The HSBC Flash Purchasing Managers Index, the earliest indicator of China's industrial sector, retreated to 48.7 in May from a final reading of 49.3 in April. It marked the seventh straight month that the index has been below 50, indicating contracting economic activity.

The figures signal that the sluggish economic conditions of the first quarter are set to continue throughout the first half of the year in China's longest slowdown since the global financial crisis.

"Policymakers have been and will step up easing efforts to stabilize growth," HSBC's chief economist Qu Hongbin, wrote in a statement accompanying the PMI release. "As long as the easing measures filter through, China will secure a soft landing in the coming quarters."

Factory output hit a seven-month high, building on a rebound of new orders in April. But new orders fell back in May's flash survey with a sharp fall in new orders from overseas.

The new export orders sub-index dropped to 47.8 from April's final figure of 50.2 - pushing it back to within a whisker of March's 47.7 - according to data from Markit Economics Research, which publishes the index.

The Chinese data weighed moderately on financial markets, although most focus was on the euro zone's deepening debt crisis and the risk that Greece will leave the bloc.

A euro zone flash PMI fell in May to its lowest level since June 2009. German manufacturing was shrinking in May at its fastest pace in three years, data showed.

Premier Wen Jiabao has called for efforts to support growth, which is set to slowdown in the second quarter of this year for the sixth straight quarter.

Unexpectedly weak economic data for April released earlier this month was followed quickly by the central bank's third cut since November in the amount of cash that banks must keep in reserve, to allow more credit to flow into the economy.

China's key money market rate hit a 13-month low on Thursday, implying there is plenty of liquidity but too little demand for loans.

"The recent required reserve ratio cut will at best make a marginal difference to lending by reducing funding costs for banks, and even then the economic benefits will be felt with a lag," wrote Mark Williams and Qinwei Wang of Capital Economics, in a note published before the data. They argued that any turnaround would not be reflected in May's PMI data.

Comments by Wen that more priority should be given to "maintaining growth" and news that Beijing intends to fast track infrastructure investment "signal stronger stimulus in coming months," they said.

Beijing also plans to boost private investment into areas previously reserved for the state sector, including rail, hospitals and energy transport.

Still, Beijing has not budged on one of the fundamental causes of the slowdown in growth -- stringent curbs on the real estate sector, which have starved private developers of funds and limited would-be buyers' purchases.

The funding crisis for Chinese property developers is intensifying, ratings agencies Standard & Poor's and Moody's said on Thursday, with builders facing spiking borrowing costs and limited ability to raise cash.

Since April's data, economists have pushed back their forecasts for a recovery in China's growth cycle and now expect the bottom to be hit in the second quarter, which would mark the sixth successive quarter of slowing growth.

They forecast China's annual rate of growth would slide to 7.9 percent in the second quarter, down from 8.3 percent before the data, a benchmark Reuters poll showed.

They now expect 2012 growth of 8.2 percent, the weakest since 1999 but still comfortably above the government's 7.5 percent target. They had forecast 8.4 percent before the April data.

STEPPING UP EASING

The poll underscored expectations of more adjustments to monetary and fiscal policies to support growth, while stopping well short of an outright stimulus package.

Fiscal data for the first four months of 2012 shows year on year central government spending growth of 26.2 percent, more than twice the 12.5 percent growth in revenue.

The last time spending outpaced income in the first four months was 2009, during the global financial crisis, when it jumped 31.7 percent on the year and revenue fell 9.9 percent.

The HSBC PMI has provided a contrast to the Chinese government's official PMI. The government PMI hit a 13-month high of 53.3 in April as exports ticked higher although domestic orders showed signs of weakness.

That survey includes more state-owned firms in its results, while the HSBC PMI captures more private firms, which have a more restricted access to credit. The two surveys also have differing methodologies for seasonal adjustment.

The HSBC Manufacturing PMI index has not been consistently above 50 since June 2011, although it is far above readings of the low-40s reached during the depth of the global financial crisis in late 2008 and early 2009.

The flash reading is based on as many as 90 percent of total responses to the monthly survey. A final report will be issued in the first few days of June.

The slowdown in China's economic growth has rattled commodity markets, prompting falls in raw materials prices.

In a sign of renewed caution by Chinese firms, private aluminum smelters in the central province of Henan have idled high-cost production, taking about one-quarter of capacity in China's largest producing province off-line after earlier attempts to ride out the slump.

The cuts come after a number of global metal producers trimmed output at the beginning of the year, on fears of slower growth. Chinese aluminum futures have traded in a flat range in Shanghai this year, as stocks grew to one-year highs.

(Reporting By Lucy Hornby; Editing by Neil Fullick and Nick Edwards)

• A Permanent Economic Emergency