(Yicai) Aug. 5 -- China's Business Sentiment Index for the industrial sector edged down slightly in the second quarter from the previous quarter but remained above the 50-point threshold separating expansion from contraction, indicating that overall industrial activity continued to expand, according to a new report.

The Business Sentiment Index dipped one percentage point to 53 in the three months ended June 30 from the first quarter, according to the Cheung Kong Graduate School of Business’ latest Business Sentiment Index report. The index, which has been published for the last 10 years, is widely used as a gauge of China's industrial economy.

Of the index's core measures, the business conditions diffusion index fell one point from the previous quarter to 62, while the expected business conditions diffusion index slumped to the half-way mark of 50. The investment opportunity diffusion index was unchanged at 48.

The index also incorporates supplementary indicators related to production, inventories, costs, prices and financing. Of these, the production diffusion index rebounded to 53, almost fully reversing the previous quarter's contraction. The improvement suggests companies have moved beyond the initial shock and are beginning to rearrange orders, production capacity and deliveries.

Cost pressures also eased during the quarter. The unit cost diffusion index dropped to 64 from 72, while the raw material cost diffusion index tumbled to 64 from 74, indicating that the sharp rise in costs seen in the first quarter has eased significantly.

The price diffusion index slipped to 52 from 56 but remained above the boom-bust line, suggesting that pricing power persisted even as cost-driven inflation eased. With costs stabilizing and prices still rising modestly, firms are in a better position to rebalance production, inventories and orders.

The combination of moderating costs and more stable prices has given manufacturers greater operational flexibility, which many companies view as more important than price increases, the report said. Rapid price hikes can suppress demand and surging input costs can erode profit margins. The conditions in the second quarter were more conducive to enabling firms to optimize their production schedules and balance costs, pricing and orders.

Inventory Pressure

The data also point to mounting inventory pressure despite restrained borrowing. The proportion of companies holding finished-goods inventories fell to 61.2 percent from 63.1 percent, indicating that inventory pressure was affecting fewer firms.

However, the share of companies reporting that finished-goods inventories would take more than three months to clear jumped to 15.7 percent from 5.7 percent. The divergence indicates that although fewer firms are carrying inventories, those that are face significantly slower turnover times as production recovers.

This also explains why stronger investment activity has not translated into higher borrowing. The proportion of companies making fixed-asset investments rose to 22.2 percent from 18.7 percent, while the share undertaking expansion-oriented investments increased to 19.8 percent from 16.8 percent. Yet only 2 percent of surveyed firms reported taking out new loans, broadly unchanged from the previous quarter. Meanwhile, the bank lending conditions diffusion index dropped to 96 from 99 although it remains at a high level, suggesting that credit availability has stayed relatively supportive.

Recovery Outlook

Looking ahead to the second half, Chinese companies are still likely to face a challenging environment. Geopolitical developments, movements in the US dollar index, artificial intelligence-related capital expenditure, global energy prices and China-US trade relations could all impact firms’ cost structures and order expectations.

In the second half, the key will not be whether the business sentiment index rises or falls in a single quarter, but whether the recovery in production is backed by stronger orders, faster inventory turnover and improved profitability, the report said.

If prices remain above the expansion threshold, inventories continue to normalize and fixed-asset investment gathers momentum, the foundation for a sustained recovery in industrial activity this year will become more solid. Conversely, if demand fails to keep pace, the rebound in production seen in the second quarter could translate into renewed inventory pressure.

The authors of this article are Gan Jie, professor of finance and director of the Research Department on Finance and Economic Growth at CKGSB, Li Xuenan, professor of finance and director of the Research Department on Industrial Policy at CKGSB, and Wang Xiaolong, senior researcher at CKGSB.

Editor: Kim Taylor