China's factory sector shrank for the first time in a year in July, a survey showed on Thursday, feeding worries among the country's main trading partners that its growth is unsustainable and could lead to a slump.

The HSBC flash purchasing managers' index (PMI) fell to 48.9 in July, suggesting the manufacturing sector contracted at its fastest pace since March 2009, as monetary policy tightening and slack global demand weighed on the sector.

The PMI is the earliest available indicator of industrial activity in the world's second-biggest economy.

It also showed that factory prices rebounded quite sharply in July, accentuating the tough battle China's authorities have on their hands as they try to keep inflation in check with minimal fallout on demand and growth.

Chinese authorities have made clear that fighting inflation is their priority and that stance won backing from the International Monetary Fund, which said on Thursday Beijing should persist with tightening policy, including allowing the yuan to rise in value.

In its annual report on China, the IMF emphasized the economy was doing well.

Yet, in a separate IMF report on spillovers from Chinese policy, China's trading partners said their biggest concern is that China's economic growth, which has average more than 10 percent in the last decade, was unsustainable and could lead to a hard landing.

We are slowing, clearly, said Stephen Green, China economist at Standard Chartered Bank in Hong Kong, who felt monetary policy would be less stringent by the fourth quarter.

The HSBC flash PMI of 48.9 for July was the lowest reading in 28 months and fell from the final reading in June of 50.1. The index was last below 50, which demarcates expansion from contraction, in July 2010.

The vast manufacturing sector, accounting for about 40 percent of GDP, has led the slowdown in China's economic growth this year. The flash PMI showed a new-orders sub-index fell below 50 to its lowest level in 12 months, reflecting the weaker global demand.

The slowdown has weighed on global investors, already worried by the risk of Europe's sovereign debt crisis and weakening growth in the United States.

The Australian dollar and crude oil prices, both leveraged to China's growth and appetite for resources, dipped after the PMI was released.

With the central bank flagging no sign of an end to policy tightening, economic growth will continue to lose steam in the second half, said Wang Jin, an analyst at Guotai Junan Securities in Shanghai. But we don't see any risks of a hard landing and the slowdown is in the comfort zone.

IMF REPORT AND BEIJING'S RESPONSE

The IMF's annual report was reasonably sanguine, citing as risks the possibility of a property bubble and unpredictable upside shocks to inflation and calling for more monetary tightening, including allowing the yuan to rise.

We definitely support the idea of reducing some of the fiscal stimulus that was put in place over the past couple of years, Nigel Chalk, IMF mission chief to China, told reporters.

The IMF said a higher yuan -- a demand of many Western governments -- would have limited impact on rebalancing the global economy.

But it was vital to financial reforms and rebalancing demand within China. It said the yuan was somewhere between 3 percent and 23 percent undervalued.

Private economists expect the central bank to be less aggressive in tightening monetary policy after ramping up bank reserve ratios nine times and interest rates five times since October. But they see no risk of the economy crash landing.

The slowdown at the moment is policy induced. There is an awful lot of easy growth to come, said Standard Chartered's Green.

The property market looks a little bit under the weather but it doesn't look like it's tipping over. The local government debt problem is manageable, urbanization is low, per capita income is low, so as long as policy makers don't over-tighten, you shouldn't see any hard landing in the economy.

Indeed, while the flash PMI points to a monthly fall in Chinese industrial output, government data shows that the annual pace of industrial output is healthy at around 15 percent.

The economy grew 9.5 percent in the second quarter, just a shade slower than 9.7 percent in the first quarter. A Reuters poll on July 18 showed the economy is expected to grow 9.3 percent this year.

Still, the IMF survey showed the first issue of concern among China's trading partners about its domestic policies was that they could lead to unsustainable growth and a hard landing.

They worried continued high investment in China could create excess capacity. Given uncertain demand prospects in advanced economies, that could risk a hard landing that reverberates beyond China, the IMF said.

PRICE PRESSURES

China's authorities are trying to balance the need for healthy growth with attempts to control inflation, which they fear could spark social unrest if left unchecked.

Most analysts believe China's inflation peaked in June at 6.4 percent, a three-year high, or is close to peaking.

A sub-index of factory input prices in the flash survey rebounded to 54.5 in July from a final reading of 51.9 in June.

While food costs, a key driver of inflation so far this year, could lose steam in the second half, non-food inflation is picking up due to rising wages and utility costs.

That said, food prices remain elevated. Price pressures on pork, a popular meat in Chinese meals, should make the People's Bank of China extremely wary of even hinting it is done with tightening policy, lest that feeds into wider inflationary pressures.

Pork prices surged 57.1 percent in June from a year ago, contributing 1.4 percentage points to June's inflation and prompting authorities to release frozen pork stocks to alleviate price pressures.

Even if inflation is peaking, economists reckon the easing of price pressures in the second half of the year will be gradual, keeping consumer inflation near 5 percent and above the government's target of 4 percent.

Inflation is likely to have peaked. Provided there are no big surprises in food prices, it should peter out from here until year end, economists at HSBC said in a note. But the subsequent slowdown is likely to be very gradual through the third quarter. In other words, price stability will continue to top Beijing's agenda.

The People's Bank of China, keen to put a lid on price rises, has lifted the reserve requirement ratio for big banks to a record high of 21.5 percent. The benchmark one-year lending rate stands at 6.56 percent and the deposit rate at 3.5 percent.

Many analysts expect the central bank to lean more on interest rates to fight inflation in coming months, partly because they see limited room for higher bank reserve ratios.

A Reuters poll published on July 7 showed a small majority of analysts expected at least one more rate rise this year.

(Additional reporting Aileen Wang and Gui Qing Koh in Beijing and Lesley Wroughton in Washington; writing by Vidya Ranganathan; Editing by)

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