By Xiaoyi Shao and Tetsushi Kajimoto
BEIJING/TOKYO (Reuters) - China's manufacturing activity hit a three-month low in August, raising the case for fresh policy steps to keep growth on track, while a Reuters poll showed Japan's economic recovery is likely to be modest despite a small acceleration in the factory sector.
Surveys conducted by HSBC/Markit and Reuters highlighted fragility in recovery of the world's second- and third-largest economies at a time when policymakers try to walk a fine line between supporting growth and pushing structural changes.
The HSBC/Markit Flash China Manufacturing Purchasing Managers' Index (PMI) fell to 50.3 in August from July's 18-month high of 51.7, badly missing a Reuters forecast of 51.5 but still hovering above the 50 threshold that separates expansion from contraction.
"The sharp drop in the PMI is perhaps not surprising given last month's disappointing activity and lending data. That said, we are not expecting a rapid deterioration in economic momentum," Julian Evans-Pritchard, China economist at Capital Economics, wrote in a note.
"Meanwhile, we expect the government to continue to fine tune policy as necessary to prevent growth from slipping too much over the coming quarters."
Most Asian stock markets, including Hong Kong and China, extended early losses after the PMI survey while the Australian dollar (AUD=D4), often used as a liquid proxy for bets on China, fell.
A burst of policy stimulus steps since April lifted China's annual economic growth to 7.5 percent in the second quarter - in line with the full-year official growth target - from 7.4 percent in the first quarter - the weakest pace in 18 months.
But with conditions looking increasingly unsteady into the third quarter as policy support moderated, some analysts say even more stimulus may be needed in coming months to bolster growth and offset the downdraft from the housing market.
A sharp drop in bank lending and fiscal spending in July underscored fear that banks may be increasingly reluctant to extend credit, particularly to private companies, as bad loans continue to rise and asset quality deteriorates.
More policy steps may be needed, but analysts also caution against high expectations given that China's reform-minded leaders have shown greater tolerance for slower growth and ruled out large-scale policy stimulus.
"Definitely there will be more measures to keep growth momentum steady in coming months," said Zhu Qibing, an economist at Minzu Securities in Beijing. "But we don't expect interest rate cuts in the near term as the central bank has reiterated that it would keep its prudent monetary policy unchanged."
An abrupt drop in credit in July has strengthened the case for rate cuts, but policy insiders believe it will be reluctant to take more aggressive steps and for now will stick with more targeted measures.
China has relaxed monetary policy since April by easing controls in the property market, accelerating the construction of some infrastructure works, and relaxing reserve requirements for small banks to boost lending.
MODEST RECOVERY IN JAPAN
A similar survey on Japan showed factory activity accelerated in August as export and domestic demand increased, in another sign the economy is steadying after shrinking in the second quarter due to a sales tax increase. But a Reuters Tankan poll indicated the economic recovery is likely to be modest, which could keep pressure on the central bank to act to sustain growth in the world's third largest economy.
The Markit/JMMA flash Japan PMI jumped to a seasonally adjusted 52.4, up from 50.5 in July and the highest reading since March, just before a hike in taxes throttled demand.
Separately, the Reuters Tantan poll showed confidence at Japanese manufacturers inched up in August to mark the first improvement since April, but the service sector's mood soured for the second straight month, reflecting a tame economic recovery from April's sales tax rise.
Data on Wednesday showed Japan's exports rose in July for the first time in three months in a tentative sign that global demand is starting to recover, raising hopes that exports can offset sluggish consumer spending.
Japan's economy shrank an annualized 6.8 percent in April-June, its biggest slump since the March 2011 earthquake, stoking fears that consumer spending had weakened more than expected due to the April tax hike.
While a bounce was expected in the second half of the year as the impact of the tax increases fades and consumers start buying again, the plunge in GDP and uncertain export outlook have cast doubt on the strength of such a recovery.
Flash PMIs from the eurozone later in the day are expected to show a similar cooling trend, with factory and service sector activity still expanding but at a slower rate. Germany's economy shrank in the second quarter and France again failed to conjure up any growth, snuffing out any signs of a recovery in the euro zone which is now also weighed down by tit-for-tat sanctions with Russia.
A similar survey for U.S. manufacturing is expected to show continued strong expansion, which could add to speculation on when the U.S. central bank will begin raising interest rates. Most economists do not expect that to happen until mid-2015 given still sluggish wage growth and tame inflation.
(The story was refiled to fix a typo and missing word in lead paragraph)
(Writing by Kevin Yao; Editing by Simon Cameron-Moore)