UPDATE 1-China steel selloff fuels iron ore slide, but fundamentals seen intact

* Industry group says steel price rally unsustainable

* Rebar, iron ore futures fall about 4 percent

* Gap between high-grade and low-grade iron ore widest in 5 months (Adds industry group statement, updates prices)

MANILA, Aug 23 (Reuters) - Steel and iron ore futures in China fell about 4 percent on Wednesday as a selloff in steel dragged down prices of the steelmaking raw material, cutting short a rally that lifted iron ore to five-month highs this week.

The slide came after the China Iron and Steel Association said it saw little likelihood of a big shortage in steel supply, despite a crackdown against polluting industries and producers of low-quality steel, limiting the prospect of further price surges.

But traders say the losses in steel prices may be fleeting as underlying demand in China, the world’s top producer, remains strong and supply tight amid Beijing’s reforms to curb overcapacity.

The most-active rebar on the Shanghai Futures Exchange closed down 4 percent at 3,779 yuan ($567) a tonne. The construction steel product, which touched a 4-1/2-year high of 4,016 yuan on Aug. 10, touched a session low of 3,710 yuan.

Hot-rolled coil fell 4.4 percent to 3,865 yuan per tonne.

Iron ore on the Dalian Commodity Exchange slid 3.8 percent to end at 578.50 yuan a tonne, off the day’s trough of 565 yuan. It peaked at 609.50 yuan on Tuesday, its strongest since March 16.

“Fundamentally, the physical steel market still looks healthy with supply-side reforms restricting supply and demand remains firm,” said a Shanghai-based trader.

Cooler weather in China should spur construction activity and boost steel consumption, he said, adding the selloff in futures showed investors cashing in on recent sharp gains.

But the outlook for iron ore prices isn’t as bright as steel, he said, particularly for lower-grade material.

“High-grade iron ore is in big demand because all mills are trying to increase productivity. But for medium to low-grade iron ore, there’s basically no demand,” he said.

This has widened the gap between prices of high-grade and low-grade iron ore to almost $28 a tonne this week, the widest in five months.

Iron ore with 62-percent iron content .IO62-CNO=MB, considered high grade, stood at $79.65 a tonne on Tuesday, little changed from the previous day, according to Metal Bulletin. Lower grade iron ore, with 58-percent iron, .IO58-CNO=MB was at $53.33 per tonne. ($1 = 6.6667 Chinese yuan) (Reporting by Manolo Serapio Jr.; Editing by Richard Pullin)