Japanese manufacturers turned optimistic for the first time in two years in May, a Reuters poll showed, providing further evidence of the economy's continuing recovery led by Asian demand.

Manufacturers expect sentiment to improve further over the next three months, with export-led industries such as electrical appliance and machinery makers encouraged by growing demand from China and elsewhere in Asia, the Reuters Tankan showed.

Consumer confidence also hit a 2- year high in April, a separate government survey showed, in a sign the optimism was spreading.

Finance Minister Naoto Kan said the economy continued to recover, although he warned that financial markets have not completely settled down from the European debt crisis.

The situation in Europe has caused Japanese stocks to fall and led to temporary gains in the yen. I hope this situation settles down, Kan told a news conference on Tuesday.

Economists expect solid exports to fast-growing Asian economics to lift Japan's first-quarter economic growth to a brisk 1.3 percent, or an annualized 5.4 percent, when provisional growth figures are released on Thursday.

There are early signs of improvement in domestic demand. Japan's core machinery orders rose in March and manufacturers expect further increases in the coming months, suggesting capital spending will keep rising moderately.

Consumer confidence improved for the fourth straight month in April to hit its highest level since October 2007, a Cabinet Office survey showed on Tuesday.

But the Reuters Tankan showed service-sector sentiment worsened slightly due to frail domestic demand, in a sign the recovery remains patchy.

Weaker sentiment at service-sector firms suggests government stimulus is petering out, and this may cause a temporary slowdown in the overall economy in April-June, said Kyohei Morita, chief economist at Barclays Capital Japan.

But strong Asian demand is expected to help the Japanese economy recover steadily ... The current financial market turmoil stemming from Greece's debt problems is unlikely to break this trend, unless it drags on for a long time, he said.

The poll, which has a 95 percent correlation with the Bank of Japan's tankan survey, could mean the headline business sentiment index for large manufacturers in the BOJ tankan for June will climb out of negative territory for the first time in two years.

The upbeat data comes as welcome news for the Bank of Japan, which is considering a new loan program aimed at encouraging private banks to lend more to industries with growth potential.

The central bank is expected to unveil an outline of the new scheme after its two-day policy meeting that ends on Friday.

In the Reuters Tankan survey of 400 large firms, of which 227 responded, the manufacturers' sentiment index rose 4 points from April to plus 4, its highest since plus 8 in March 2008.

Manufacturers expect the index to rise to plus 9 in August.

The index for non-manufacturers however, worsened to minus 15 in May from minus 14 the previous month and is expected to remain in negative territory at minus 4 in August.

Indexes in the Reuters Tankan, taken from April 23 to May 13, are calculated by subtracting the percentage of pessimistic respondents from optimistic ones. A negative figure means pessimists outnumber optimists.

(Additional reporting by Stanley White, Editing by Charlotte Cooper)

China Japan