German business sentiment dropped in July to its lowest level in more than two years, adding to signs that Europe's largest economy is losing momentum along with its immunity to fallout from the region's deepening debt crisis.

The Munich-based Ifo think tank said on Wednesday its business climate index, based on a monthly survey of some 7,000 companies, fell for the third month running to 103.3, its lowest since March 2010, when the economy was recovering from financial crisis.

A Reuters poll of 45 economists had forecast a fall to 104.7 from a marginally downwards revised 105.2 in June.

"It looks as if German businesses have finally woken up to reality. Today's Ifo index sends a clear warning that even the most solid ship can capsize in a rough thunderstorm," said ING economist Carsten Brzeski.

Europe's 2-1/2 year-old debt crisis, which appeared to be easing early in 2012, has flared again on concerns Spain may succumb to a full sovereign bailout and Greece be forced to exit the single currency zone.

Ifo economist Klaus Wohlrabe told Reuters uncertainty had increased and would grow further in coming months.

He saw no risk to Germany's AAA sovereign debt rating but said Monday's move by credit agency Moody's to cut its outlook to negative was a warning to the region not to overburden the eurozone's paymaster with financial demands.

"Germany's strength is not unlimited," Wohlrabe told Reuters in an interview.

An Ifo sub-index on current business conditions fell to 111.6 from 113.9, while expectations worsened further to 95.6 from 97.2, pointing to a rockier road ahead.

RECESSION THREAT

The German economy weathered the crisis comfortably until late last year and even now is faring better than its peers, many of which are struggling under mountains of debt and tough fiscal reforms that have sent unemployment soaring and at times led to civil unrest.

"Germany is faring well compared to the rest of Europe. It could be even worse," Wohlrabe said, forecasting economic growth of 0.1 percent both in the second and third quarters.

German gross domestic product fell by 0.2 percent in the last three months of 2011, reversing that with growth of 0.2 percent in the first quarter to keep the eurozone as a whole from falling into recession.

But recent data suggests the domestic economy is now losing steam again.

The finance ministry said in its monthly report that growth would probably reach 0.2 percent in the second and third quarters, and the economy ministry reaffirmed a full year forecast of 0.7 percent on Wednesday.

But Tuesday's Purchasing Managers Index data showed the private sector shrank for a third straight month in July, suggesting the economy may in fact contract in both the second and third quarters.

"The sudden deterioration in market sentiment is very likely to affect the real economy even more in the months to come," said Berenberg Bank economist Christian Schulz.

"Even countries such as Germany, with a fundamentally healthy economy, could enter recession if waning confidence leads companies to postpone investment and households to delay purchases."

Spain paid its second highest euro-era yield on short-term debt at an auction on Tuesday, and European Union officials said Greece had little hope of meeting the terms of its bailout, casting fresh doubt on its future in the single currency zone.

The problems among its eurozone trading partners, along with an economic slowdown in China, are filtering through, even to Germany's corporate bellwethers.

Europe's biggest engineering conglomerate Siemens (SIEGn.DE: Quote, Profile, Research, Stock Buzz) looks set to report a decline in third-quarter new orders of its flagship products as manufacturing demand across the region flags.

Ifo said the retailing sector offered a ray of hope, with retailers more positive about their current business situation and their six-month outlook.

Traditionally export-led, Germany's economy has recently come to rely more on domestic demand, helped by rising wages and unemployment near the lowest levels since reunification - though the eurozone turmoil could potentially impact there too.

"The crisis costs Germany money. Not because of the bailouts it guarantees, not because of a potential ratings downgrade ... but because the economy is growing much more slowly than it otherwise would," said Berenberg Bank's Schulz.

"It could stagnate or even fall into recession, costing jobs and tax revenues."