-October), the pro-growth camp may begin to gain upper hand in the policy debate, in our view.

In conclusion, we think the PMI reports suggest that economic numbers are getting worse but the chance of imminent policy relaxation does not rise.