By Sarah Marsh
The Munich-based Ifo economic think tank said on Friday that its closely-watched business climate index, based on a monthly survey of some 7,000 companies, fell to 106.4 in October from a revised 107.4 in September.
This was the lowest level since June 2010, albeit slightly better than the 106.3 forecast in a Reuters poll of 52 economists.
Market sentiment has been rocked this month by uncertainty about a bailout for Greece and fears the euro zone will fail to resolve its debt crisis, which could in turn spiral back into a banking crisis.
Criticism of Germany has grown as its deep disagreements with France have indicated the euro zone will make scant progress on strengthening its bailout fund at a summit on Sunday.
German daily Financial Times Deutschland wrote on Friday the situation was turning into a farce and devoted its front page to a plea to leaders to get their acts together and "throw all their weight" at saving the common currency bloc.
France and Germany said in a joint statement on Thursday that European leaders would discuss a global solution to the crisis on Sunday but no decisions would be adopted before a second meeting to be held by Wednesday at the latest.
"Confidence and activity received a blow from the escalating sovereign debt crisis, which has spread to the banking industry and the real economy," said Aline Schuiling, senior economist at ABN AMRO Bank.
Germany's export-driven economy recovered swiftly from the 2008 financial crisis, outperforming its peers and providing a crucial growth engine for Europe.
But data increasingly suggest growth is easing due to a global slowdown and the euro zone's debt crisis. Industry output, orders and retail sales slumped in August.
Forward-looking indicators such as the Ifo business climate index point to a darkening outlook. Data this week also showed German investor morale dropping to its weakest level in nearly three years.
Chancellor Angela Merkel's government nearly halved its forecast for growth next year to 1 percent on Thursday, catching up with other recent downwards revisions by think tanks.
An Ifo sub-index on current conditions fell to 116.7 from 117.9 in September, while the expectations reading dropped to 97.0, down from a revised 97.9 in September.
Many economists said that, while sentiment was worsening as the euro zone crisis reached a critical stage, the real economy was still in good shape and well placed to weather the crisis -- for the time being.
"There is no denying that the German economy will cool off in coming quarters," said Andreas Rees of UniCredit.
"However ... doomsday is certainly not around the corner. Companies are still sitting on a huge pile of backlog orders which will be worked off in coming months."
The German government and most economic think tanks still see full-year 2011 growth of around 3 percent.
"The propensity of companies to invest further in Germany remained at historically high levels recently, at least partly offsetting declining impulses from exports," Rees added.
German bluechips have warned recently about the deteriorating outlook, while nonetheless reporting good business.
German retailer Metro AG <MEOG.DE> said on Thursday it was on track to beat last year's record profit of 2.4 billion euros ($3.3 billion euros).
Ifo economist Klaus Abberger told Reuters companies were pulling in their horns due to increasing cautiousness but still were not planning to cut jobs.
"They are bracing themselves for a period of weakness, so are reducing capacity levels for example to have a cushion," he said. "But they are not expecting a collapse."
Abberger nonetheless said the European Central Bank should cut its key interest rate to 1.0 percent, adding he expected this to happen in two stages.
(Additional Reporting by Stephen Brown, Alexandra Hudson, Annika Breidthardt and Christian Kraemer; Editing by Catherine Evans)