By Leika Kihara
TOKYO (Reuters) - Japanese business sentiment has suffered its sharpest fall since the 1970s oil crises, taking the Bank of Japan's tankan survey to its lowest in nearly seven years and adding gloom to an economy facing a lengthy recession.
The quarterly survey fueled speculation that the central bank will downgrade its economic assessment and might even cut its already low interest rates of 0.3 percent at a policy review this week.
The global financial crisis and the yen's jump to a 13-year high against the dollar has hit exports, prompting companies to cut output and capital spending as the world's No.2 economy grapples with its first recession in seven years.
Signs that this might develop into Japan's longest contraction on record were underscored by remarks from BOJ Governor Masaaki Shirakawa, who told the Financial Times the Japanese economy may shrink in the year to March 2010.
An index gauging big Japanese manufacturers' sentiment worsened to minus 24 from minus 3 in the survey three months earlier, the December tankan showed, slightly worse than the market's median forecast of minus 23.
"The tankan is full of figures showing Japan's recession will be a deep and long one," said Yasuhide Yajima, a senior economist at NLI Research Institute.
"We expect the Bank of Japan to further ease monetary policy by March. Depending on yen moves, there's a good chance it could cut rates this week."
Derivatives markets show investors see a 40 percent chance of a 25-basis-point rate cut in Japan by March, up from about 20-30 percent last week.
The manufacturers' result was the most bleak reading since March 2002, when the economy was recovering from a prolonged slump sparked by a banking crisis. The quarterly slide was the biggest since the 1970s oil shocks, matching a fall in early 1975 and second only to a record slide in mid-1974.
The index for big service-sector firms dropped for the sixth straight quarter to minus 9, matching a low hit in December 2003, as the economic gloom hurt personal consumption.
Companies were even more pessimistic about the outlook.
The index measuring big manufacturers' outlook for three months ahead fell to minus 36, while that of big non-manufacturers declined to minus 14.
After the tankan, the yen traded at around 90.90 per dollar, weakening slightly, although the market was more focused on a 5 percent jump in Tokyo's benchmark Nikkei share average <.N225> on hopes for a U.S. auto bailout. <.T>
BOJ MOVE FOCUS
Japan's economy sank deeper into recession in the third quarter, the second straight quarter of contraction, also fanning fears it may return to deflation.
The government has expanded a fiscal stimulus plan and bolstered a war chest for bank rescues to $131 billion, increasing spending to ease the pain from a worsening job market and cut taxes on purchases of low-emission cars.
But large job cuts have been announced by from leading companies such as Sony <6758.T> and Canon <7751.T>, and the tankan survey also showed that big companies said they were cutting capital spending by 0.2 percent in the fiscal year to next March.
Business plans may be downgraded further on sharp yen rises, which reduce the value of profits earned overseas.
Big manufacturers expect the yen to move at 103.32 to the dollar on average during the current fiscal year, much lower than current levels.
The Bank of Japan cut its key policy rate to 0.3 percent from 0.5 percent in October and unveiled a series of measures to ease credit strains as the fallout from the global financial turmoil spread.
Market players are divided on whether the Bank of Japan will cut rates at its two-day policy review until Friday but a growing number of them see it happening by early next year.
"We currently expect the Bank of Japan to cut its key rate to 0.1 percent in March," said Junko Nishioka, chief economist at RBS Securities.
The tankan indexes are derived by deducting the percentage of respondents who say business conditions are poor from those who say they are good. Negative readings mean pessimists outnumber optimists.
(Additional reporting by Hideyuki Sano, Yuzo Saeki, Tetsushi Kajimoto; Editing by Edwina Gibbs)
