German business sentiment improved unexpectedly in May, raising hopes that the euro-zone's largest economy, teetering on the brink of outright recession, might now pick up over the second half of the year.

But economists greeted the rise with scepticism, insisting there was little sign of a turnaround, while business leaders warned that Germany's fragile economy could contract this year for the first time in a decade.

The Munich-based Ifo institute said yesterday its business climate index climbed to 87.6 in May from 86.6 in April. But the closely watched index remained well below its level of 91.6 a year ago and still short of March's 88.1.

Mr Gernot Nerb, Ifo economist, said the rise in the index reduced the risks of recession in Germany and increased the chances for an upturn later this year. "We can expect things to improve over the next six months," he added.

But Ifo officials cautioned that the rise in the index was based solely on improved business expectations, helped by the end of the war in Iraq, while current conditions showed signs of deteriorating further.

The German chamber of industry and commerce, DIHK, said it now thought the economy would shrink this year for the first time since 1993. "We said at the beginning of the year we expected zero growth . . . but now that looks optimistic," said an official. He said the euro's strength was posing a serious threat to the export sector, which has long underpinned German growth.

Yesterday the euro again hovered around its all-time highs of $1.18. The strong euro is also capping euro-zone price pressures and is likely to provide the cue for a European Central Bank interest rate cut next week.

Mr Ernst Welteke, the Bundesbank chief and an ECB council member, yesterday joined the chorus of bank officials stressing that falling inflation provided room for manoeuvre on monetary policy.