Business sentiment among large Japanese manufacturers is weaker than expected during the quarter ending December 2007. The Japanese central bank's quarterly tankan survey dropped to 19, as compared with 23 at the end of the previous quarter.

The tankan shows business sentiment of large manufacturers, measured by a diffusion index. It is forecast to deteriorate further in the coming quarter, according to a survey released on Friday 14 December by the Bank of Japan.

The shift in sentiment is considerable, after a relatively cheerful September survey, which did not capture any changing perceptions despite the US sub-prime meltdown in August. Notwithstanding the sentiment, investment intentions among large manufacturers remained expansionary, but small and mid-sized manufacturers were forecasting flat or contracting investment.

Economists had expected a downturn in business confidence among large manufacturers. Forecasts indicated a two-point decline in the diffusion index to 21. But the four-point fall has come as an unpleasant surprise.

Confidence among large non-manufacturers has fallen to 16 in December from 20 in the previous survey, slightly better than expectations. The survey shows that large manufacturers and non-manufacturers both expect business conditions to worsen in the coming January-to-March quarter.

Economists say a weaker tankan would make it more difficult for the Bank of Japan to raise its overnight lending rate from the current level of 0.5 per cent. The Bank of Japan was expected to hike interest rates by a quarter point in the fourth quarter of next year, but analysts now feel the forecast may be overly optimistic, given the weakening outlook.

After the release of the tankan the futures markets were pricing in a zero per cent chance of an interest rate hike at the BoJ's next rate setting meeting, which concludes on 20 December.

Among the brighter indicators in the survey, large companies' capital expenditure plans were revised upwards to 10.5 per cent from 9 per cent in fiscal 2007. Medium-sized companies plan to increase capital spending by 3.3 per cent, while small firms plan to reduce investment by 4.6 per cent. Small manufacturers plan to cut investment spending by an alarmingly high 7.6 per cent.

Official data released recently shows that Japan's industrial production increased 1.6 per cent in October from the previous month, on a seasonally adjusted basis. The purchasing managers index, another measure of business sentiment, rebounded in November. Despite a falling dollar, exports have shown strong growth.

Though the surveyed projections for March would likely indicate expectations of further erosion, analysts say the tankan readings are likely to be consistent with the Bank of Japan's outlook of ongoing moderate expansion.