WRAPUP 1-Japan to cut spending plan, may prompt BOJ response

(For more stories on the Japanese economy, click [ID:nECONJP])

* Govt abandons some spending due to slumping tax revenue

* Less spending may hurt economy, raise call for BOJ action

* BOJ Shirakawa repeats ready to act promptly, decisively

* Hatoyama's cabinet seen approving 2010/11 budget on Friday

By Stanley White and Leika Kihara

TOKYO, Dec 24 (Reuters) - Japan's government is likely to cut spending plans pledged in its election campaign as it scrambles to keep next year's budget under control, putting more burden on the central bank to avert a deflation-led downturn next year.

Bank of Japan Governor Masaaki Shirakawa offered few clues on Thursday on his policy options, although he promised that the central bank would act promptly and decisively if financial markets were to become unstable. [ID:nTKX006612]

The government and the BOJ have clashed over how to deal with deflation, which the central bank forecasts will last at least three years, as policymakers fret it could drag down the economy just as it is emerging from the global financial crisis.

The BOJ buckled earlier this month, calling an emergency meeting to announce a new short-term funding facility and last week underlined its deflation-fighting credentials by declaring it would tolerate nothing but price growth.

Now, with the government cutting its spending plans to appease worried investors and keep a ratings downgrade at bay, the onus may swing once again to the BOJ.

"The BOJ will most likely face pressure to do more," said David Cohen, director of Asian economic forecasting at Action Economics in Singapore.

"They felt they needed to make some noise about the yen's rise, and in a certain sense they succeeded. They could try buying more securities, bonds or other credit facilities."

Japan's public debt is rising towards 200 percent of GDP, the biggest in the developed world. In office for just three months, the Democratic Party-led government is keen to avoid a worsening economy before upper house elections in mid-2010.

Dithering over budget and other decisions has already undermined government popularity. Cabinet ministers have said they hope to approve next fiscal year's budget on Friday.

Prime Minister Yukio Hatoyama abandoned a campaign pledge on Monday to abolish a gasoline surcharge in order to support revenues and keep new bond issuance in the fiscal year starting April 1 from exceeding 44 trillion yen ($482 billion).

It risks a Fitch ratings downgrade if it borrows much more in fresh issuance. [ID:nT218318]

The 2010/11 spending is set to exceed 92 trillion yen, a lawmaker from a small ruling coalition party said on Thursday. [ID:nTKB006630]

That is roughly in line with a Nikkei report saying spending would be around 92 trillion, which would be a record but still less than initial spending plans of 95 trillion yen.

For a graphic on Japan's fiscal pressure:

r.reuters.com/paw97f

The Nikkei newspaper reported on Thursday that more than half of 7.1 trillion yen in spending the government had pledged in its election campaign for major policy initiatives in 2010/11 will now be cut from the final budget.

The spending cuts may help the government achieve its self-imposed cap on new bond sales and ease market worries about a supply glut that has steepened the bond market yield curve.

But cuts also carry risks for the economy, which is already headed for a slowdown as support from stimulus measures put in place by the previous government fade, analysts said.

"Next fiscal year's budget will bring a big decline in public works from the previous year, which will hurt domestic demand," said Yasuo Yamamoto, senior economist at Mizuho Research Institute in Tokyo.

"I understand Japan's finances aren't great, but it isn't good to cut public works so suddenly."

Yamamoto said initial estimates suggested public works spending could fall around a third from 2009/10 and shave around 0.8 percentage point from economic growth.

Such a loss could be significant. The Nikkei said the government is to forecast real GDP growth in 2010/11 at 1.4 percent. [ID:nWNBB4149]

WHAT NEXT FROM BOJ?

The Bank of Japan has cut rates to 0.1 percent to support the economy during the financial crisis that pushed the country into its deepest recession in decades. It also provided several measures to boost liquidity and support corporate funding.

Shirakawa reiterated to business leaders on Thursday that the BOJ will maintain very easy monetary policy to beat deflation.

The BOJ's commitment to low rates has put steepening pressure on the JGB yield curve, pinning down shorter-dated yields while longer-dated yields drift higher on concern over Japan's worsening finances.

Indeed, the Finance Ministry plans to increase issuance of 30 year bonds in 2010/11, sources said, which could add to the steepening pressure. [ID:nTOE5BM04T]

"I seriously question the decision to sell more long-dated bonds. Fiscal woes mean 30-year yields already carry a premium," said Katsutoshi Inadome, fixed income strategist at Mitsubishi UFJ Securities in Tokyo.

The five- to 20-year yield spread expanded a basis point Thursday to 164 basis points, towards the decade high struck last week of 165 basis points.

While the BOJ has said there was little more it can do with rates near zero, it may come under pressure for more action next year if Japan slips into recession or renewed worries about its soaring public debt pushes up bond yields, analysts say.

"One likely option for the BOJ is expanding the new short-term funding operation put in place on Dec. 1," said Yuichi Kodama, an economist at Meiji Yasuda Life Insurance.

"But if the economy clearly worsens, the BOJ may take bolder steps such as increasing government bond purchases, although the BOJ apparently wants to avoid giving the impression it is monetising debt."

The BOJ has been hesitant about increasing bond purchases from the current 21.6 trillion yen per year, arguing that its bond holdings were nearing a self-imposed ceiling. ($1=91.28 Yen) (Additional reporting by Rie Ishiguro, Hideyuki Sano; Editing by Neil Fullick)