Japanese firms have cut capital spending less than expected in the third quarter of 2007, but despite the expected upward revision in growth figures this week, Bank of Japan governor Toshihio Fukui warned on Monday 3 December that the well-being of Japan''s economy still depended on how far the US economy slowed down in the months to come.

Japanese companies reduced spending on plant and equipment by 1.2 per cent in July-September compared with the previous year''s Q3, less than the 2 per cent fall that economists had forecast. This means the government will likely hike the capex component of Japan''''s gross domestic product (GDP) Q3 data, due on Friday, boosting the country''s Q3 growth by around 0.2 per cent.

Fukui said the US economy could slow down much more if its housing sector slump deepens further. But he also cautioned that the Japanese central bank should not focus solely on downside risks, as it needs to keep an eye on inflation given robust growth in the world economy.

Speaking at a meeting of local business leaders in the central Japanese town of Nagoya, Fukui said, ''''As long as the Japanese economy follows a sustainable growth path under stable prices we''''re in a direction of raising rates, because monetary conditions are very accommodative.'''' But his comments failed to cut much ice in financial markets. Swap contracts on overnight call rates reflect a less than 30 per cent chance of a rate hike by March, and remained largely unchanged from last week.

Preliminary data shows Japan''''s economy expanded 0.6 per cent in the quarter, after a 0.4 per cent contraction from April-June, thanks to solid exports and firm capital spending.

But, despite the Q3 good news, optimism at Japanese companies continues to ebb. Manufacturers registered only a slight improvement in business sentiment in November after a two-year low in October, and they remained cautious on the outlook. Optimism among non-manufacturers sank to its lowest level in three-and-a-half years, owing to soaring oil prices and a plunge in construction caused by tighter regulations.

All expectations are that the Bank of Japan will hold off raising interest rates at least until well into next year, given the ongoing tensions in the world''''s financial markets. While many economists still expect Japanese economic expansion to continue well into next year and beyond, they also say troubles in financial markets and a possible US slowdown could seriously disrupt Japan''''s export-led growth.

A finance ministry survey shows that the recurring profits of Japanese firms fell 0.7 per cent in Q3 from the previous year''s quarter, even as their sales rose 2 per cent. This is the first profitability drop in more than five years, partly because of rising raw material costs.