By Andy Bruce and Douglas Busvine
LONDON (Reuters) - Britain's economy is shrinking, the broadest survey of business confidence since last month's historic vote to quit the European Union showed on Friday, leading finance minister Philip Hammond to pledge a loosening of purse strings if the weakness endures.
The Bank of England has also been clear that easing monetary policy may be necessary.
The flash, or preliminary, Markit survey of purchasing managers - executives who make spending decisions at 1,250 big firms - fell by the most in its 20-year history.
It was consistent with an economy contracting 0.4 percent in the third quarter, contrasting with an actual reading of plus 0.4 percent in the first quarter.
"July saw a dramatic deterioration in the economy," said Chris Williamson, Markit's chief economist. "The downturn, whether manifesting itself in order book cancellations, a lack of new orders or the postponement or halting of projects, was most commonly attributed in one way or another to Brexit."
The readout, little more than a week after Prime Minister Theresa May formed a new Conservative government, indicates the challenge she faces to maintain market and investor confidence as she embarks on what promise to be long and difficult Brexit talks.
Hammond played down the purchasing manager surveys as a measure of sentiment, not of "hard activity", but also said he would act to support the economy when he announces his budget plans later in the year.
"Exactly what that framework looks like will depend on the state of the economy at the time of the Autumn (budget) statement. The data that we see over the next three months or so will be crucially important in shaping our response," he told Sky News during a visit to China.
Hammond is attending a weekend meeting of finance ministers from the Group of 20 economies at which counterparts will be keen to hear how Britain can pull off a smooth exit from the EU while minimising the damage to the global economy.
The International Monetary Fund has already cut its forecast for global growth after Brexit threw "a spanner in the works". It has slashed its UK growth forecast for 2017 by 0.9 percentage points to 1.3 percent.
The darkening outlook jars with the resolute optimism of newspapers that backed Brexit: "Britain BOOMS after EU vote: Ignore the doom-mongers...it's good news all round," the Daily Express has trumpeted in a raft of bullish headlines this week.
ALARM BELLS
The Markit PMIs, which give an early indication of how gross domestic product is likely to perform, suggest the 1.8 trillion pound ($2.4 trillion) UK economy is shrinking faster than at any time since the aftermath of the global financial crisis.
It showed the services sector - one of the few British growth drivers - has been hit especially hard by Brexit, with orders plunging and confidence crumbling.
A major concern among businesses is the access Britain will have to the EU's single market after leaving. Britain insists it want to limit freedom of movement of workers; the EU says such freedom is a condition of the single market.
The PMI for the services sector fell to 47.4 in July from 52.3 in June, the steepest drop since records began in 1996 and the worst reading since March 2009, around the low point of the global economic recession. Economists polled by Reuters had expected a much smaller fall to 49.2.
The evidence of a sharp drop in business activity across a broad swathe of Britain's economy may alarm the Bank of England, which is trying to decide how aggressively to act at its August policy meeting to cushion the shock of the referendum vote.
Sterling extended earlier losses to trade 1 percent lower to hit fresh lows for the day at $1.3095 to the dollar, while British government bond prices rose.
Sterling's post-referendum plunge to its lowest level against the dollar since the mid-1980s has helped manufacturing exports expand at the fastest pace in almost two years, Markit said. But the pound's fall also pushed up costs for energy and raw material at the fastest pace in five years.
"This is the first major survey showing the pace of activity through the economy and it is soft. Taken literally it would imply a period of contraction in the economy," Investec analyst Philip Shaw said.
Economists said the "reset" Hammond had in mind may resemble the fiscal rule adopted by his Osborne in 2010 when he aimed to balance the public finances within five years, excluding investment spending and taking into account where Britain was within the economic cycle.
"He could both loosen fiscal policy at a time when the economy may well need it but also he could claim that he wasn't completely abandoning the conservative's concern for being responsible with the public finances," said Sam Hill, senior UK economist at RBC Capital Markets.
The manufacturing PMI fell to 49.1 from 52.1 in June, the lowest since February 2013. The composite index, which combines services and manufacturing, slumped to 47.7 from 52.4, the weakest reading since April 2009.
