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China’s flash PMI index from HSBC – an early indicator of the final data – has hit its highest level for six months, reading 51.2, up from 50.1 in August (50 is the mark that separates contraction from expansion).

As data readings go, it bodes pretty well.

The flash reading, which is based on 85 to 90 per cent of total PMI survey responses, shows that the manufacturing rebound driven a mixture of domestic and overseas demand looks to be continuing.

Hongbin Qu, Chief China Economist at HSBC said:

The HSBC Flash China Manufacturing PMI rose to a six-month high in September, adding further evidence to China’s ongoing growth rebound. The firmer footing was supported by simultaneous improvements of external and domestic demand conditions. We expect a more sustained recovery as the further filtering-through of fine-tuning measures should lift domestic demand. This will create more favourable conditions to push forward reforms, which should in turn boost mid- and long-term growth outlooks.

But what is driving domestic demand? Louis Kuijs, economist at RBS, said a note:

Some fear, or claim, that domestic demand has recently largely been fueled by unsustainable credit-based stimulus. But that is an exaggeration. After all, China is still a current account surplus country… Looking ahead, we expect the cyclical pick up to be consolidated in the coming quarters, benefiting from the strengthening global demand outlook, which supports growth directly via stronger exports and by improving sentiment and profitability in industry and thus the willingness to invest.

If the improvement in exports peters out and/or private sector investment disappoints, the government would need to show restraint in not easing up on monetary policy too much, taking comfort from the cushion provided by robust growth in the domestically oriented service sector and a still favourable labour market situation. Such a scenario should still be manageable from the government’s perspective. Markets would not like the short-term demand implications but would appreciate the commitment to reining in credit.

And if that doesn’t cut it?

In a more unfavourable scenario, the downward pressures on growth would remain and the government would “give in” and provide stimulus along traditional, credit-based, lines. This is the kind of scenario that would increasingly scare the financial markets. In our view, it is the least likely scenario, notably because of the messages that senior leaders such as the Prime Minister have recently given. But, given the keenness for growth and investment that there still is among many in government circles, we cannot rule it out.

Preferably not, though.

Related reading:
China factory data bolster economy hopes
, FT
Asia PMIs: just one positive
, beyondbrics

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