Japanese bank lending logged its biggest annual fall in more than four years in January as companies faced with overcapacity and a murky economic outlook steered clear of borrowing for capital investment purposes.

The softness in domestic demand could also be seen in Japan's current account surplus, which surged more than fivefold in the year to December thanks to a recovery in exports.

While that bodes well for the outlook for an export-led recovery, Bank of Japan Deputy Governor Hirohide Yamaguchi said the economy could linger in the doldrums until around the summer before getting back on a more sustainable course to recovery.

We expect the recovery to continue, but the economy will be in a severe condition until the summer. Quarter-on-quarter growth won't be big, and we may even hit a soft patch, Yamaguchi told parliament's lower house budget committee.

Many analysts expect economic growth to slow down early this year as the government has suspended some public works project plans drawn up by the previous government to reallocate funds for its own policy steps.

The Bank of Japan in December decided to offer banks more short-term funds, caving in to pressure from the government for more action to fight deflation and support the economy ahead of elections in the summer.

But Monday's data showed that the cash is not spreading through the economy as funding demand remains anemic.

Bank lending fell 1.5 percent in January from a year earlier, BOJ data showed. That followed a 1.0 percent drop the month before and was the largest fall since September 2005.

The drop (in bank lending) is mostly a reaction to the sharp gain last year -- but it also shows that fund demand is weak even though banks are easing their lending attitude, said Junko Nishioka, chief economist at RBS Securities.

Bank lending has been falling in much of the developed world. U.S. bank credit slumped 7.3 percent in December. In the euro zone, bank loans to the private sector were flat in December after falling 0.7 percent in November.

Financial markets brushed off the Japanese data, with many market players more concerned about the fiscal woes in Europe.

CURRENT ACCOUNT SURPLUS JUMPS

Japan's current account surplus rose 452.8 percent in the year to December, supported by a recovery in exports, which some said would continue to support the economy.

The balance of payments slipped to a rare deficit last January as the financial crisis battered exports and cut gains in overseas investments. It has been in the black since then.

U.S. gross domestic product is looking very strong, and emerging markets are also doing well, so Japan's exports are likely to remain strong for a while, said Yoshiki Shinke, a senior economist at Dai-ichi Life Research Institute. The risk of a double-dip recession in Japan is very small.

Japan's economy, the world's second biggest after the United States, has been growing since the second quarter of last year as government stimulus measures worldwide help to boost exports, particularly to China and other Asian countries.

But many firms are reining in business investment due to excess capacity, with capacity utilisation still about 20 percent below its level before the global economic crisis.

Still, a survey of taxi drivers, hotel employees, restaurant staff and other service sector workers called economy watchers for their proximity to consumer and retail trends found that sentiment improved for the second month running in January.

But economists say consumers are likely to tighten their belts due to falling incomes, fuelling concerns about deflation, where buyers put off spending to wait for yet lower prices.

The central bank has kept interest rates near zero and introduced several emergency funding schemes to help the economy recover from its worst slump since World War Two, but it has been bombarded by government calls for more.

Analysts say the government fears falling prices and a strong yen could push Japan back into recession ahead of upper house elections this summer. The government's own policy options are limited with national debt nearing 200 percent of GDP.

Japan's corporate bankruptcies fell 21.8 percent in January from a year earlier to their lowest level in more than two years, Tokyo Shoko Research said on Monday.

But the total debt involved, at 2.6032 trillion yen ($29 billion), was the biggest amount for the month of January since World War Two, due to the collapse of Japan Airlines Corp, it said.

(Editing by Hugh Lawson)

Japan Inflation