* Aug bank lending up 1.8 pct y/y, slowest rise since last Sept * Weaker fund demand reflects slow capital spending * Money supply in August grows at fastest pace in 9 years * Current account surplus shrinks on fall in income surplus (Adds govt monthly report in paragraph 16)
By Stanley White
TOKYO, Sept 8 (Reuters) - Japanese bank lending grew at the slowest pace in a year in the 12 months to August partly as companies saddled with excess capacity have less need to borrow funds for capital expenditure.
At the same time, August's money supply rose from a year earlier at the fastest rate in more than nine years, suggesting that ample funds in the economy are not flowing into new loans as companies become accustomed to lacklustre domestic demand.
The contrast between bank lending and the money supply show the limits of the Bank of Japan's policy of keeping its benchmark interest rate near zero and supporting corporate finance by purchasing assets from commercial banks.
"The idea that monetary policy is pushing on a string has been around in Japan," said Naomi Hasegawa, senior fixed-income strategist at Mitsubishi UFJ Securities.
"It takes time for the negative supply gap to shrink, and that is a pre-condition for loan growth."
Weak lending also highlights the tentative nature of Japan's recovery from its worst recession since World War Two as the Democratic Party prepares to take power this month, ending five decades of almost unbroken rule by the Liberal Democratic Party.
Lending rose 1.8 percent in August from a year earlier, slowing further from a record gain logged in January and marking the smallest rise since September 2008, when it rose 1.6 percent, BOJ data showed on Tuesday.
Loan growth slowed for the seventh straight month, partly reflecting easing credit conditions and companies' hoarding of cash, but companies also have less need for funds as they scale back their spending plans.
Machinery orders -- a leading indicator of such capital spending -- are expected to have fallen 3.5 percent in July, a Reuters poll showed, suggesting firms are still cautious about spending on equipment. The data is due on Thursday.
"The bank lending data reflects a lack of funding needs at companies as capital spending remains restrained and inventories still need to be cut back. It shows weak demand in line with economic activity," said Masamichi Adachi, a senior economist at JPMorgan Securities Japan.
SUPPLY OUTSTRIPS DEMAND
Japan's output gap narrowed in April-June to minus 7.4 percent from a record minus 8.0 percent the previous quarter, but supply continued to outstrip demand by a large margin, government data showed last month.
Japan's M3 money supply rose 2.0 percent in August from a year ago, separate data from the BOJ showed on Tuesday. That was the biggest increase since May 2000, when it rose an annual 2.1 percent.
A breakdown of figures for July, also released on Tuesday, showed deposits held by companies rose 3.3 percent from 2.1 percent in June. That suggests companies were finding it easier to raise funds but at the same time were in less need of money as they were not actively spending on equipment, a BOJ official told reporters at a briefing.
The BOJ decided in July to extend a raft of measures to support corporate finance to December from their planned expiry in September. The BOJ is likely to keep rates steady at 0.1 percent at least until March 2011, according to a Reuters poll.
In another sign of weakness in the economy, Japan's service sector sentiment fell to 41.7 in August from 42.4 in July, the first drop in eight months, a government survey showed on Tuesday.
The government kept its overall assessment of the economy unchanged in a monthly report issued on Tuesday, saying Japan's economy shows signs of picking up but a record jobless rate is clouding its near-term prospects.
Revised figures on Friday are expected to confirm that while Japan's economy emerged in April-June from its worst recession since World War Two, recovery will be slow and far from assured as much of it depends on stimulus measures.
Japan's Democratic Party, which takes over the government on Sept. 16 after a landslide election victory, has promised to boost growth by using subsidies to increase household incomes.
But economists fret that the Democrats could struggle to find the money to fund their policies.
Japan's current account surplus fell a larger than expected 19.4 percent in July from a year earlier as surplus from returns on overseas investments fell. (Additional reporting by Leika Kihara and Rie Ishiguro; Editing by Michael Watson)