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BEIJING (Reuters) - China's manufacturing sector unexpectedly picked up some momentum in September even as factory employment slumped to a 5-1/2-year low, a potential source of worry for Communist leaders who prize social stability above all else.
Signs of a weakening labor market reinforced expectations that China would further relax financing conditions in coming weeks, but stop short of cutting interest rates or loosening the reserve requirement for all banks to support the economy.
The HSBC/Markit Flash China Purchasing Managers' Index (PMI) rose to 50.5 in September from August's final reading of 50.2.
Economists polled by Reuters had expected factory growth to stall at 50.0, the mark which separates expansion from contraction, citing deteriorating business confidence and the growing drag from the cooling property market.
"We believe liquidity conditions will be easy," said Ting Lu, an economist at Bank of America-Merrill Lynch. "But we don't expect a universal cut in interest rates or the reserve requirement ratio."
Instead, policymakers are likely to lower select lending rates such as mortgage rates, and the central bank may extend more loans to big banks with the cash being re-lent to businesses under a "re-lending" exercise, Lu said.
Economists' bets that there would be no overt policy easing are in line with remarks by senior leaders such as Finance Minister Lou Jiwei, who said over the weekend that China would not dramatically alter its policy based on any one indicator.
But the government's promises to desist from ramping up credit supply are increasingly being tested by a run of data showing that the world's second-biggest economy is sliding into a deeper slowdown.
Tuesday's PMI showed a measure of employment shed more than a point to drop to 46.9, its lowest since February 2009 during the global financial crisis, when a collapse in exports threw tens of millions of Chinese out of work.
A hefty drop in employment could raise alarm bells for the government, which has indicated it will tolerate slower economic growth below 7.5 percent for the year as long as employment is not affected.
"The real estate risk is already materializing," said Dariusz Kowalczyk, an economist at Credit Agricole Corporate and Investment Bank in Hong Kong.
"This will keep gross domestic product growth at a depressed level of around 7 percent year-on-year this quarter."
Still, Asian markets found consolation in the PMI poll that China's economy was not faring as badly as some feared. Stock markets and the Australian dollar AUD=D4 clawed back some of their early losses, while Shanghai stocks .CSI300 rose.
China's urban unemployment rate was nearly 4.1 percent at the end of June, though many economists believe the real number may be much higher given its army of migrant workers.
The employment index aside, other measures in the PMI poll fared better, which could temper Beijing's policy response for now.
Total new orders rose, and new export orders also climbed to their highest level since March 2010.
The overall output level remained flat on the month, while output prices fell to a six-month low.
The final HSBC/Markit manufacturing PMI for the month is due on Sept. 30, with the official reading on Oct. 1.
The HSBC survey largely covers small- to medium-sized companies, which are facing tighter credit conditions and greater stresses than the larger, state-owned firms which the official report tends to focus on. Smaller firms account for about 60 percent of gross domestic product and 75 percent of the new jobs created in the country.
A dramatic increase in reliance on state support starkly illustrates the industrial weakness that is weighing on the economy. Subsidies accounted for four-fifths of the profits reported by Chinese steel companies in the first half of this year, according to a Reuters analysis of corporate financial statements.
"We still expect some more measures to support growth, such as stimulating infrastructure investment, relaxing property market policies and some more monetary easing steps," said Louis Kuijs, an economist at RBS in Hong Kong.
"However, the recent signs of policymakers suggest to us that they will not resort to more significant and higher profile measures unless growth takes another turn for the worse."
Export growth has been unsteady, and the cooling housing market is undermining already softening domestic demand. Recent data showed factory output grew at the weakest pace in nearly six years in August.
Prices for Chinese steel and iron ore futures have slumped to record lows, while oil, copper, rubber and other raw materials have also skidded on fears of slowing China demand, which is rapidly leaving the United States as the only major driver of world economic growth.
Chinese leaders have publicly ruled out another massive stimulus program this year like the one launched during the global financial crisis, but are prepared to take targeted measures supporting the most vulnerable sectors.
Further measures are already being rolled out even as leaders publicly advise caution.
The central bank last week injected money into the country's top banks in a bid to help support the economy by keeping borrowing costs down, and media have reported this week that the "Big Four" banks plan to ease rules on mortgage lending in a move orchestrated by regulators.
"The economy still faces significant headwinds, particularly from the property sector, and our base scenario remains a gradual slowdown in the coming months," Capital Economics said in a note to clients.
Editing by Kim Coghill and Jacqueline Wong