July 1 (Bloomberg) -- Confidence among Japan's largest manufacturers fell to a four-year low and companies expect earnings to decline for the first time since the 2001 recession.

The Tankan index of manufacturer sentiment slid to 5 points in June from 11 in March, a third quarterly decline, the Bank of Japan said today in Tokyo. Large companies said profits will drop 7 percent in the year ending March 31, compared with a 0.3 percent increase predicted three months ago.

``This is bad news for Japan's economy,'' said Hiromichi Shirakawa, chief economist at Credit Suisse Group in Tokyo. ``The pessimistic view on profits suggests a vicious cycle from companies to households may slow wage growth and the labor market.''

Record energy and commodity prices are eroding profits at Nissan Motor Co. and Canon Inc., and the U.S. slowdown is rippling through Europe and Asia, stifling demand for Japanese cars and electronics. Costlier materials will push large manufacturers' profit margins down to 5.6 percent this fiscal year from 6.4 percent last year, the survey showed.

The yen traded at 105.67 per dollar as of 10:20 a.m. in London from 106.15 before the report. Japan's currency has weakened 3.6 percent since the previous Tankan on April 1. Large manufacturers see the yen trading at 102.74 on average this year.

The Nikkei 225 Stock Average fell 0.1 percent. The yield on Japan's 10-year bond rose 6.5 basis points to 1.675 percent. Economists predicted large-manufacturer confidence to slide to 3.

Slowdown Under Way

``The Tankan figures weren't as bad as anticipated, but they indicated an economic slowdown is surely under way,'' said Mari Iwashita, chief market economist at Daiwa Securities SMBC Co. in Tokyo. ``Rising raw-material costs are squeezing corporate profits, posing downside risks to the economy.''

Costlier raw-materials caused companies' first-quarter profits to fall at the fastest pace since 2002. Nissan's Chief Executive Officer Carlos Ghosn last week said higher steel and rubber costs have become ``practically impossible to absorb.''

Canon may report its earnings fell 18 percent in the first half of the year, the Nikkei newspaper reported last month.

Some economists say Japan may avoid a recession because businesses have shed excess debt, labor and capacity. Profit margins remain almost double those when the economy most recently contracted for two straight quarters in 2001.

``Companies are much more profitable than they were,'' said Richard Jerram, chief economist at Macquarie Securities Ltd. in Tokyo. ``They have much less to fear from a short-term margin squeeze. It's not going to threaten their survival.''

Kansai Paint

Kansai Paint Co., Japan's largest maker of automotive paints, forecasts record profit this year as demand from China and India makes up for slower sales in Japan and the U.S., company President Shoju Kobayashi said on Bloomberg Television.

Nikkei 225 companies' debt-to-equity ratio has dropped an average of 7 percent annually over the past five years to 1.15 times, Bloomberg data show.

Businesses have managed to control costs by trimming staff and keeping wages down, said Tetsuro Sugiura, chief economist at Mizuho Research Institute Ltd. in Tokyo. ``Companies are better prepared to handle external shocks than before,'' he said.

The large manufacturer index, while the lowest since September 2003, is still above the negative numbers recorded during Japan's decade of economic stagnation in the 1990s. The survey plunged to minus 51 in 1998, when Asia was in the throes of a currency crisis and the government had to buy failed lenders including Long-Term Credit Bank of Japan Ltd.

Service Companies

Confidence at big service-sector companies fell to a four- year low of 10 points in June from 12 in March, less than economists' expectations for a drop to 8.

The nation's largest manufacturers and non-manufacturers both expect to be less confident three months from now, with their outlook indexes at 4 and 8 respectively. A positive number means optimists outnumber pessimists.

Large companies said they plan to increase capital spending 2.4 percent this fiscal year, the worst reading for a June survey since 2002. Crude oil prices have doubled in the past year and reached a record $143.67 a barrel yesterday.

``One of our biggest concerns is the crazy crude-oil prices,'' Kansai Paint's Kobayashi said.

The world's second-largest economy probably shrank at an annual 0.4 percent pace last quarter, the first contraction in a year, according to economists surveyed last month.

Slower growth is likely to prevent the Bank of Japan from raising its key interest rate from 0.5 percent this year, even as inflation runs at the fastest pace in a decade, according to economists surveyed by Bloomberg News.

The Tankan survey was conducted from May 28 to June 30 and covered 10,579 companies.

To contact the reporter on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net

Last Updated: July 1, 2008 05:21 EDT