The central bank's quarterly corporate survey, or "tankan", showed the key diffusion index for large manufacturers was minus 38, below the minus 31 in the previous survey in March.

But the figure was slightly better than expected. Economists surveyed by Reuters had predicted the key index would stand at minus 42 for June.

"The drop was smaller than what we have expected. It was probably because some firms expected a positive impact from the government's stimulus package and tax cuts," said Susumu Kato, Chief economist at Barclays Capital.

The index for major non-manufacturers in June was minus 28, compared with minus 30 in March and economists' average prediction of minus 36.

"It's encouraging that non-manufacturers appear to be saying that things have stopped getting worse," said Richard Jerram, chief economist at INGBarings.

But some economists also said some firms were too optimistic about prospects for the economy.

"It is still at low levels and the weak sentiment has not been changed. It is too early to say the worsening sentiment has bottomed out from this data alone," said Yasuhiko Ushikubo, an economist at Industrial Bank of Japan.

The dollar, which had risen above 143 yen in early Asia trade in anticipation of the worsening sentiment in the survey, quickly dropped below 142 yen as the key indices were better than expected. It was traded at around 141.70 by 0130 GMT.

The diffusion index measures the percentage of companies that consider business conditions favourable minus the percentage that see them as unfavourable. A negative reading means pessimistic firms outnumber optimistic ones.

In a separate report, the Ministry of International Trade and Industry (MITI) said industrial production fell a preliminary 2.0 per cent in May from the previous month on a seasonally adjusted basis, adding that Japan'sindustrial output was still on a declining trend. Retail sales for May, on the other hand, rose on the month by 0.9 per cent, though on a year-to-year basis it fell by 2.0 percent, MITI said.

The slew of mostly dismal data underscored the urgent need for Tokyo policy-makers to finalise steps for Japan's ailing banking sector.