By Luc Cohen

NEW YORK (Reuters) - A scandal involving the alleged sale of falsely labeled Egyptian cotton products by an Indian textile manufacturer to U.S. big box retailers highlights a stiff reality facing the high-end fiber market: there isn't much Egyptian cotton any more.

The shortage of cotton from Egypt, which commands a premium due to its superior quality, creates an incentive to blend it with other types of cotton without disclosing it or to counterfeit the label altogether, cotton traders said, exacerbating a problem that has plagued the industry for years.

Welspun India has lost 42 percent of its market value in the three days since Target Corp said it would sever ties with the textile manufacturer, one of the world's largest, accusing it of substituting cheaper, non-Egyptian cotton into sheets and pillowcases.

Egyptian cotton is prized because much of it is "long staple" or "extra long staple," meaning the length of the cotton fibers is longer, resulting in a finer, lighter more durable fabric and longer-lasting, higher-end clothing.

While other countries including the United States and Australia produce larger quantities of high-end cotton than Egypt, cotton from the North African country has retained its prestige because of a long history growing the crop.

But Egypt's cotton output has been declining for the past decade after farmers failed to adapt to shifting consumer demand for mass-produced items made from short- or medium-staple fiber, according to the U.S. Department of Agriculture (USDA).

The decline has become a full-fledged crisis in recent years after the government removed cash subsidies, and many farmers replaced cotton acreage with rice, the USDA said.

Egypt will produce just 160,000 480-lb bales of cotton in 2016/17, down from 1.4 million bales as recently as 2004/05, accounting for less than 0.2 percent of expected global output.

This means some products marketed as containing Egyptian cotton almost certainly do not, or are blended with other types of cotton without proper disclosure, said Jordan Lea, chairman and co-owner of cotton merchant Eastern Trading in Greenville, South Carolina.

"If you look at the volume of Egyptian goods that are for sale, and you look at the volume ofEgyptian cotton that's produced, it would lead one to scratch one's head," Lea said.

A GOLD SEAL?

Long and extra long staple cotton is rare - it makes up just 2.5 percent of annual world cotton production of more than 100 million bales, according to the USDA - and trades at a substantial premium.

U.S. extra long staple cotton, or "pima," trades for 152.25 cents per lb, according to Thomson Reuters Eikon data, a 125 percent premium over cotton prices on ICE Futures U.S., a contract that accepts cotton of a "strict low middling staple length".

Ron Lawson, a cotton industry veteran and broker with LOGIC Advisors in Sonoma, California, said he had "no idea" what Egyptian cotton prices were, which he said showed how much of a "novelty" item the fiber was.

Improper labeling of cotton products including clothing and bedding is a violation of the U.S. Textile Act and Rules, which are enforced by the Federal Trade Commission (FTC).

An FTC spokesman declined to comment on whether the agency was aware of Target's allegations or had started an investigation.

Egypt's cotton association appears to be aware of widespread counterfeiting. In April, its executive director told trade publication Home and Textiles Today that it had tested retail products labeled 'Egyptian cotton' and found that 90 percent contained no Egyptian cotton at all.

The Cotton Egypt Association lists Welspun as one of just three companies permitted to label its products with the association's "Gold Seal," which was launched earlier this year and is meant to ensure authenticity.

Mukesh Saviani, a Welspun executive, told the trade publication in February that the seal was "an assurance to retailers that they will not get into any compliance issues."

The scandal could leave big box U.S. retailers wary of dealing with products labeled Egyptian cotton, potentially providing a boon to growers of U.S. Pima cotton in places like California and Arizona.

"The Supima boys are doing backflips and pirouettes on their desks right now," Lawson said, referring to an association that provides a trademark indicating cotton products come from 100 percent American Pima cotton.

(Additional reporting by Nandita Bose in Chicago; Editing by Richard Pullin)