Business sentiment among big Japanese manufacturers has sunk to a two-year low, a Bank of Japan survey showed on Friday, reinforcing expectations that any rise in interest rates will be delayed to late next year.

Rising raw material costs, plummeting construction activity because of tighter building rules and fears of a U.S. recession due to the credit crisis all played a part in eroding optimism.

But the BOJ's December tankan survey also showed companies are sticking to robust capital spending plans, and sentiment at small manufacturers showed a surprising improvement.

The outlook has sharply deteriorated, and the risk of economic downturn has increased, said Yasuhiro Onakado, chief economist at Daiwa SB Investments. A rate hike by the Bank of Japan may have to wait until after the middle of next year.

The yen dipped to a one-month low of 112.66 yen per dollar. That in turn helped boost Japanese share prices in morning trade, but the Nikkei share average .N225 later erased the gains and closed down 0.14 percent.

Swap contracts on the overnight call rate, the BOJ's main benchmark, are pricing in just a 5 percent chance of a rate hike by March, and just above a 50 percent chance by September.

The index of big manufacturers' sentiment in the quarterly survey fell 4 points to plus 19, below economists' median forecast of plus 21 and matching a figure hit in September 2005.

The worsening sentiment among big manufacturers, the engine of Japan's export-led growth, raised worries that a likely slowdown in the U.S. economy in the wake of the credit crisis could deal a blow to Japan.

The weak figures reflect a worsening of the corporate business environment, such as a rise in oil prices and an expected decline in U.S. GDP, said Mamoru Yamazaki, chief economist at RBS Securities.

BOJ SCENARIO

The survey raises doubts about when or if strength in the corporate sector will spill over to households, a scenario that the Bank of Japan relies on to justify raising rates.

The tankan showed firms are cautious, so it would be hard for the BOJ to raise rates at least during the first half of next year, said Yoshimasa Maruyama, an economist at BNP Paribas. We're at the point where we cannot really pinpoint when the BOJ could raise rates.

No rate change is expected at the BOJ's two-day policy meeting that ends next Thursday.

The central bank has long said it will raise rates gradually, as keeping its current ultra-low policy rate of 0.5 percent may lead to overheating in the economy in the long term.

Financial markets at one time had thought rates would be raised to 1 percent by next March, but growth has stalled and the outlook is murky, given uncertainties about how deep the U.S. slowdown could be.

The government maintained that the weak survey did not change the economic outlook, but the chief government spokesman acknowledged headwinds were increasing.

We are not at all blindly optimistic, Chief Cabinet Secretary Nobutaka Machimura said. There are various worrisome factors such as the rise in crude oil prices.

The tankan showed a deterioration in business sentiment among small companies, the sector that employs most Japanese and has been hit hardest by the rising cost of oil and raw materials, but the fall was not as big as feared.

The index for small manufacturers improved by 1 point to plus 2, contrary to expectations for a fall to minus 2, helped by an improvement in the auto and ship-building sectors on solid output.

Economists have worried that recent rises in raw materials and food prices will squeeze profits at many companies, which are reluctant to pass on rising costs to already wary consumers.

Small firms, which employ seven of 10 Japanese workers, are considered to be particularly vulnerable.

But the survey showed big firms expected their capital spending to rise 10.5 percent in the year to next March, above economists' median forecast for a 9.0 percent rise.

Companies are getting cautious, but the solid capex shows they are still fairly optimistic on the economy in the longer term, Takahide Kiuchi, chief economist at Nomura Securities, said in report.

(Additional reporting by Tetsushi Kajimoto, Leika Kihara and Yuzo Saeki)

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