China Remains Entrenched in Producer Price Deflation

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The deflationary spiral in China's producer prices that has plagued factories in the mainland for 16 consecutive months highlights the weakening growth momentum in the world's second largest economy, said economists.

"It is worrying to see the Chinese producer price index remain in deflationary territory - it is the internal weakness in the Chinese economy that has been producing this deflationary pressure on the wholesale price level," Chi Lo, senior strategist, Greater China at BNP Paribas told CNBC on Tuesday.

The producer price index (PPI) dropped 2.7 percent in June from the year ago period, official data showed on Tuesday, compared to a fall of 2.9 percent in May. Producer prices in China have been declining since February 2012, weighed down by falling commodity prices, overcapacity and weakening demand.

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China's consumer inflation, however, accelerated in June, driven by a rise in food prices.

China's consumer price index (CPI) rose 2.7 percent in June from a year earlier, slightly higher than a Reuters forecast of 2.5 percent, and compared to a 2.1 percent tick up in the previous month. However, June's reading is well under the central bank's 3.5 percent target for 2013.

"Food prices are going to be a wild card. The Chinese food supply issues as the middle class grows are critical. [But] it's not a worry yet," said Thomas Murphy, managing partner at Family Office Research & Management.

Despite inflationary pressures remaining contained, China watchers believe the likelihood of government stimulus remains low.

"Credit growth slowed in May, and the recent liquidity crunch in the interbank market suggests monetary and credit conditions would become less accommodative in the second half. In addition, government emphasis on reforms may bring short-term pain before reaping long-term gain," economists at Citi wrote in a note.

China's second quarter gross domestic product (GDP) data, set to be published on July 15, will demonstrate the extent to which tighter liquidity conditions are weighing on economic growth.

Growth is expected to decelerate to 7.5 percent - its slowest pace in over two decades - from 7.7 percent in the previous three months.

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What might trigger the government to provide monetary or fiscal support in the second half, according to Citi, is deterioration in employment conditions.

While there is no reliable unemployment data, the purchasing managers' index's employment sub-index provides an indication of the health of the job market, the bank said.

Both the official and HSBC employment sub-indexes showed that job shedding intensified last month. The pace of job cuts was the fastest since last August, the HSBC sub-index showed.

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"Based on our discussion with government think tanks, quarterly growth of below 7 percent year on year is still not acceptable. A stimulus, if any, may still rely on credit-fueled investment, and the dosage will likely be limited to stabilizing growth at just above 7 percent," said Citi economists.

—By CNBC's Ansuya Harjani