By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) - Japanese business sentiment barely improved in the three months ending March and the corporate outlook is now considerably weaker than when Japan last raised its sales tax in 1997, the Bank of Japan's tankan survey showed on Tuesday.
The findings highlight the daunting challenge facing Prime Minister Shinzo Abe in his quest to increase the consumption tax while simultaneously rescuing Japan from years of deflationary stagnation.
The headline index for big manufacturers' sentiment rose by one point from three months ago to plus 17, the BOJ's closely watched survey showed, marking the fifth straight quarter of improvement but slightly short of a median market forecast of plus 18. The rise was smaller than a 4-point gain in the previous survey in December.
Big service-sector sentiment also improved, by four points to plus 24, matching the median market forecast, as consumers rushed to beat the April 1 sales tax hike.
But crucially, both big manufacturers and non-manufacturers expect conditions to worsen in the three months ahead, the tankan showed, as they brace for a slump in spending after the tax hike that comes as exports remain sluggish.
The outlook index for big manufacturers worsened 9 points to plus 8, more than a 8-point decline when Japan previously raised the sales tax to 5 percent from 3 percent in 1997.
The outlook indices for big non-manufacturers, as well as for small manufacturers and non-manufacturers, also worsened at a faster pace than in 1997, underscoring the alarm companies feel about the potential effects of the tax hike.
Big firms expect to increase capital spending by just 0.1 percent in the new financial year starting this month, compared with a median market forecast for a 0.2 percent rise -- a marked slowdown from a 3.9 percent increase in planned spending for the fiscal year that ended in March.
The data will keep alive market expectations the BOJ may ease policy further in coming months if the pain from the tax hike proves to be much worse than estimated, analysts say.
"The results were somewhat weaker than expected. Companies are cautious about the outlook mainly due to the tax hike and aren't in the mood to boost capital spending," said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute.
"The chance of further BOJ easing may have risen a bit but the tankan alone won't be a trigger for action. The bank will probably wait to see more evidence on how much the tax hike actually hurts demand," he said.
DIFFERENT FROM 1997?
Growth in the world's third-largest economy slowed in the final quarter of last year as the effect of Abe's reflationary policies began to fade. Analysts expect the economy to contract in April-June due to a pullback in consumption after the tax hike, before returning to moderate growth in following quarters.
A Reuters poll showed analysts expect the BOJ to ease again by July, despite reassurances by the bank the economy can withstand the tax hike without further stimulus.
"Big companies are very worried about what will happen after the sales tax hike. Memories of the last sales tax hike in 1997 are still in the back of many corporate executives' minds," said Yasuo Yamamoto, senior economist at Mizuho Research Institute.
Back in 1997, Japan slipped into recession as the tax hike coincided with domestic banking-sector woes and the Asian financial crisis. The BOJ argues that this time is different as Japan's banking sector remains healthy and solid U.S. demand will offset the weakness in emerging markets.
The BOJ has stood pat since deploying an intense burst of stimulus in April last year, when it pledged to double base money via aggressive asset purchases to accelerate consumer inflation to 2 percent in two years.
The tankan survey will be among data the BOJ board members scrutinize when they meet for a rate review next week. The central bank is widely expected to keep monetary policy steady at the meeting, preferring to wait at least a few months to evaluate out the degree of pain from the sales tax hike.
The tankan's diffusion index (DI) is calculated by subtracting the number of firms which say business conditions are worse from those which feel they improved. A positive reading means optimists outnumbered pessimists.
(Additional reporting by Stanley White; Editing by Eric Meijer)