China's factory activity shrank for the first time in seven months in May as new orders fell, a preliminary manufacturing survey showed, entrenching fears that its economic recovery has stalled and that a sharper cooldown may be imminent.

The flash HSBC Purchasing Managers' Index (PMI) for May fell to 49.6, slipping under the 50-point level demarcating expansion from contraction for the first since October and sending Asian financial markets sharply lower.

The final HSBC PMI stood at 50.4 in April.

The lack of vigor in the world's second-biggest economy implies its ability to meet the government's 7.5 percent growth target this year is increasingly difficult, analysts said, albeit it is still possible.

The soft data also sharpens Beijing's policy dilemma over whether to act to stabilize activity, or tolerate an orderly slowdown while focusing on reducing the country's dependence on exports and investment for growth, changes that would bring longer-term benefits.

Yao Wei, an economist at Societe Generale in Hong Kong, said the debate favors policy inaction from Beijing for now, as long as economic growth remains above 7 percent.

"We don't think it will trigger any cyclical policy move as long as the job market is fine," she said.

"China is really on a path of structural (growth) deceleration. It's possible (to meet the growth target) but it's becoming increasingly difficult."

The PMI survey suggested China is up against weakness both at home and abroad. A sub-index measuring overall new orders dropped to 49.5, the lowest reading since September, suggesting domestic consumption is not strong enough to offset soft global demand.

Asian stock markets extended early losses after the report, with Japan's Nikkei tumbling more than 7 percent. Oil, copper and rubber prices also retreated on concerns about softer Chinese demand, while the Australian dollar and riskier assets such as emerging Asian currencies skidded.

Thursday's PMI revived investor worries about whether China can sustain an economic revival this year, after annual growth slumped to a 13-year trough in 2012. China's factory output and investment performance for April released earlier this month had already underwhelmed markets.

The run of dismal data reports have prompted economists to slash their growth forecasts for China.

UBS this week downgraded its 2013 growth target for China to 7.7 percent, from 8 percent, and Societe Generale is in the midst of lowering its estimates. Bank of America-Merrill Lynch cut its China 2013 growth forecast earlier this month to 7.6 percent from 8 percent.

If the economy meets the government's growth target and expands 7.5 percent this year, it would still be its worst performance in 23 years.

JOBS ARE KEY

The HSBC flash PMI comes about a week before the final reading and is the earliest indicator of how the Chinese economy is faring each month.

The PMI survey showed new export orders hovered below the 50-point level in May, though the rate of decline slowed from April.

Still, the weak showing implied foreign demand remained lethargic due to a patchy U.S. recovery and Europe's nagging debt crisis, and echoes weak export momentum seen in Taiwan and South Korea in May.

In a reflection of the cooldown in the vast factory sector, both indices for input and output prices stayed muted in May to be near troughs seen in the third quarter last year.

"A sequential slowdown is likely in the middle of the second quarter, casting downside risks to China's fragile growth recovery," said Qu Hongbin, an economist at HSBC.

Yet, barring a slump in the labor market, most analysts believe Beijing will opt to stay on the policy sidelines. Measures such as reducing corporate taxes may be enacted, but only as part of broader tax reforms, not to pump-prime growth.

A stable employment market ranks high among China's policy priorities as the Communist Party justifies its one-party rule with tacit promises of economic prosperity.

Although Chinese media has reported that a record 7 million graduates will join the labor force this year, there are few reports of widespread discontent among job hunters. Thursday's PMI also pointed to a stable employment market.

"We believe the government will not loosen monetary policy to stimulate the economy in the second quarter because the labor market is still tight and although headline activity indicators are weaker, they are not collapsing," Zhiwei Zhang, chief China economist at Nomura, said in a note.

Chinese leaders for their part appear to be comfortable for now with moderating economic growth.

Chinese Premier Li Keqiang said last week the country has limited room to rely on government spending or policy stimulus to spur its growth, dispelling market speculation that Beijing may act to pump-prime its economy.

At the depth of the global financial crisis in 2008/09, an estimated 20 million rural migrant workers lost their jobs, prompting Beijing to unveil a 4 trillion yuan stimulus package to shore up the economy and guarantee employment.

The latest sputter in China's growth engine is clearly taking a toll on its corporate sector, but there are no signs of major defaults on loans.

Among China-listed companies which have posted their first-quarter earnings, 67 percent missed market expectations, ThomsonReuters data showed.

Zoomlion Heavy Industry Science and Technology Co Ltd (1157.HK)(000157.SZ), China's second largest construction equipment maker, reported a 72 percent plunge in its first-quarter earnings from a year earlier.

Government data this week also showed that profit growth in China's giant state firms cooled in the first four months of the year.