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 weak exports

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

* 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 surplus unexpectedly rose i n August from a year earlier due to an increase in earnings on overseas investments, but a faltering Chinese economy and Europe's debt crisis still cloud the export outlook.

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

The Bank of Japan warned that factory output will remain weak in the October-December quarter because of curtailed overseas demand and a potentially prolonged economic slowdown in China.

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

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

Japan's 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 said project growth will likely stall for the rest of this year because of weak external demand and a strong yen.

Adding to the gloom, Japanese car makers reported tumbling sales in China for September, spotlighting the impact of a territorial row between the two countries and raising concerns that Japanese manufacturers' share of the world's biggest auto market will continue to shrink.


Japan's current account and exports:



Japan saw its current account surplus expand 4.2 percent in August 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 40.6 percent decline in July, as inflows from Japan's extensive holdings of overseas assets kept the balance in surplus.

But analysts say 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 in Tokyo.

"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."

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

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

Some travel agencies complained that Japan's territorial disputes with China and South Korea were discouraging tourists from visiting Japan, according to a nationwide survey that covered workers such as taxi drivers, hotel employees and restaurant staff.

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

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

But Asian Development Bank President Haruhiko Kuroda told reporters that there was more the central bank could do to beat deflation, which has plagued the country for most of the past decade.

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

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

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

(Editing by Eric Meijer)