The Bank of Japan raised its outlook for the economy by a notch on Friday and announced a loan scheme targeting growth industries, but also warned that Europe's debt debacle posed a risk to the global economy.

The central bank said the world's second-largest economy was starting to recover moderately -- striking a slightly more optimistic tone than in previous statements.

However, market turmoil surrounding euro zone's struggle to limit the fallout from the Greek debt crisis and the yen's ensuing rise against the euro clouded the outlook. 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, the way they did two weeks ago.

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.

Worries about Europe's financial woes pushed the euro to an 8.5-year low against the yen on Thursday, lifting the Japanese currency also sharply against the dollar.

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 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 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 persistently 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.

At least the BOJ could keep away from political pressure while showing an attitude of working in tandem with the government to support growth ahead of the upper house election, said Hirokata Kusaba, senior economist at Mizuho Research Institute, referring to elections expected in July.

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 analysts expect growth to slow ahead as the stimulus effect fades and Europe's belt-tightening threatens to dent demand of 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 Tomasz Janowski; Editing by Neil Fullick)

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