The Bank of Japan (BOJ) forecast the economy will contract in the current fiscal year but kept monetary policy steady on Tuesday, expecting that exports to emerging markets and spending for reconstruction after last year's earthquake will help fuel a steady recovery later this year.     

The central bank is keeping a wary eye on developments in Europe as Greece teeters on the edge of default, with some market watchers not ruling out a worsening of the crisis that could knock Japan back into recession.     

With the chance of this happening slim for now and the yen off record high levels, the BOJ likely decided to save its limited policy options in case renewed market turmoil or a prolonged slump in overseas growth threaten Japan's recovery.     

Still, the central bank may not hold fire for too long.     

"Europe remains the biggest risk in the eyes of the BOJ. If Greece suffers a disorderly default or Europe fails to work out assistance measures for key states like Italy, triggering share price falls and renewed yen rises, the BOJ is likely to ease policy further," said Naomi Hasegawa, senior fixed-income strategist at Mitsubishi UFG Morgan Stanley Securities.     

"The possibility of this happening will remain high towards the spring as a large amount of government bonds reaches maturity in Europe."     

As widely expected, the BOJ kept its key policy rate at zero to 0.1 percent and held off on further expanding its 55 trillion yen ($713 billion) asset-buying scheme.     

But in a quarterly review of long-term projections, the BOJ cut its economic forecast for the year ending in March to a 0.4 percent contraction, matching a Reuters poll of private-sector analysts, from a 0.3 percent rise.     

It trimmed its forecast for the next fiscal year to an expansion of 2.0 percent from 2.2 percent, reflecting the effects of the global slowdown, although it was still higher than 1.8 percent growth forecast in a Reuters poll.     

The government is somewhat more upbeat, forecasting a 0.1 percent contraction for the current fiscal year and a 2.2 percent expansion for the following year.     

"The BOJ's forecasts are largely in line with private sector economists. The timing of the next step depends on how markets move. We've seen this pattern before," said Norio Miyagawa, senior economist at Mizuho Securities Research & Consulting.     

"If the yen is rising due to risk aversion stemming from Europe's debt crisis, then we might see an increase in asset purchases."

Europe's sovereign debt crisis, the stubbornly strong yen and slowing overseas growth have taken a heavy toll on an export-reliant economy barely emerging from the devastation of the March disaster.     

The BOJ warned of risks posed by Europe's debt crisis and cut its assessment on the economy, saying its activity has been "more or less flat." That compared with the previous month's view that the pickup in economic activity has moderated.     

But it stressed that the economy will resume a moderate recovery sometime by September this year with post-quake spending and solid growth in emerging economies to support.     

The government, eager to pass through parliament bills to raise taxes to fix Japan's tattered finances, kept up pressure on the central bank to help support the fragile economy.     

"In order to overcome the yen's rise to historical levels and prolonged deflation we will fortify cooperation with the BOJ ... and manage solid economic and fiscal policies," Prime Minister Yoshihiko Noda told parliament.      

The BOJ releases its long-term economic and price forecasts in a twice-yearly outlook report in April and October, and reviews them in January and July of each year.     

With interest rates virtually at zero, the central bank put in place in 2010 a pool of funds to buy assets ranging from government to public debt to pump cash into the economy and shield it from the pain from a strong yen.     

It last boosted the scheme in October last year and has been standing pat since then, but has expressed its readiness to ease again if Europe's debt crisis and the market fallout threaten Japan's recovery prospects. Many market players expect another expansion in its asset purchases by mid-year. – Reuters