Japanese business confidence was at its best in two years in the three months to June and big firms revised up capital spending plans, a Bank of Japan survey showed, in a sign the export-driven economic recovery is taking hold.

The tankan survey showed Europe's sovereign debt woes and the sharp appreciation in the yen that followed have not yet taken a toll as Japanese companies benefit from solid exports to Asia, to the relief of policymakers.

But analysts say sentiment may sour as world stock prices extend losses on fresh sovereign debt stress in Europe and growing fears of another global economic downturn.

“Overall, the tankan survey shows better corporate sentiment, especially among big manufacturers, who have raised their outlook, but it still leaves some elements of concern. The survey does not paint an entirely optimistic view for the economy,” said Ayako Sera, market strategist at Sumitomo Trust and Banking in Tokyo.

“Companies' exchange rate forecasts show they still expect the yen to stay under strengthening pressure, which will hurt their earnings.”

The headline index measuring big manufacturers' sentiment improved 15 points to plus 1 in June, the tankan quarterly survey shows, higher than a median market forecast of minus four. It was the fifth consecutive quarter of improvement and the first time sentiment turned optimistic in two years.

The index for September was seen at plus three, showing firms expect conditions to improve further over the next three months.

In a sign the recovery is broadening, the survey showed big firms expect to increase capital spending by 4.4 percent for the year that started in April.

While that was smaller than the 4.9 percent rise forecast by economists, it was an improvement over the previous tankan that showed companies planned to cut spending by 0.4 percent. In the previous year, big firms cut capital spending by 17 percent.

Benefits moderating
Japan's benchmark 10-year yield gained two basis points to 1.1 percent after the tankan, pulling away from a seven-year low hit on June 30. But the optimism shown in the survey was not enough to keep the Nikkei average from hitting a seven-month low.

Japan's first-quarter economic growth outpaced that of the US and Europe on solid exports to Asia. The rebound in exports has led to a bottoming out in capital spending.

But falling shipments and rising inventory in May signalled the benefits of a rebound in exports may be moderating. Analysts say growth will likely slow this year as the impact of subsidies on energy-efficient goods fades.

Recent yen gains may also dampen sentiment. Big manufacturers forecast the dollar on average to stand at 90.18 yen in the current fiscal year, the June tankan showed, against 91.00 yen predicted three months ago. The yen has already moved higher than the June forecast and is hovering around 88 yen to the dollar.

“Uncertainty over the outlook, stock falls, the yen's further gains as well as a rise in real interest rates due to deflation may hit corporate capital spending ahead,” said Junko Nishioka, chief Japan economist at RBS Securities.

“Excess employment and production capacity continued to ease but the situation has not improved enough to resolve output gap, so deflation remains a drag on the economy.”

The tankan's index measuring job conditions showed companies see excess labour shrinking only modestly, a sign they will not boost hiring any time soon.

That adds to challenges for Prime Minister Naoto Kan, seeking to appeal to voters before a July 11 upper house election with pledges that his Democratic Party can strengthen the economy and repair the country's tattered finances with tax hikes.

The tankan will also be scrutinised when BOJ board members next meet for a rate review on July 14-15. The central bank is expected to keep interest rates near zero. It will also review its long-term growth forecasts issued in April, under which it expects the economy to recover on solid Asian growth.

“The BOJ must be relieved to see this tankan, because it confirms that the economic outlook report issued in April is still valid,” said Naomi Hasegawa, a senior fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo.

“The BOJ is likely to keep monetary policy unchanged. At the same time, the BOJ will mention increasing uncertainties due to fiscal concerns in Europe.”

The sentiment indexes are derived by subtracting the percentage of respondents who say conditions are poor from those who say they are good. Negative readings mean pessimists outnumber optimists.