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UPDATE 1-Japan Aug current account surplus up on investment income

(Adds economist's quote, graphic)

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

* Japan's hefty holding of overseas assets offsets weak exports

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

TOKYO, Oct 9 (Reuters) - Japan's current account surplus unexpectedly rose i n August from a year earlier due to an increase in earnings on overseas investments, but sagging exports due to the faltering Chinese economy and Europe's debt crisis still cloud the outlook.[JPCURA=ECI]

The 4.2 percent annual rise in the current account surplus was the first in 18 months. It compared with the median estimate for a 2.5 percent annual drop and followed a 40.6 percent decline in the year to July.

Although slackening global demand will likely continue to weigh on exports, inflows from Japan's extensive holdings of overseas assets are likely to keep the balance in surplus.

But the surplus could narrow if China grows more slowly than expected and the euro zone debt crisis further dampens demand for Japanese goods.

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

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

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Japan's current account and exports:

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The current account, a broad measure of trade and other investment flows, stood at 454.7 billion yen ($5.82 billion) compared with economists' median forecast for 425.5 billion yen, finance ministry data showed on Tuesday.

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

The economy has so far outperformed most of its peers in the Group of Seven helped by spending on reconstruction from last year's earthquake and tsunami. But economists polled by Reuters say project growth will likely stall the rest of this year because of weak external demand and a strong yen.

The Bank of Japan kept monetary policy unchanged last Friday, but left the door open to more monetary easing later this month by striking a pessimistic note on the state of the world's third-largest economy.

The central bank is expected to cut its long-term economic and price forecasts due out at the Oct. 30 review, and Japan remains years away from achieving its 1 percent inflation target, sources told Reuters.

(Reporting by Kaori Kaneko; Editing by Eric Meijer)

((kaori.kaneko@thomsonreuters.com)(Reuters

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Keywords: JAPAN ECONOMY/CURRENT