* Economy expands a paltry 0.2 pct in Q1 from previous quarter
* Quarterly growth at 0.8 pct on a year-on-year basis
* Weak investment data bodes poorly for recovery
* Pressure mounts on Rousseff to take more dramatic steps
By Brian Winter and Silvio Cascione
SAO PAULO, June 1 (Reuters) - Brazil's economy barely expanded i n the first quarter a s frustrated business leaders cut back on investments, se tting the stage for another disappointing year and casting new doubt on the health of emerging markets.
The economy grew just 0.2 percent compared to the final three months of 2011, l ess than half t he pace m arkets expected. The third straight quarter of weakness in the world's sixth-largest economy prompted new calls for President Dilma Rousseff to enact much bolder reforms that could reclaim Brazil's mantle as a favorite of global investors.
That reputation has faded since mid-2011 as Brazil failed to cope adequately with the challenges posed by its boom over the past decade. A combination of a clogged transport system, an overvalued currency and an expensive and underqualified labor force have raised the costs of doing business and have caused companies to delay or cancel expansion plans.
The data released by the government on Friday showed that, despite numerous stimulus packages enacted by Rousseff since late last year, investment shrank in the first quarter. Some business leaders say that much more dramatic steps - such as an across-the-board simplification of Brazil's byzantine tax code - are necessary to unloc k a new era of fast growth.
"Brazil is not going to grow unless we make the necessary reforms," said Sussumu Honda, president of the Brazilian Association of Supermarkets. "The country is not competitive. It's not just a question of this year."
The worst-performing sector in the first quarter was agriculture, which has been damaged by a severe drought in southern Brazil. While industry did better than some expected, separate and more up-to-date data released on Fri day suggested a meaningful recovery in that sector also remains far off.
Taken together, the data seem likely to spark more interest rate cuts by Brazil's central bank and cause another wave of downward revisions to the economic outlook. Economists had already expected growth of just under 3 percent this year - in line with growth of 2.7 percent in 2011, and a far cry from the booming 7.5 percent expansion in 2010.
"These are signs that, really, GDP (this year) may end up below what people are expecting, what the government's expecting," said Rodrigo Melo, chief economist at Maua Sekular, an asset management firm in Sao Paulo.
Several other big emerging markets are also sputtering, threatening to deprive the global economy of one of its only sources of fast growth. India reported its slowest quarterly pace of growth in nine years on Thursday, while South Africa may also struggle to reach 3 percent growth this year.
Payroll data released in the United States on Friday also added to pessimism about the global economy.
The darker economic outlook at home and abroad caused Brazil's real to w eaken almost 1 percent a gainst the dollar by midday. Brazil's stock market fell more than 2.5 percent before recovering to trade down about 1 percent.
Interest rate futures also fell sharply as investors bet the central bank would continue an easing cycle that has already caused the benchmark Selic rate to fall 4 percentage points since last August, including a 50 basis-point cut announced on W edn esday.
BRAZIL'S WOES HOMEGROWN
Brazil's problems are to some extent a reflection of problems abroad, including a slowdown in China, its biggest trading partner, and a loss of confidence in the euro zone. Rousseff has blamed a monetary "tsunami" of cheap money in Europe and the United States for making Brazil's currency over-valued and causing its exports to become less competitive.
Yet other Latin American countries have generally held up better, with the International Monetary Fund forecasting the region as a whole will grow 3.7 percent this year. That suggests that more local factors are playing a big role in Brazil's woes.
Still, Finance Minister Guido Mantega said on Friday that the economy should accelerate in the second half of this year as interest rate cuts and measures to stimulate credit take effect. He indicated that further tax incentives for targeted sectors, similar to those Rousseff has enacted already this year, were likely to come. [ID :nL1E8GS4YF]
"We haven't yet had an increase in credit or a reduction in rates that are sufficient to stimulate the economy, but we're taking the first steps in that direction," Mantega told reporters hours after the data was released.
Central bank chief Alexandre Tombini also issued a statement saying the economy should accelerate throughout the year as domestic demand supports activity.
Private economists also expect some improvement, noting that unemployment remains near all-time lows and retail sales have been robust. Ho usehold consumption expanded 1 percent in the first quarter from the previous quarter.
"Consumption among families is compatible with greater growth than what we're seeing right now," Mantega said.
A 16 percent depreciation of the real since March has also made the currency less overvalued, which could give some relief to struggling industries.
But a deeper look at Friday's data shows several problems, particularly the chill in investment, that could limit Brazil's prospects going forward.
Spending on capital goods declined 1.8 percent compared with the previous quarter, the IBGE statistics agency said. Investment overall fell to 18.7 percent of GDP compared with 19.5 percent in the first quarter in 2011.
"The plunge in investment is the issue that appears of most concern to us, underscoring that, not only the destocking cycle is hurting the economy, but also that confidence is deteriorating," Mauricio Rosal, an analyst for Raymond James, wrote in a research note.
PROBLEMS ON THE FARM
The farm sector contracted 7.3 percent compared with the previous quarter after dry weather over the past season dragged down output from Brazil's two most important crops - soybeans and sugar cane.
Early signs such as fertilizer sales indicate that soy, in particular, should rebound toward the end of the year. For an analysis, click on
Industrial output expanded 1.7 percent from the last quarter of 2011, IBGE said. Yet the HSBC Purchasing Managers' Index for Brazil, a survey released separately on Fr iday, showed that manufacturing activity contracted for a second straight month in May as output and new orders fell.
Gross domestic product had been expected to expand 0.5 percent on a quarter-on-quarter basis, according to the median forecast of 29 analysts polled by Reuters.
To see the complete IBGE report on Brazil's economy, please go to URL: