China’s Factory Activity Slides Back Into Contraction, Exposing Fragile Recovery and Mounting Policy Dilemmas

China’s manufacturing sector stumbled at the start of the year, reinforcing concerns that the economy is entering 2026 with weakening momentum and unresolved structural strains, even as policymakers intensify efforts to pivot growth toward domestic demand.

Official data released on Saturday showed the manufacturing purchasing managers’ index (PMI) fell to 49.3 in January from 50.1 in December, slipping back below the 50 mark that separates expansion from contraction, according to Reuters. The reading undershot market expectations of 50.0 and marked a clear reversal from the modest improvement seen at the end of last year, suggesting that factories are once again struggling to secure sufficient demand to sustain output.

The deterioration was evident across key sub-components. New orders dropped to 49.2 from 50.8 in December, pointing to a slowdown in domestic demand at the very start of the year. New export orders declined further to 47.8 from 49.0, highlighting renewed pressure on external demand despite exports having played a crucial role in propping up growth through much of 2025. Together, the data signal that both domestic and overseas demand are faltering simultaneously, a combination that leaves manufacturers with few buffers.

Weaknesses extended beyond factories. The non-manufacturing PMI, which captures services and construction activity, slid to 49.4 from 50.2 in December, its lowest level since December 2022. That decline underscores that services consumption, which authorities increasingly view as the next engine of growth, is also losing momentum. Construction activity remains constrained by the prolonged property downturn, while consumer-facing services continue to suffer from cautious household spending.

Huo Lihui, a statistician at the National Bureau of Statistics, noted that some manufacturers typically enter a seasonal lull in January and said market demand remains weak. While seasonality may partly explain the slowdown, economists say the scale and breadth of the contraction point to more persistent issues, particularly the lack of confidence among households and private firms.

China met its official growth target of about 5% last year, an outcome that offered political reassurance but masked growing imbalances. Export strength, helped by competitive pricing and firms rushing shipments ahead of anticipated trade restrictions, offset domestic softness. That strategy now looks increasingly fragile as trade tensions with the United States intensify under President Donald Trump’s renewed tariff push, and as global demand shows signs of cooling.

At home, consumption remains the weakest link. Retail sales growth softened further toward the end of last year, contributing to fourth-quarter GDP growth slowing to its weakest pace in three years. Job insecurity, subdued wage growth, and lingering stress in the property sector have continued to weigh on household confidence. For many consumers, precautionary saving remains a rational response to uncertainty, blunting the impact of policy support.

Beijing has begun deploying targeted fiscal measures in response. Authorities recently front-loaded 62.5 billion yuan ($8.99 billion) from ultra-long special treasury bonds to fund subsidies encouraging consumers to replace goods such as home appliances, vehicles, and smartphones. The programme is designed to stimulate spending without resorting to broad cash transfers, which policymakers remain reluctant to adopt.

Monetary policy has also been nudged toward accommodation. Earlier this month, the central bank cut several sector-specific interest rates and signaled it has scope this year to reduce banks’ reserve requirement ratios and implement broader rate cuts if conditions warrant. These steps are aimed at lowering financing costs, supporting credit growth, and easing pressure on indebted firms, though officials remain wary of reigniting financial risks.

As authorities struggle to lift spending on manufactured goods, attention is increasingly shifting toward service consumption. Policymakers hope sectors such as tourism, healthcare, education, culture, and elderly care can absorb excess industrial capacity and provide new sources of employment. The January PMI data, however, suggest that this transition is proving difficult, with services activity also slipping into contraction territory.

Analysts remain cautious about the outlook. Ting Lu, chief China economist at Nomura, said Beijing will need to do significantly more in the coming months to secure growth above 4.5% in 2026. He warned that as policymakers exhaust easily implemented tools, more comprehensive measures will take time to prepare, raising the risk of a prolonged period of subpar growth.

Strategically, Beijing has made boosting domestic demand its top economic priority this year, alongside accelerating efforts to achieve technological self-reliance. President Xi Jinping has urged officials to push ahead with advanced manufacturing while also making domestic demand the main driver of growth, a balancing act aimed at reducing exposure to external trade pressures and supply-chain disruptions.

Even so, stimulus is likely to remain measured. According to the South China Morning Post, China is expected to set its 2026 growth target between 4.5% and 5%, signaling a cautious approach as policymakers weigh growth support against concerns over asset bubbles and financial stability.

Looking ahead, investors will closely monitor private-sector indicators for confirmation or contrast. Analysts surveyed by Reuters expect the Caixin/RatingDog manufacturing PMI to edge up to 50.3 in January from 50.1 previously, when it is released on February 2. A divergence between official and private surveys could again highlight uneven conditions, with smaller, export-oriented firms potentially faring better than state-linked manufacturers tied more closely to domestic demand.