UPDATE 1-Japan current account surplus up but mood gloomy

* Current account surplus +4.2 pct vs forecast -2.5 pct

* Japan's hefty holding of overseas assets offsets weakexports

* Outlook murky due to China's subdued growth, Europe debtcrisis

* Service-sector sentiment hits 16-month low - govt survey

* BOJ warns of weakening output, private consumption woes

(Adds sentiment survey, BOJ report)

By Kaori Kaneko and Leika Kihara

TOKYO, Oct 9 (Reuters) - Japan's current account surplusunexpectedly rose i n August from a year earlier due to anincrease in earnings on overseas investments, but a falteringChinese economy and Europe's debt crisis still cloud the exportoutlook.

Service-sector sentiment worsened in September to levelsseen just after last year's devastating earthquake, a separatesurvey showed, a sign that slowing global demand was taking atoll on the export-reliant economy.

The Bank of Japan warned that factory output will remainweak in the October-December quarter because of curtailedoverseas demand and a potentially prolonged economic slowdown inChina.

"The timing of when overseas growth will recover remainshighly uncertain," the central bank said in a monthly economicreport for October released on Tuesday.

Private consumption will likely remain firm but may suffer adownturn with the end in September of government subsidies forlow-emission cars that had supported domestic demand, it said.

Japan's economy has so far outperformed most of its peers inthe Group of Seven helped by spending on reconstruction fromlast year's earthquake and tsunami. But economists polled byReuters said project growth will likely stall for the rest ofthis year because of weak external demand and a strong yen.

Adding to the gloom, Japanese car makers reported tumblingsales in China for September, spotlighting the impact of aterritorial row between the two countries and raising concernsthat Japanese manufacturers' share of the world's biggest automarket will continue to shrink.


Japan's current account and exports:



Japan saw its current account surplus expand 4.2 percent inAugust from a year earlier, finance ministry data showed,contrary to the median market forecast for a 2.5 percent drop.

It was the first rise in eight months and followed a 40.6percent decline in July, as inflows from Japan's extensiveholdings of overseas assets kept the balance in surplus.

But analysts say the surplus could narrow if China growsmore slowly than expected and the euro zone debt crisis furtherdampens demand for Japanese goods.

"The overall trend is that the current account surplus islikely to shrink in the future, because overseas economies areweak and this will pressure exports," said Norio Miyagawa,senior economist at Mizuho Research & Consulting in Tokyo.

"The government may want to consider some extra measures tosupport the economy, but it is unclear if the schedule inparliament will lead to a quick response."

Japan's exports dropped for a third straight month in theyear to August while manufacturing sentiment hit its lowestlevel since February, more signs that weakening global demand istaking its toll on the export-reliant economy.

Japan's service sector sentiment index slipped to 41.2 inSeptember, falling for the second straight month and hitting thelowest level since May 2011.

Some travel agencies complained that Japan's territorialdisputes with China and South Korea were discouraging touristsfrom visiting Japan, according to a nationwide survey thatcovered workers such as taxi drivers, hotel employees andrestaurant staff.

The BOJ, which had hoped that the weakness in exports wouldbe offset somewhat by firm domestic demand, warned in itsmonthly report that it had to be vigilant to developments inJapan's job market where recent gains had paused.

The central bank eased monetary policy three times so farthis year to prevent a strong yen and slowing overseas growthfrom threatening Japan's recovery.

But Asian Development Bank President Haruhiko Kuroda toldreporters that there was more the central bank could do to beatdeflation, which has plagued the country for most of the pastdecade.

The International Monetary Fund also said that while theBOJ's monetary loosening in September should support economicgrowth, more stimulus may be needed for the country to achievethe central bank's 1 percent inflation target.

The BOJ kept monetary policy unchanged last week, but leftthe door open to more easing later this month by striking apessimistic note on the state of Japan's economy, the world'sthird-largest.

The central bank is expected to cut its long-term economicand price forecasts due out in an Oct. 30 review.

(Editing by Eric Meijer)