Japanese manufacturers' confidence has recovered to its highest level since the global financial crisis hit, but remains weak overall due to concerns about deflation and sluggish domestic demand, a Reuters poll showed.

Sentiment in the service sector improved for the first time in three months, although service companies are still much more pessimistic than manufacturers due to weak consumption at home.

Many manufacturers have been helped by brisk demand from China and other fast-growing Asian economies. China's economy booked its fastest quarterly growth in two years, data showed last week, and Japanese exporters have been keen to target that rapid expansion.

But not all manufacturers were upbeat. Some leading exporters, such as automakers, became more pessimistic due to the strong yen, which eats into the value of overseas earnings.

The Japanese economy is on a recovery trend but there are worries about impact from deflation and the yen's rise, said one respondent, an executive at a transport equipment maker.

The Reuters survey of 400 big firms, of which 231 responded, showed that confidence at both manufacturers and non-manufacturers is expected to edge up over the next three months, but the pace of recovery is likely to be slow.

The poll is designed to be a leading indicator of the Bank of Japan's influential quarterly tankan survey, and has a 95 percent correlation. The BOJ's tankan last month showed that sentiment continued to improve from a record low hit last year.

For graphic on the Reuters and BOJ surveys, click on: http://link.reuters.com/cuw94h

Overall, the manufacturers' sentiment index in the Reuters Tankan rose 8 points to minus 19, the best level since the minus 14 in September 2008. It is expected to rise a further 3 points to minus 16 by April.

Service sector confidence remains deep in negative territory: it rose by 5 points to minus 34. It is seen rising 3 points to minus 31 by April.

Faced with uncertainty ahead, consumers are increasingly cutting back or holding off spending and only selectively buying low-priced goods, said one respondent, an executive at a retailer.

Japan has barely emerged from its deepest recession in postwar history, and the government is worried that deflation and weak demand may push the economy back into recession, which could warrant more aggressive policy action by it and the BOJ.

The BOJ may say at its two-day policy review through Tuesday that there is less chance the country will slip back into recession. It is expected to hold off on new initiatives, having introduced a new funding operation last month.

The Reuters Tankan indexes are calculated by subtracting the percentage of pessimistic respondents from optimistic ones. A negative figure means pessimists outnumber optimists.

(Writing by Rie Ishiguro; Editing by David Dolan)

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