The Bank of Japan has outlined a loan scheme aimed at supporting growth industries and upgraded its assessment of the economy, but said Europe's debt debacle needed watching for its impact on the global economy.

The eurozone's struggle to limit the fallout from the Greek debt crisis and the yen's ensuing rise against the euro clouded the outlook for Japan's economy, which the BOJ described as “starting to recover moderately” even as the finance minister warned of the potential damage of sharp yen gains.

As widely expected, the central bank kept interest rates on hold at 0.1 percent and refrained from any new monetary easing steps.

“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.”

Morita said this was the kind of step the government should be taking in fiscal policy, “but the government has budget constraints. I think the BOJ is working hard here”.

Analysts were also sceptical about how effective the new scheme would be and how it would work in practice, though they said it could help ease government pressure on the central bank for more action.

“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.

Finance Minister Naoto Kan, who met Prime Minister Yukio Hatoyama to discuss the economy, said Hatoyama ordered him to monitor market conditions but the government was not considering any specific steps on the economy for now.

Worries about Europe's financial woes pushed the euro to an eight year low against the yen on May 20, lifting the Japanese currency also sharply against the dollar.

Kan, asked after a cabinet meeting earlier whether more action should be taken globally to deal with sharp currency and stock market moves, said: “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.”

Kan also said there were no plans so for the Group of Seven finance ministers to discuss the situation in a conference call this weekend, the way they did two weeks ago.

He added, however, that it was undesirable for the yen to rise too much. “A close watch is needed so that yen rises do not become excessive,” he said before meeting the prime minister.

Yen gains threaten to undermine economic recovery by eating into exporters' profits and prolonging deflation by pushing down the costs of imports.

But with the direct impact of Europe's woes on Japan limited so far, the central bank is expected to avoid easing monetary policy further for now.

Taking the view that flooding markets with cash alone would not help overcome deflation, the BOJ said in April that it would consider a new framework to redirect money to industries with potential new demand.

Under the new loan scheme, the BOJ will offer private banks fixed-rate loans at 0.1 percent with maturity of one year that can be rolled over if necessary.

Applicants of the programme will submit a plan on how they plan to “strengthen the foundations for Japan's economic growth” through their lending. The BOJ will assess the plan in deciding how much loans it will extend to the applicants.

The BOJ has said monetary easing was not the aim of a plan that focuses on specific borrowers. But analysts are doubtful how much the scheme can boost lending and support the economy saying the problem lies in weak demand for credit, not a lack of funds.

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

Japan's economy posted its fastest growth in three quarters in the first three months of this year, outpacing its eurozone and US peers on solid exports to Asia.

But analysts expect growth to slow ahead and keep Japan stuck in grinding deflation for at least another year, prompting firms and consumers to delay spending.