By Fergal Smith

TORONTO Contraction in Canada's manufacturing sector gathered pace in August as production and new orders declined, data showed on Friday, in a potential sign that higher borrowing costs are working to slow the domestic economy.

The S&P Global Canada Manufacturing Purchasing Managers' Index (PMI) fell to a seasonally adjusted 48.0 in August, its lowest level since June 2020, from 49.6 in July.

A reading below 50 indicates contraction in the sector. The PMI has been below that level since May.

"Canada's manufacturing sector continued to struggle during August, with output and new orders falling at solid rates," Paul Smith, economics director at S&P Global Market Intelligence, said in a statement.

"Firms responded by cutting purchasing and utilising existing inventories, and signalled some worries over the potential for demand weakness to linger in the months ahead."

The output index fell to its lowest level since December at 47.7, down from 51.1 in July, while the new orders index also posted a reading of 47.7, falling from 49.2.

Weakness in demand was concentrated in the domestic market, with the measure of new export orders showing expansion for a second straight month.

The Bank of Canada raised its policy rate in July to a 22-year high of 5%. The Canadian economy has also contended in recent months with wildfires and a dock workers strike at the country's busiest ports.

Staffing levels were cut for a fourth straight month and inflation pressures persisted - the input and output price indexes both climbed to 53.9.

"Despite further signs of product supply stability and a further drop in demand for inputs, inflationary pressures picked up as firms throughout the supply chain continued to push higher operating expenses onto their clients," Smith said.

(Reporting by Fergal Smith; Editing by Chizu Nomiyama)