The Ifo institute said its business climate index fell to 88.5 this month from 91.5 in May. A Reuters poll of analysts had predicted a smaller drop to 90.7 in June.

"Sentiment in the German economy has clouded over noticeably," Ifo's president Clemens Fuest said.

Expectations were much more pessimistic, with the related index falling to 83.6 from May's 88.3. Companies also assessed their current situation more poorly, with that index falling to 93.7 from 94.8.

The economy faces the prospect of a longer recession as domestic demand and the expectations of exporters have both weakened, Klaus Wohlrabe, head of Ifo surveys, told Reuters in an interview on Monday.

"The probability has increased that gross domestic product will also shrink in the second quarter," he said.

China's weaker than hoped for economic performance since its reopening from tight COVID-19 lockdowns, a looming U.S. recession and ongoing monetary policy tightening seem to be weighing on German company sentiment, said Carsten Brzeski, global head of macro at ING.

"What is clear is that the optimism at the start of the year seems to have given way to more of a sense of reality," Brzeski said.

The decline in Ifo is in line with the drop in the flash purchasing managers index, published on Friday. There was a combination of a slower rise in service sector business activity and a deepening downturn in manufacturing output, that report showed.

"The slump in the German Ifo, together with the drop in the PMIs, suggests that German GDP probably contracted for the third quarter in a row in the second quarter," said Franziska Palmas, senior Europe economist at Capital Economics. The economic research firm expects the economy to remain in recession throughout 2023.

"We feel confirmed in our forecast that the German economy will shrink again in the second half of the year," Commerzbank's chief economist Joerg Kraemer said.