HIGHLIGHTS 3-BOJ Shirakawa: Japan economy rapidly stagnating

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FUKUOKA, Japan, Dec 1 (Reuters) - Bank of Japan Governor Masaaki Shirakawa said on Monday Japan's economy was stagnating rapidly but reiterated that further interest rate cuts could distort money market functions.

Shirakawa said financial conditions have rapidly become less accommodative, with availability of funds for Japanese firms falling sharply.

The central bank will hold an emergency policy meeting on Tuesday to discuss measures to ease credit strains.

Following are key comments by Shirakawa during his meeting with business leaders in Fukuoka, southern Japan, and at a news conference that followed:

MONETARY CONDITIONS

(From speech)

"Financial markets in Japan, which had remained stable relative to those in the United States and Europe, have also drastically changed since the bankruptcy filing by Lehman Brothers.

"Interest rates applied to funding in the market, such as issuing commercial paper and corporate bonds, are rising, reflecting growing risk aversion among investors such as investment trust companies and life insurance companies ...

"The issuing rates on corporate bonds have been rising, especially for those with low credit ratings, and issuing rates on CP, which had been creeping up since the summer, have risen rapidly since September.

"Although the level of these interest rates is somewhat lower than in 1998 and 1999, when corporate financing experienced a period of increased pressure, the so-called credit crunch, the pace at which these rates are rising is comparable to that in 1998 and 1999.

"Even with the current sharp rise in issuing rates on CP, funding rates as a whole remain broadly unchanged and remain very low relative to firms' profitability ...

"Nevertheless, corporate profits are under strong pressure ... This seems to indicate that the level of funding rates relative to profitability is becoming less accommodative ...

"With respect to the quantitative side, the availability of funds is showing marked changes ... The rate of increase in the amount outstanding of CP issued, which had been around 10 percent year-on-year since 2007 until the failure of Lehman Brothers, declined sharply thereafter owing to growing risk aversion among investors, and has recently fallen below the previous year's level.

"Furthermore, the postponement of corporate bond issuance, which had been limited to firms with low credit ratings, is spreading to firms with high credit ratings, which in the past had been able to issue bonds without difficulty.

"Under these circumstances, it seems that firms' attitudes are becoming increasingly defensive against the backdrop of the deceleration in global economic growth and the turmoil in financial markets as well as increased future uncertainty, and this is leading to a growing number of firms hoarding liquidity.

"To sum up, financial conditions in Japan seem to have become less accommodative at an accelerating pace, particularly in terms of availability of funds, reflecting the turmoil in global financial markets."

(From news conference)

"Fund flows in the money market are determined not just by interest rates and spread levels but by various other factors involving financial institutions.

"We would like to avoid a situation where a rate action by the Bank of Japan works to diminish market functions."

MONETARY POLICY

(From speech)

"For the time being, it is particularly important to pay attention to the downside risks to economic activity that may arise from developments in the U.S. and European financial systems and in global financial markets as well as their influence.

"To produce maximum monetary easing effects, it is a necessary precondition that markets function in a stable and smooth manner. When this condition is not met, as the recent situation in the United States shows, actual funding rates may rise notwithstanding a substantial reduction in policy interest rates.

"From this standpoint, the BOJ has undertaken various measures. The first aim of these measures is to ensure stability in money markets through the provision of liquidity ...

"The second aim is to facilitate corporate financing ... Financial conditions are currently becoming less accommodative mainly in terms of fund availability, and the risk is increasing that the effects of the current low interest rates may not permeate through the economy.

"The BOJ has already been conducting purchases of CP under repurchase agreements, and to facilitate corporate financing, the BOJ has started to increase such purchases since October, and further increased them since November.

"Furthermore, the BOJ is currently working on practical ways to contribute as a central bank to facilitate corporate financing during the run-up to the calendar and fiscal year-ends ...

(From news conference, when asked about the chance of more rate cuts)

"We have always been examining various possibilities on how, as a central bank, we should act when economic and financial conditions worsen further.

"As I have said before, we need to keep in mind that with interest rates very low, more rate cuts could cause various problems in ensuring smooth functioning of the money market.

"Having said that, and this is also repeating what I've said before, we will make a decision after closely examining economic and price moves, as well as financial market developments at the time ...

"A series of data released on Friday underscored anew the severe state of Japan's economy ... We want to carefully examine at the next policy meeting the degree of downside risk for Japan's economy."

JAPAN ECONOMY

(From speech)

"Economic activity in Japan has become increasingly sluggish recently. Data released last week, such as industrial output, showed the economy was in a severe state.

"The price situation has also changed significantly ...

"Aggregate supply and demand conditions will likely ease, as growth in real GDP is expected to continue to fall short of the potential growth rate for the next several quarters.

"Although it depends on developments in prices of petroleum products and materials, the rate of change in the CPI may, for a brief period, turn negative in fiscal 2009."

FOREX

(From meeting with business leaders, when asked about currency intervention)

"Regardless of whether it's the yen strengthening or weakening, currency moves could have a big economic and financial impact. As such, we are carefully examining the effects ...

"The basic stance on currency intervention shared by developed nations, including Japan, is that volatile exchange rate moves are undesirable. It's not specific currency levels that count. Currency rates should move stably reflecting economic fundamentals. That's the basic stance." (Reporting by Leika Kihara; Editing by Michael Watson)