The Chinese economy will start to stabilize in the fourth quarter after the recent marked slowdown due to government tightening measures, but it might face downside risks next year as external demand weakens, a senior economist with the Royal Bank of Scotland (RBS) said on Wednesday.

"The ratio between new orders and finished goods in China's purchasing managers' index readings has started stabilizing in the past two months, showing the inventor adjustment is taking place," Ben Simpfendorfer, chief China economist at RBS, said.

"The economy will initially stabilize in the fourth quarter as the inventory adjustment ends," he said.

China's purchasing managers' index (PMI), a leading indicator of economic health, has fallen for two consecutive months to 51.2 percent in July, barely above the expansive baseline of 50 percent.

The moderate PMI, together with marked slowdown in China's GDP, which dropped to 10.5 percent in the second quarter from the 11.9 percent three months ago, has caused concern that the economy may head for a deeper slowdown in the coming months.

The country is due to release its August PMI figure next Wednesday.

Simpfendorfer noted there is a risk of the Chinese economy weakening again in the first or the second quarter of next year as exports soften due to weak market demand in Europe and the United States.

"Most European governments have tightened their fiscal policies significantly, while in the US, the problem is primarily there is not enough job growth, and retail sales growth, a figure closely linked to the country's imports, has contracted to 4 percent in July from the peak reading of 12 percent three months ago," he said.

He said there is a risk of a second dip in the US, but not as serious as it was in 2008. "It's much like if you throw a stone across a pond, each dip is a little bit smaller than the last," he added.

Due to the grim global economic outlook, Simpfendorfer does not expect any interest rate hikes in China for the rest of this year.

"In addition, I don't expect China's inflation to rise above 3.5 percent this year due to the low base effect, even though food prices are going to be a major driver of inflation," he said.

Simpfendorfer said it would be very unlikely for the renminbi to appreciate against the US dollar this year.

"If the yuan does appreciate, it would be a very modest amount, no more than a few percent," he said, adding that China's exchange rate policy is unlikely to be a major topic in the US mid-term elections as the focus had shifted to other issues.

China scrapped its 23-month-old peg to the greenback in mid-June and pledged to add more flexibility to its currency exchange rate.