The purchasing managers' index, an indicator of the state of activity in the manufacturing sector, painted a gloomy picture as an increasing number of overseas customers terminated contracts with UK businesses.

Pessimists continued to outnumber optimists among those questioned after the headline index fell below 50 in April to 49.5 and dropped further to 49.3 in May despite City expectations of an improvement.

Manufacturing troubled

According to the index's scale, a figure below 50 indicates a decline in manufacturing, while a number above 50 represents expansion in the sector.

More than a quarter of those questioned said their export order books had weakened in May, compared with the previous month.

Export demand has fallen steadily since the start of the year as a larger number of domestic orders are also being lost to cheaper imports.

Manufacturers, however, continued to benefit from lower prices of imported raw materials and components on the back of the strong pound.

But prices fell sharply again in May following weakening global demand in the wake of the Asian crisis.

One in four firms chose to reduce their volume of raw material purchases in an effort to run down stocks as part of cutting costs.

Job losses

The downturn in exports is starting to hit jobs

But moves to keep costs down hit employment levels which fell modestly for the third month in succession from 49.3 in April to 49.1 in May.

Audrey Childe-Freeman, economist at CIBC Global Markets, said job losses should eventually affect domestic demand.

"This reinforces our view that a steady hand monetary policy is the most appropriate at this stage of the cycle," she said.

The real question is the extent to which the weakness in manufacturing - which accounts for just under a quarter of the economy - feeds through to the larger and more robust service sector.

Philip Shaw, chief economist at Investec said: "For the time being it looks like robust consumer demand has kept the service sector reasonably buoyant over the last few quarters despite the slackening off in the manufacturing sector."

"But with signs that retail sales activity is slowing down, services may be more vulnerable to a downturn in manufacturing."