Aug 26 (Reuters) - Australia, the world's third largest cotton exporter, is expected to produce its best harvest in five years as higher returns have lured back farmers and ample rain helped crops, National Australia Bank said on Thursday.

NAB (NAB.AX) agribusiness economist Michael Creed forecast the country's cotton output in 2010/11 at around 520,000 tonnes or 2.3 million bales, up 34 percent a year earlier, and in line with the government chief commodities forecaster's last estimate in June.

Australia's exports around 80 percent of the cotton it produces. Its production fell as low as 133,000 tonnes or 585,000 bales in 2007/08 as drought reduced water availability.

Recent rain has provided the potential for increased dryland plantings which will start next month while the crop will be harvested in the April-May period next year.

"Much of the increased plantings are expected to be dryland plantings, given the limited availability of irrigated water," said Creed.

Australia has been cutting back on allocations of water for irrigation to protect its inland river systems.

Creed said despite a recovery in global prices to around 85 cents per pound CTZ0 from lows below 54 cents in March 2009, when demand for cotton was hit by the global financial crisis, prices were unlikely to reach the $1 per pound level, last seen in June 2008.

"It would appear that prices have already peaked and should settle at around current levels before a gradual decline as global stock levels are rebuilt," said Creed.