By Leika Kihara
TOKYO (Reuters) - A prolonged U.S. budget standoff would hit global markets very hard, the Bank of Japan warned on Friday as it said it was ready to top up its existing massive stimulus if the recovery underway in the world's third-largest economy was threatened.
But for now, BOJ Governor Haruhiko Kuroda saw no need to ease policy further as Japan was on the path to escape deflation and, if international risks receded as hoped, government fiscal stimulus would further boost growth next year.
The U.S. budget deadlock and fears of an unprecedented U.S. default dragged Tokyo shares to a four-week low and boosted the yen, casting a cloud on an otherwise upbeat outlook for Japan's export-driven economy.
"If this continues for a long time, this could destabilise financial markets and worsen sentiment," Kuroda told reporters after a two-day policy review meeting, adding that the BOJ was ready to respond to any sudden shocks.
He declined to comment on the possibility of a U.S. debt default, but said the consequences of a prolonged standoff on global markets would be "severe."
"We sincerely hope a solution is reached at an early date," Kuroda said. Through its massive holding of U.S. government debt, Japan is one America's biggest creditors.
Other top international policymakers have also warned that a failure to raise the U.S. debt ceiling before mid-month would be a serious blow to the world economy.
As widely expected, the BOJ kept intact its intense monetary stimulus launched in April, under which it aims to double base money via asset purchases to meet its target of lifting inflation to 2 percent in roughly two years.
GRAPHIC: Abenomics effect http://link.reuters.com/tam37t
Japan inflation, rates http://link.reuters.com/nux65t
EYES GDP REVISION UPGRADE
On Tuesday, Prime Minister Shinzo Abe said he would proceed with a planned increase in the sales tax to 8 percent from 5 percent next April, and cushion its impact with a 5 trillion yen stimulus package.
Kuroda said the tax rise was an important first step in reining in Japan's huge public debt which, at double the size of its $5 trillion economy, is the biggest among major industrialised nations.
He also said the stimulus package would give a significant boost to growth, suggesting the central bank will revise up its long-term economic forecasts when they are released on October 31.
The BOJ upgraded its assessment on capital expenditure to say it was picking up, adding strength to its view the economy was recovering moderately and suggesting that no additional monetary policy measures are needed to counter the impact of the sales tax increase.
Japan's economy has now grown for three successive quarters as Abe's reflationary policies bolstered household spending and drove down the yen, benefiting exports, with annualised growth of 3.8 percent in April-June outpacing many G7 nations.
The BOJ expects the sales tax hike to shave about 0.7 percentage point off growth, and estimates the economy will expand 1.3 percent in the business year beginning in April 2014.
This already far outpaces the 0.7 percent growth projected in a recent Reuters poll, and its forecast does not factor in the effect of the government's stimulus package.
"I don't think the BOJ's view that the sales tax hike won't derail the recovery is too optimistic," said Junko Nishioka, chief Japan economist at RBS Securities.
"But the 2 percent inflation remains a distant goal. Core consumer inflation could hit 1 percent early next year. But it's an uphill battle from there."
Having launched its intense burst of stimulus in April, the BOJ does not want to act again easily. But it has not ruled out expanding stimulus if the damage from the tax hike proves bigger than expected and threatens the 2 percent inflation target.
The big test will come in spring next year, and not just from the sales tax. By then there will also be more clarity on whether companies will raise wages enough to offset some of the pain households will feel from the tax hike, BOJ officials say.
(Additional reporting by Tetsushi Kajimoto and Stanley White; Editing by John Mair)