By Stanley White and Leika Kihara
TOKYO (Reuters) - Japan primed financial markets on Tuesday for currency intervention after the yen tested record highs overnight, signaling it may try to tame the unit with a combination of yen-selling and monetary easing.
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Even as the yen pulled back from Monday's heights, Japanese officials adopted a new, more direct tone, suggesting they were increasingly convinced markets needed a nudge to keep the yen at levels the economy could live with.
The yen traded as high as 76.29 per dollar on the EBS platform on Monday, close to its March peak of 76.25. The currency eased to around 77.40 on Tuesday.
"The yen is being valued stronger than we think ... I'd like to watch currency market conditions especially carefully today," Finance Minister Yoshihiko Noda told parliament.
Reinforcing a sense of urgency, the central bank was likely to ease its already ultra-loose monetary policy if the finance ministry decided to intervene and sell yen, sources familiar with the central bank's thinking told Reuters.
The world's third-biggest economy was plunged into its second recession in three years by the deadly March 11 earthquake and tsunami that wiped out whole coastal communities and killed more than 20,000 people.
Economists and officials have been counting on overseas demand for Japanese goods and reconstruction spending at home to help the economy start growing again later this year.
But the yen's nearly 5 percent surge in the past month, a result of broad dollar weakness fueled by fears of a U.S. credit downgrade, cast doubt over that outlook.
While there's no hard evidence yet that the currency was hurting economic activity and confidence, Japanese exporters, such as Toyota Motor, have been increasingly vocal in the past weeks in their calls for action. Japan's biggest carmaker estimates that every one yen drop in the dollar cuts its annual operating profit by 30 billion yen ($390 million).
A U.S. House of Representatives's vote backing a last-gasp deal to raise the U.S. borrowing limit, a key step in averting a disastrous default, eased some of the pressure on the yen.
But Noda made plain the currency was still too strong for Tokyo's taste. He said he was in discussions with the Bank of Japan and international partners about the yen's strength, which if persisted would hurt several sectors of the Japanese economy.
A government official, speaking on condition of anonymity, told reporters that Tokyo had not yet decided whether to intervene. But markets players were increasingly convinced it was a matter of when, rather than whether, Tokyo would act.
"Japan could intervene in the currency market anytime," said Masamichi Adachi, senior economist at JPMorgan Securities Japan. "The authorities are likely waiting for a good time not in terms of yen's levels but such factors as market liquidity and changes in sentiment."
"Because Finance Minister Noda is the prominent candidate for the next prime minister, he cannot afford to do nothing or request nothing of the BOJ," Adachi added.
BOJ ON STANDBY
Central bank policy loosening would aim to amplify the impact of any intervention, sources familiar with the BOJ thinking said. The central bank is due to hold a regular policy review on August 4-5.
"If there is intervention, there is a strong chance the BOJ will ease policy," said one source, who declined to be identified due to the sensitivity of the matter.
BOJ hopes further easing, likely a move to expand its 10 trillion-yen asset buying program by 5 trillion yen, would also help shore up business confidence threatened by the currency gains, sources said.
Some currency strategists, however, doubted whether Tokyo would risk trying to turn a powerful tide.
Japan last intervened to stem the yen in the aftermath of the March earthquake, when speculation that Japanese investors would sell their overseas assets to fund recovery at home pushed the yen to record highs.
Back in March, Tokyo acted in concert with its Group of Seven peers, but this time most market players believe Japan would have to go it alone given that the yen's gains were mainly driven by investors unsettled by U.S. debt concerns.
Tokyo last acted solo in September 2010, when it returned to currency markets after a six-year hiatus and sold 2.1 trillion yen.
It may seem ironic that Japan, saddled with public debt twice the size of its $5 trillion economy and faced with its biggest rebuilding effort since World War Two, would serve as a safe haven for risk-shy investors.
However, with the euro area mired in its own debt crisis, Japan's deep financial markets make it one of few viable options, market analysts say.
($1 = 76.615 Japanese Yen)
(Writing by Tomasz Janowski; Editing by Nathan Layne and Kim Coghill)