The world’s second-largest economy has suffered a serious and surprising setback. China’s manufacturing PMI has dropped to the lowest point in three months as gains in output weakened, and the employment market weakened. The Purchasing Manager’s Index has now dropped to 50.5, which suggests weak growth, and well below expectations of 50.9.

ETF China

The Purchasing Manger’s Index measures new orders, inventory levels, production, supplier deliveries, and the employment environment. As such, it is one of most vital measures for examining any economy. A reading below 50 suggests contraction, so China’s economy is still growing, but the reading has dropped from 50.8 in November, suggesting a slowdown.

Also see: What Ever Happened To China’s Ghost Towns?

The PMI report was released by HSBC and took many analysts by surprise. The report released today is only a flash report, which includes responses from 85 to 90 percent of China’s companies. A final PMI will be released on January 2nd, so numbers will likely have to be revised.

China’s PMI report hits Asian stock markets

The negative report caused a strong sell-off in China’s stock markets, sending them to their lowest point in a month. Unsurprisingly, most other major Asian Indices across the region also recorded red ink, with Japans Nikkei 225 (INDEXNIKKEI:NI225) dropping by over 1.5 percent and the Taiwan weighted index dropping by .75 percent. European stock indices, however, have been shrugging the news off and trending upwards. U.S. stocks have also been trending upwards.

Also see: China And The Next Phase of Reform: Stratfor Analysis

Central bank Governor Zhou Xiaochuan said that a tight liquidity market might be to blame, and warned that as the country liberalizes its financial markets, interest rates could rise. Further, it remains difficult for non-state owned companies to secure funding as banks prefer to lend to companies backed by the government itself. Already, strong demand for credit has raised borrowing costs, while a potentially building property bubble continues to threaten markets across the country. These setbacks come at a time when the Chinese government is pushing hard for reform and liberalization.

Concerns about exports rises

The poor PMI report suggests that November’s exports reports may have been inflated. Official reports suggested that outbound shipments rose by 12.7% last month from a year earlier. While this number brought hopes that the world economy was recovering and global demand rising, now experts are wondering if the reading needs to be adjusted.

Also see: China Punishes 20,000 Officials For Waste, Mediocrity, Indolence

As demand remains weak in the West, while wages and costs of doing business continue to rise in China, some fear that the country could be losing its main source of economic growth. While China is now considered the world’s “factory”, this position is not guaranteed, especially as competition for investments continues to heat up. China may be entering its prime, but the country still faces many challenges.