UPDATE 1-Japan manufacturer mood hits 5-yr low-Reuters Tankan

(Click [ID:nT237065] for table) (Adds analysts' comments)

By Shigeo Kodama and Tetsushi Kajimoto

TOKYO, April 17 (Reuters) - Confidence among Japanese manufacturers fell to a five-year low in April as a weak dollar, high raw materials costs and sluggish domestic demand weigh on business, a Reuters survey showed, underlining the view that Japan may need to cut interest rates to shore up the economy.

Manufacturers were slightly more upbeat on the outlook, while service-sector firms' sentiment improved a little but they were less optimistic about business conditions in three months' time.

The Reuters Tankan, a monthly survey of leading Japanese firms that tracks the Bank of Japan's influential tankan corporate sentiment survey, produced an index of plus 1 in April for manufacturers, down from plus 8 in March.

It was the lowest showing since July 2003, when the index stood at minus 5 when the economy was in a soft patch. It marked the fifth straight month of decline since last November, when the index was at plus 23.

"It provides more evidence that real economic conditions are deteriorating at a faster pace than the central bank thinks," said Takehiro Sato, chief economist at Morgan Stanley Japan.

"That goes against the bank's judgment and leaves room for a rate cut given the possibility for Japan and the United States to fall into a recession in the first half of this year."

The index is derived from the percentage of respondents who say business conditions are good minus those who say they are poor. A result greater than zero means more of those surveyed are optimistic about conditions.

The BOJ's March edition of its quarterly tankan showed that Japanese business sentiment was at a four-year low, underlining the bank's view that the economic growth is slowing, mainly due to the effects of high energy and materials prices.

The BOJ lowered its assessment of the economy at a review last week when it kept interest rates unchanged at 0.5 percent amid looming fears of a U.S. recession and slowing growth at home.

Swap contracts on the overnight call rate are now pricing in around a 10-20 percent chance of a rate cut by the end of this year, down from around 55 percent earlier this month. JPONIBOJ=TRDT

MANUFACTURERS HIT

In the Reuters Tankan conducted from March 27 to April 14, the hardest hit were processing manufacturers such as those that make cars, electronics and precision machinery that rely largely on exports.

"Market conditions have worsened further because of U.S. subprime loan problems and a rise in steel materials prices," said a machinery firm official, adding that the impact of revised building rules implemented last year was still putting a damper on business conditions.

The new rules have led to a tumble in Japanese housing starts since July, unrelated to the U.S. subprime mortgage mess, that curtailed the economy's growth in the second half of last year.

Some companies in the electric machinery sector, where the sentiment index fell eight points to zero -- the lowest since May 2003 when it was at minus 4 -- cited high crude oil and other raw materials costs and the yen's rise as negative factors.

Manufacturers also blamed sluggish domestic demand.

"If that's true, the problem will be compounded," said Yasuo Yamamoto, senior economist at Mizuho Research Institute. "Weak domestic demand means companies will have to cut production."

Yamamoto said the BOJ may be forced to cut interest rates if Japan's exports to emerging economies lose steam to the extent that they cannot cover up falls in Japanese shipments to the United States, and he saw such a risk rising gradually.

The index for service-sector firms stood at plus 3, up slightly from plus 2 in March but crawling along near a four-year low of plus 1 registered in January.

Retailers suffered the most as they faced slack personal consumption, which makes up more than half of economic activity, pushing the sentiment index to minus 6 from plus 12 in March.

The outlook index over the next three months stood at plus 4 for manufacturers and plus 2 for non-manufacturers, compared with last month when it stood at plus 8 for manufacturers and plus 9 for nonmanufacturers.

Japan's economy -- the world's second biggest -- entered an expansionary period early in 2002 and has since been in its longest postwar growth cycle thanks to exports and corporate activity.

But the government said in its monthly economic report last month that the economic recovery appeared to be pausing recently. (Editing by Hugh Lawson)