* 40 pct for Japan firms say domestic demand is biggest headache
* Labour shortage a close second, cited by 34 pct
* Nearly half of Japan firms plan to expand capex over next 3 yrs
* Few Japanese firms keen to boost China, U.S. investment
TOKYO, June 21 (Reuters) - Japanese firms say shrinking domestic demand is their biggest worry over the next three years while labor shortages are a close second, a Reuters poll found, highlighting the difficulties of coping with a dwindling and rapidly aging population.
Japan's demographic challenges have for decades hindered efforts by policymakers to engineer a sustained economic recovery as the country's graying consumers, lacking confidence in the future, tend to scrimp and save rather than spend.
Asked what was their biggest concern over the next three years, 40 percent of businesses cited the country's shrinking market, the Reuters Corporate Survey showed.
"The domestic market isn't expanding and there's nothing we can do about it," wrote a manager at an auto sector firm in the survey conducted June 2-15.
But the problem of fewer customers is now being exacerbated by a lack of workers as population woes deepen, pressuring companies to raise wages and in some cases even cut back on services offered. Thirty-four percent of firms said the lack of workers was now their main concern.
"We're having trouble both in hiring new grads and with pulling in people mid-career, especially those with technical expertise," said a manager at a metals and machinery firm.
Delivery firm Yamato Holding Co is one of many firms that has grabbed headlines recently, announcing in April it would cut delivery volumes and hike prices because it did not have enough workers.
The country's working-age population has dropped 11 percent since its peak in 1995 to 77.2 million in 2015 and is projected to tumble to 45.2 million by 2065.
While most firms said they could secure sufficient staff over the next three years, 26 percent thought they wouldn't be able to. By sector, IT services firms, transport as well as other services were the most pessimistic with 40-45 percent of companies worried they would be left short of employees.
To secure sufficient labor, 48 percent said they would expand training and investment in human resources, a quarter saw wage hikes as a way to go, while 13 percent plan to hire foreign workers.
Worries about domestic demand and the lack of workers far outstripped other corporate concerns. Trade stagnation due to protectionism only garnered 9 percent of the votes, while deflation, a state of falling prices that has long been the bete noire of Japanese authorities, gained just 5 percent.
The survey, conducted monthly for Reuters by Nikkei Research, polled 526 big and mid-sized businesses, who reply on condition of anonymity. Between 200 and 240 companies answered questions on their three-year outlook.
COOL ON CHINA CAPEX
The poll also showed that 48 percent plan to expand domestic capital spending over the next three years, while 46 percent said they would keep it at current rates. The remaining 6 percent said they were taking a cautious stance.
Those results underscore a firm, although not exactly robust, trend for Japan business investment - one that is being driven in part by the need for companies to invest in labor saving technology as they seek to offset the shortage of workers, said Hidenobu Tokuda, a senior economist at Mizuho Research Institute, who reviewed the survey results.
Japanese companies were, however, much more cautious about boosting investment in their main overseas markets. Over the next three years, only 12 percent plan to boost capital spending in China and only 18 percent aim to do so in the United States.
"We'll reduce the weighting of China in our investment strategy. It's easy to expand sales there given the size of China's market, but it's hard to raise profits due to regulations, licenses, high labor costs and opaque business practices," wrote a manager at an electrical machinery firm.
The outlook for investment in the rest of Asia was somewhat brighter with 38 percent expecting to lift investment.
(Reporting by Tetsushi Kajimoto; Additional reporting by Izumi Nakagawa; Editing by Malcolm Foster and Edwina Gibbs)