China's factory activity shrank again December as demand at home and abroad slackened, a purchasing managers' survey showed on Friday, reinforcing the case for pro-growth policies to underpin the world's second-largest economy.

The People's Bank of China is widely expected to lower its requirement for the amount of cash banks must hold as reserves to let lenders inject more credit into the economy to fight headwinds from Europe's debt crisis and sluggish U.S. demand.

The HSBC Purchasing Manager's Index, designed to preview the state of Chinese industry before official output data are published, inched up to 48.7 in December from a 32-month low of 47.7 in November, but fell short of the flash reading of 49.

The HSBC PMI has been mostly under 50, which demarcates expansion from contraction, since July.

While the pace of slowdown is stabilizing somewhat, weakening external demand is starting to bite, said Qu Hongbin, China economist at HSBC.

This, plus ongoing property market corrections, adds to calls for more aggressive action on fiscal and monetary fronts to stabilize growth and jobs, especially with prices easing rapidly.

He said China would avoid a hard economic landing so long as policy easing measures filtered through in coming months.

HSBC believes a PMI reading of as low as 48 in China still points to annual growth of 12-13 percent in industrial output.

China's once turbo-charged economy is on track to slow for a fourth successive quarter, easing further from the first quarter's 9.7 percent annual growth rate with economists expecting the final three months of the year to have slipped below 9 percent.

The official PMI, due to be published on Sunday, is expected to paint a similar picture, suggesting the world's second-largest economy is finishing 2011 on a weak note, in tandem with the global economic outlook.

Both the official and HSBC PMIs are stuck near their weakest levels since early 2009, when China took a blow from the global financial crisis.

Economists polled by Reuters earlier this month forecast the PBOC will deliver 200 bps of required reserve ratio (RRR) cuts by the end of 2012 but refrain from an outright cut in interest rates unless quarterly GDP growth dips below 8 percent.

Economists typically view growth of 7 to 8 percent as the bare minimum needed to generate enough jobs to help China absorb the urban influx of rural migrants and maintain social harmony.

I think the government will ratchet up pro-growth policies if (quarterly) growth falls below 8 percent, otherwise the economy could face big risks, said Guotai Junan Securities economist Wang Hu in Shanghai.

Another RRR cut could happen any time.


China's central bank cut reserve requirements for commercial lenders late in November for the first time in three years.

The RRR remains at 21 percent for big banks, giving the central bank plenty of room to cut and free up funds that could be used for lending.

Persistent capital outflows from China are putting more pressure on the central bank to release cash to keep credit conditions supportive for growth.

Underlying indexes of the HSBC PMI showed softening demand at home and abroad, which helped cool inflation -- a boon for Chinese policymakers, according to the data collated by UK-based information firm, Markit.

The sub-index for overall new orders edged up to 46.9 in December from November's 45, but still signaled falling demand. New export orders shrank in a reflection of listless demand from the United States and Europe -- China's top overseas markets.

Average input costs faced by manufacturers continued to moderate as raw material prices slipped, the HSBC survey showed.

Inflation appears to be cooling, having fallen from a three-year high of 6.5 percent in July to 4.2 percent in November, creating additional room for policy easing to support growth.

HSBC's Qu expects the government to move on the fiscal front to boost job creation, cutting taxes for exporters -- a sector employing more than 30 million workers -- while increasing spending on public housing and other projects.

On top of monetary easing, mainly in the form of further reserve ratio cuts, we have long argued that fiscal policy can and should play a more important role in stabilize growth and jobs, Qu said.

(Editing by Nick Edwards and Chris Lewis)