UPDATE 3-BOJ focus on crisis, warns against cutting too far

(For more stories on the financial crisis click [ID:nCRISIS]) (Recasts with revised GDP poll figures)

By Leika Kihara

TOKYO, Nov 5 (Reuters) - Bank of Japan Governor Masaaki Shirakawa said risks of economic weakness remained the bank's main concern in the face of the global financial crisis, but warned that too big a cut in interest rates in Japan could distort the market.

Shirakawa also said on Wednesday the central bank's decision last week to cut its key policy rate by 20 basis points, instead of the usual 25 points, was not aimed at leaving room for further monetary easing, as some market players have speculated.

"It's not true that we wanted to leave more room to cut rates in the future," Shirakawa told a parliamentary committee.

"We made that decision as we thought it the most appropriate."

Joining a worldwide response to the global credit crisis, the BOJ slashed its already low key interest rate target to 0.3 percent on Friday, the first rate cut in seven years.

Behind the decision were wild swings in markets that saw Tokyo's benchmark Nikkei average .N225 plunge by almost a quarter in October, its worst month ever, and the yen JPY= touch a 13-year high against the dollar.

The European Central Bank and the Bank of England are expected to cut interest rates this week after Australia slashed rates more deeply than forecast.

Appearing at a seminar before speaking in parliament, Shirakawa repeated that the BOJ was focusing on downside economic risks for the time being, as recent falls in commodity prices have diminished the risks of runaway inflation in Japan.

But he also said that with Japanese interest rates already low, cutting them too much could do more harm than good by distorting market functions.

"If the BOJ sharply lowered interest rates, returns on interest rates would not be able to cover funding costs, resulting in declines of liquidity in the financial market," Shirakawa said.

"Lowering interest rates could disturb market functions and then worsen fund circulation in financial markets."

While economists were divided over whether Japan slipped into recession in July-September, their median expectation was for gross domestic product to slightly grow, a Reuters poll showed. [ID:nT368711]

Japan's economy contracted by the most in seven years in the second quarter, and another quarter of contraction would put it into recession, using the most common definition of two quarters in a row of shrinking GDP.

Shirakawa said there was high uncertainty whether Japan's economy would return to a sustainable growth path, as the BOJ forecasts, given market tensions and lingering banking problems in the United States and Europe.

While derivates markets show few investors expect another BOJ rate cut by the end of this year, some analysts say further monetary easing cannot be ruled out if the fallout from the credit crisis spreads. JPONIBOJ=TRDT

"If economic and market conditions don't get any worse, the BOJ probably won't have to do anything beyond what it has already done," said Masaaki Kanno, chief Japan economist at JPMorgan Securities.

"But if the Japanese economy deteriorates more notably in the next few quarters, which is likely, and if the financial system faces a renewed crisis, the BOJ may launch additional rate cuts as well as more steps to stablise credit markets," he said.

Much of the developed world is now in recession, officials and economists say, based on the most common definition of two consecutive quarters of shrinking gross domestic product, and economists see little sign of improvement anytime soon.

The Nikkei average rose 4.5 percent to a three-week closing high on Wednesday, buoyed by rises in Honda Motor Co (7267.T) and other exporters after Barack Obama won the race for president of the United States. [.T] FXNEWS [ID:nN04356344] (Additional reporting by Yasuhiko Seki and Hideyuki Sano)