BENGALURU - Activity in India's dominant services industry shrank for a third consecutive month in July as restrictions to control the coronavirus pandemic hit demand, with companies turning the most pessimistic in a year, a private survey showed on Wednesday.

Restrictions imposed by local governments to curb the devastating second wave of COVID-19 were relaxed over the past few months following a drop in infection rates, but the threat of a third wave has cast a shadow over the already weak economic outlook.

Although the Services Purchasing Managers' Index, compiled by IHS Markit, rose to 45.4 in July from 41.2 in June it stayed firmly below the 50-level separating growth from contraction for a third month.

Overall demand in the sector shrank again last month, albeit at a slower pace, and overseas demand declined for a 17th month - the longest streak since the sub-index started in September 2014.

"The current COVID-19 environment continued to weigh on the performance of the service sector that is so crucial to the Indian economy," noted Pollyanna De Lima, economics associate director at IHS Markit.

"July data was somewhat disappointing, with incoming new business and output falling solidly over the month, but there was at least a slowdown in rates of contraction."

That weak demand and a dour outlook pushed services firms to cut headcounts for an eighth month, indicating it may take a long time for the labour market to reach pre-pandemic levels.

Meanwhile, business expectations turned negative for the first time since July last year.

"Uncertainty over when the pandemic will end, as well as concerns about inflationary pressures and financial troubles, dampened business confidence in July," added De Lima.

Both input costs and prices charged increased at a faster pace last month, with the latter surging at the quickest rate in eight months.

Still, the Reserve Bank of India is expected to keep key interest rates untouched until the next fiscal year to help the economy through the pandemic. 

An overall composite index rose to 49.2 last month from June's 43.1, staying below the 50-mark for a third month as the contraction in services offset a rebound in manufacturing.

(Reporting by Indradip Ghosh; Editing by Kim Coghill) ((Indradip.Ghosh@thomsonreuters.com; +91 98742 85145))