Activity in China's manufacturing sector unexpectedly expanded at its fastest pace in nearly two years in August as construction boomed, suggesting the economy is steadying in response to stronger government spending.

The best factory reading since late 2014 may reinforce growing views that China's central bank will be in no hurry to cut interest rates or banks' reserve requirements, for fear of adding to high debt levels or fuelling asset bubbles.

But the official factory survey also highlighted growing lop sidedness in the world's second-largest economy, with larger firms expanding, likely thanks to Beijing's largesse, while smaller manufacturers continued to struggle.

"Our view is that the People's Bank of China doesn't really have any reason to ease until we start to see clear signs of another downturn," Julian Evans-Pritchard, China Economist at Capital Economics said, saying it is concerned such action could aggravate economic imbalances and credit risks.

"I think eventually they'll come under pressure to ease further, but given the economy is still stable, I don't think it'll happen this year," he said, predicting the factory strength could last through the end of the year.

The official Purchasing Managers' Index (PMI) rose to 50.4 in August from 49.9 in July, and above the 50-point mark that separates growth from contraction on a monthly basis.

Analysts had expected a reading of 49.9 for the second month in a row, and some thought there would be added weakness after Beijing ordered many plants around Hangzhou to close to clear the air ahead of China's first summit of G20 leaders September 4 to 5.

Yet factory output growth accelerated, with the index rising to 52.6, the highest this year, from 52.1 in July. Total new orders expanded sharply, though export orders continued to shrink, albeit at a more modest pace.

"While many factories have been shut down before the G20 summit, overall manufacturing activities are still elevated, reflecting improving growth momentum," said Zhou Hao, senior economist at Commerzbank AG in Singapore.

Buoyed by a government infrastructure building spree and a housing boom, Shanghai futures prices for steel bars used in construction have surged about 43 percent so far this year, coaxing steel mills to keep output at high levels even as Beijing tries to cut overcapacity in the sector.

But analysts are divided over how much domestic demand is actually improving, with China's steel exports on track for record highs, and prolonged weakness in imports.

In another sign that business conditions remain tough, factories continued to cut staff, though at a slightly slower pace than in July.

China has vowed to quicken the pace of cutting excess steel and coal capacity after falling behind this year, raising the risk of more layoffs and debt defaults in coming months, which could further strain the banking system.

SMALLER FIRMS STRUGGLE

The divergence of performance between smaller and larger enterprises is also a concern if struggling smaller firms have more trouble servicing their debt burdens, some analysts said, noting recently introduced debt-for-equity swaps are likely to help bloated state companies more than private ones.

Smaller firms showed a sharp contraction in activity in August, while one for larger companies showed a solid expansion, suggesting state-owned enterprises, though often inefficient, remain the backbone sustaining China's economic growth.

"Fiscal expansion will likely need to continue at a strong pace, to ensure stable growth in the coming months," HSBC economists said in a note.

"We still see challenges in the second half, from further moderation in the housing sector to uncertainties about private investment. Therefore despite some upside surprise, withdrawal of policy stimulus at this stage would be highly premature."

A private PMI survey focusing more on small and mid-sized firms reinforced the picture of a two-track economy. The survey suggested that activity at smaller manufacturers stagnated in August as output and new orders both grew at a softer pace.

The Caixin/Markit Manufacturing Purchasing Managers' index (PMI) slipped to 50.0, the no-change mark which separates expansion of activity from contraction on a monthly basis.

An official survey on the services sector showed the sector continued to expand at a rapid pace, though slightly more modestly than in July.

China is counting on growth in services to offset persistent weakness in manufacturing and exports that dragged economic growth to a 25-year low. – Reuters