India's economy showed further signs of slowdown on Monday, with July factory expansion the weakest in 20 months, a government panel cutting its growth forecasts and its top car maker posting a steep drop in sales.

Morgan Stanley also became the latest bank to cut its outlook for Asia's third-largest economy, predicting economic growth in the fiscal year that ends in March of 7.2 percent, from 7.7 percent earlier.

"A combination of factors - including persistently high inflation, higher cost of capital, cut in the ratio of fiscal spending to GDP, a weak global capital markets environment, and slow pace of investment - will cause a further slowdown in growth," Morgan Stanley economist Chetan Ahya wrote on Monday.

The HSBC Markit Business Activity Index , based on a survey of around 500 companies, fell to 53.6 in July from 55.3 in June, its third straight decline, although it remained above the 50 mark that separates growth from contraction for the 28th consecutive month.

Monday's July PMI reading reflected the impact of a steady rise in domestic interest rates as well as the dampening of demand from key markets such as the United States and the euro zone, which are reeling from their own respective debt crises.

A top Indian government economic advisory panel on Monday cut its growth forecast for the current fiscal year to 8.2 percent, from a 9 percent target in February. The Reserve Bank expects growth of roughly 8 percent this fiscal year.

The prime minister's Economic Advisory Council also said that meeting fiscal targets set in the government's annual budget "present a significant challenge."

It said India's fiscal deficit could touch 4.7 percent in the year to March 2012, slightly above New Delhi's target of 4.6 percent, and advised stronger measures to increase revenue intake and cut spending.

Private economists have long been skeptical of the deficit goal, and investors expect the government to increase borrowing this year.

"We see challenges not just from expenditure but also in terms of revenue," said Shubhada Rao, chief economist at Yes Bank in Mumbai.

The Indian economy grew at 8.5 percent in the fiscal year that ended in March.

Economists have trimmed their growth forecasts for major Asian economies, including China, for this year and next.

Costs, Rates Weigh

The Reserve Bank of India (RBI) last week raised interest rates by a higher than expected 50 basis points, its 11th increase since March 2010, and stuck to its anti-inflationary stance, rattling markets and prompting economists to increase their expectations for further rate increases this year.

Despite the steady rise in rates, headline wholesale price index inflation was 9.44 percent in June, more than twice the central bank's comfort level.

Inflation will remain around 9 percent until October, and ease to 6.5 percent by March, the advisory panel said, adding that the RBI "will have to continue a tight monetary policy till inflation shows definite signs of decline."

Rising costs, interest rates and fuel prices are putting a dent in Indian car sales, which had jumped 30 percent in the fiscal year that ended in March.

Maruti Suzuki, which sells nearly half of the passenger cars in India, posted a record 25 percent drop in July sales as production of a popular sedan was crimped by a shift in its manufacturing facility.

India has seen a marked slowdown recently with industrial output growing at a feeble 5.6 percent in May, its slowest in nine months.

The steepest fall in Monday's PMI report was in new orders, which dropped to 54.5 in July from of 60.1 previously.

Input prices rose sharply in July, driven by higher raw material costs, causing manufacturers to charge more for their products, the PMI survey showed. Sub-indexes for both input and output prices remained at elevated levels.

"These numbers confirm that inflation pressures remain firmly in place despite the ongoing moderation in growth. The RBI will, therefore, have to maintain its tightening bias for a while still to anchor inflation expectations," said Leif Eskesen, chief economist for India and ASEAN at HSBC.

India's parliament is set to tackle economic reforms in a legislative session that starts this week, but political wrangling and the fallout of ongoing corruption scandals could strangle hopes for swift progress.

The worsening economic outlook adds pressure on the government of Prime Minister Manmohan to push through reforms that would bolster investment to add capacity and clear supply bottlenecks in sectors such as infrastructure and agriculture.


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