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TOKYO (Reuters) - Weakening demand at home and abroad weighed on Japanese manufacturers' confidence in the first quarter and big companies cut spending plans, clouding the outlook for Prime Minister Shinzo Abe's drive to reflate the economy.
But the latest central bank survey showed service-sector firms saw business conditions improve to a nearly one-year high as they enjoyed lower oil costs and a surge in inbound tourism, underscoring the patchy nature of Japan's recovery.
Both manufacturers and non-manufacturers expect conditions to worsen slightly in the coming three months, the closely-watched "tankan" survey showed on Wednesday. That's a worrying sign for the Bank of Japan as it prints money aggressively in the hope of nudging companies and households to boost spending.
"We can see that companies are more worried about overseas demand. At the same time, the measure of domestic demand has not improved," said Shuji Tonouchi, senior fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities.
"The capital expenditure forecasts also raise doubts about the likelihood of achieving the BOJ's inflation target," he said.
The headline index gauging big manufacturers' sentiment was flat from three months ago at plus 12 in March, the survey showed, surprising markets that expected a 2-point improvement.
Big non-manufacturers' sentiment improved by 2 points to plus 19, beating a median forecast of plus 17 and matching a high hit in June 2014.
The survey will be among data BOJ policymakers scrutinize at its rate review next week for clues on whether their massive monetary stimulus is working its way through wider sectors of the economy.
"It showed business sentiment is moving sideways at high levels. There's nothing strange about it ... Abenomics is making steady progress," Chief Cabinet Secretary Yoshihide Suga told reporters.
Big manufacturers maintained their conservative dollar-yen forecasts and were cautious about business conditions despite projecting increases in sales and profits in the year that began on Wednesday, the survey showed.
"Manufacturers know that while the weak yen is a boon to their profits, that's an external factor. That's why they may feel uncertain on the outlook," said Ko Nakayama, a senior BOJ economist who briefed reporters on the tankan.
An index showed companies saw overseas demand softening with some complaining of sluggish demand in China, which may also explain the gloomy mood among manufacturers.
Adding to the murky outlook, a separate private survey showed that expansion in Japanese manufacturing activity slowed in March as domestic orders shrank for the first time in about a year.
Non-manufacturers, on the other hand, saw slumping fuel costs make up for rising import prices from a weak yen. A surge of Asian tourists shopping in Japan also boosted retailers' sales, the survey showed.
The outlook looks murky. The tankan showed companies were barely able to raise prices and saw job market conditions tighten to multi-year highs, suggesting higher wages may start to squeeze their bottom lines.
Reflecting cautiousness, big firms expect to cut capital expenditure by 1.2 percent in the new fiscal year, confounding market forecasts of a 0.5 percent increase.
Capital expenditure is key to the BOJ's massive stimulus deployed two years ago, which aims to change the perception deflation will persist so that companies will start spending on investment rather than hoard cash.
Still, many analysts expect the BOJ to stand pat for now to gauge the effect of October's expansion of stimulus, although slowing inflation keeps alive expectations that the BOJ will ease monetary policy again sometime in 2015.
"Overall, Japanese firms remain cautious about the economic outlook despite the weak yen and tumbling oil prices, due in part to a sluggish global recovery," said Takeshi Minami, chief economist at Norinchukin Research Institute.
"That said, the sentiment indexes are hovering at relatively high levels and small firms remain optimistic, so I don't think the BOJ is looking at the results so pessimistically."
Additional reporting by Stanley White, Mari Saito and Kaori Kaneko; Editing by Richard Borsuk