Germany's manufacturing sector unexpectedly shrank at the fastest pace in nearly three years in April, denting hopes it can drive growth in the euro zone and

casting a shadow over upbeat business sentiment surveys.

Markit's manufacturing Purchasing Mangers Index (PMI) fell sharply to 46.3 from March's 48.4, according to a flash estimate released on Monday, well below the 50 mark which would sign al growth in activity.

It marked the fastest rate of contraction since July 2009 in the sector, which has been hit by a decline in some exports as the debt crisis in the euro zone has choked demand from

key trading partners.

?Reports are that sales to southern Europe are particularly weak, so there is some evidence of troubles in the periphery (of the euro zone) spilling over to the core, said

Chris Williamson at Markit, adding that global trade was also sagging.

?Germany produces exports that people want to buy when growth is good but cut back on when there are worrying signs, and that's what we've got at the moment, he said.

Germany's export-driven economy, the largest in Europe, recovered swiftly from the 2008/09 global financial crisis, interrupted only by a 0.2 percent contraction in the final quarter of last year on weak exports and private consumption.

Many economists now believe this to be just a hiccup and that Germany will avoid a recession, generally defined as two consecutive quarters of contraction.

But worries about the finances of big euro zone economies such as Spain and Italy have unsettled markets in recent weeks, despite tentative signs at the beginning of the

year that Europe's more than two-year debt crisis was easing.

The manufacturing reading undershot expectations for an increase to 49.0 in a Reuters poll, with a number of indices within the survey contracting at a faster rate than in the previous month.

The PMI's composite index, a combined measure of services and industry, fell to 50.9 from a final reading of 51.6 in March, hovering just above stagnation. Employment fell

for the first time in more than two years with the employment index dipping to 49.2 from 51.7 in March.

UPBEAT SURVEYS

A companion survey, however, showed the pace of growth in the services sector increased slightly to 52.6 from 52.1 in March.

It beat the consensus forecast of 52.3 in a Reuters poll.

?The German consumer has got some confidence in his spending so that's helping the domestic economy, certainly at the moment, Williamson said, adding further deterioration of the headline PMI figures could dent growth in the services sector.

Confidence in Europe's bulwark economy has so far shown resilience to recent disappointing industry data.

In February, German industrial orders rose less than expected, although strong demand from non-European countries provided some momentum, and industrial output fell more than expected due to cold weather.

Last week the closely-watched ZEW index charting analyst and investor sentiment reached its highest level in nearly two years and the Ifo business climate survey inched to its highest level since July 2011, despite expectations that confidence would wane this month.

?I'm surprised that (the surveys) are staying so buoyant at the moment, Williamson said, adding that the PMI usually turns down before the confidence-based surveys.

?There is an inflection point now where companies have a reasonable amount of business in their pipeline, but they are reducing that. You'll soon see those overall indicators from Ifo start to come down again, I think it will be quite soon.

Composite PMI input prices eased but still grew faster than output prices.

German companies say they expect challenges for the year ahead, with German car maker Volkswagen bracing for a ?very demanding year as the European debt crisis weighs on auto markets and global economic growth slows.

Williamson said he did not see output prices rising for some time until demand picks up.

?They will compensate for that (cutting selling prices) probably through staff cost reductions, which is why we are seeing employment start to fall now, he said.

?They will simply have to fight to stay alive, he said.

(Editing by Gareth Jones and Susan Fenton)

(alice.baghdjian@thomsonreuters.com)

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