BOJ FOCUS-Bank of Japan exit strategy debate heats up

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By Leika Kihara

TOKYO, July 3 (Reuters) - A survey showing Japanese businesses in a grim mood in June should have settled the debate at the central bank on whether to end support for the corporate finance market. It has not.

In fact the debate will likely intensify as the Bank of Japan tries to avoid the missteps of its response to the last spell of deflation. And it will probably be watched by central bankers around the world considering ways to retract their own response to the financial crisis.

BOJ Governor Masaaki Shirakawa put the tankan gauge of corporate sentiment under more than usual scrutiny when he said last month the corporate finance component of the survey would help guide BOJ policy on credit markets.

Several Bank of Japan officials, including one talking to Reuters after the tankan was released on Wednesday, said the BOJ should still retreat from credit markets now that they appear to be recovering from turmoil triggered by the collapse of Lehman Brothers last year.

Others, who represent the dominant view within the central bank, argued that withdrawal would be premature and send the wrong signal to an economy sinking deeper into its second spell of deflation this decade.

"We see no strong reason to end these measures in a hurry," one BOJ official said on condition of anonymity. Several more officials confirmed that view.

All the officials declined to be named because of the sensitivity of the matter. All have direct influence over policy.

The debate, and how the BOJ manages its message, has a significance that extends well beyond credit markets and has enormous implications for the world's second-largest economy.

During the last spell of deflation, triggered by the collapse of a property bubble in the 1990s, the BOJ's efforts to stimulate lending did not even begin to work until it gave the market a clear signal about how long it would keep flooding the banking system with cash.

In that case the signal was a promise to keep spigots of cash open until CPI changes turned positive. It made the pledge after the BOJ misread signs of recovery and raised rates in 2000, only to cut them seven months later, possibly prolonging the economic slump.

Now in the midst of a second deflationary spell, the central bank is particularly keen to avoid anything that can be seen as vacillation or a mixed signal.

"If the BOJ gives an impression that it will put an end to corporate support measures all at once, that could lead to a liquidity crisis as global financial markets remain fragile," said Hirokata Kusaba, senior economist at Mizuho Research Institute.

The BOJ may therefore opt to roll back part of its credit market programme and leave the rest in place. It could stop or cut back purchases of commercial paper that have so distorted the market that rates of return are lower than on government treasury bills, while extending low interest loans to banks against corporate debt, Kusaba said.

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