The Bank of Japan raised its outlook for the economy Friday, citing signs of sustained recovery in domestic demand, but also warned that Europe's debt debacle posed a risk to the global economy.

The BOJ also announced a loan scheme targeting growth industries and suggested it could be willing to do more to support economic recovery by accepting a broader range of collateral for BOJ operations.

We need to watch for downside risks for the European economy if financial market tensions heighten due to some European countries' fiscal reform, Governor Masaaki Shirakawa said.

But we maintain the view that emerging economies will lead the global economy's recovery and that emerging economies will maintain strong growth based on domestic demand and the United States will continue to recover moderately.

One of the effects of the market turmoil surrounding the euro zone's struggle to limit the fallout from the Greek debt blow-out is the rise of the yen against the euro. The central bank did not mention the currency, but Finance Minister Naoto Kan warned of the potential damage of sharp yen gains.

A close watch is needed so that yen rises do not become excessive, he said before meeting Prime Minister Yukio Hatoyama.

Kan said the prime minister ordered him to monitor market conditions but said the government was not considering any specific steps on the economy for now.

He also played down the need for any global action to deal with sharp currency and stock market swings and said there were no plans for the Group of Seven finance ministers to discuss market developments this weekend.

We expected the situation to calm down, but it hasn't settled yet. But I don't think we need to do anything additional now.

The euro recouped its losses on Friday after worries about Europe's financial woes pushed it an 8-½ year low against the yen on Thursday, sending the Japanese currency sharply higher against the dollar.

Shirakawa declined to comment on whether officials had intervened to support the euro but did say G7 officials were in close contact.

It is not appropriate to comment on intervention by other countries, and if the question is about Japan's intervention I won't comment as that is a matter under the jurisdiction of the finance minister, he told reporters.

DOUBTS OVER LOAN SCHEME

As widely expected, the central bank kept the benchmark rate on hold at 0.1 percent and outlined its plan to offer loans at that rate to banks that will fund projects in sectors with growth potential.

The loans will target a wide range of industries, Shirakawa said, without elaborating.

The central bank has said monetary easing was not the aim of the loan plan and economists expect it to stay pat on policy for the time being given signs of improvement at home and fears that Europe's belt-tightening may derail global economic recovery.

The central bank hopes to start the scheme around the summer.

The program will not be permanent and the BOJ will later set a deadline, Shirakawa said.

The BOJ is aware of what is going on in Europe, but they want to avoid giving unintended policy signals, said Kyohei Morita, chief Japan economist at Barclays Capital.

The new funding scheme isn't a policy change. It is just a new system.

Analysts were skeptical about how effective the new scheme would be given that weak demand for credit rather than lack of affordable funds seemed to be holding the economy back.

Bank lending matched the biggest annual decline in four years in April, showing how limp fund demand has been. [nTOE64A08L]

The BOJ said it would take into account what sectors the government identifies as growth areas in an economic strategy due next month. The BOJ could also consider accepting securitized products as collateral, Shirakawa said.

Japan's economy grew at its fastest rate in three quarters in the first three months of this year, outpacing its euro zone and U.S. peers mainly thanks to robust exports to the rest of Asia and government stimulus measures.

But growth is expected to slow as the stimulus effect fades, and Europe's woes threaten to dent demand for Japan's exports. Yen gains threaten to further undermine the recovery by eating into exporters' profits and prolonging deflation that encourages consumers and businesses to delay spending.

(Writing by Stanley White; Editing by Tomasz Janowski)

Japan Bank of Japan