By Leika Kihara and Yoshifumi Takemoto
TOKYO (Reuters) - Former top financial bureaucrat Toshiro Muto is the leading candidate to become Japan's next central bank governor, suggesting Prime Minister Shinzo Abe's hopes for a more radical policymaker are fading.
Abe will pick a nominee as early as this week, sources close to the process told Reuters. The prime minister said he would make an announcement "soon" on a nominee, who would need to be confirmed by both houses of parliament.
Abe led his party back to power in December with promises of aggressive monetary and fiscal stimulus to lift an economy dogged for years by deflation. He reiterated on Monday that he wanted the new BOJ governor to pursue bold monetary easing.
"I'd like the new BOJ governor to be someone who has the strong determination and ability to pull Japan out of deflation," he told parliament, suggesting that revising a law guaranteeing the central bank's independence was possible if the authority failed to act aggressively enough.
He said buying foreign bonds, considered an extreme measure by many officials, may be one policy option for the BOJ.
"I'd like to reflect the government's determination (of beating deflation) through the nomination, which is likely to be made soon," Abe said.
His push for looser monetary policy prompted the central bank in January to take its boldest action to date, doubling its inflation target to 2 percent and agreeing to an "open ended" asset buying program from 2014.
But some policymakers and government officials worry that radical measures could unsettle financial markets and add to Japan's debt burden, already the highest among industrialized countries.
A sharp yen decline since Abe started pushing for bold BOJ measures has already sparked global concern over Japan's policies, although Tokyo avoided direct criticism in a G20 meeting last weekend.
Ratings agency Standard & Poor's underlined what is at stake for Abe if his policy mix fails. It reaffirmed its AA minus rating with a negative outlook, which means a one-in-three chance of a downgrade in the coming fiscal year.
It will take time to determine if Abe's policies will work, S&P said.
NOT SO RADICAL
Choosing Muto, 69, would suggest the Bank of Japan will intensify stimulus efforts to reflate the economy but also suggest it would refrain from the more radical measures advocated by other candidates.
"The choice of Muto appears to be gaining momentum," said one of the sources familiar with the selection process.
Abe and his advisers have cut the field of final candidates to two or three and have excluded academic and private-sector economists in favour of those with bureaucratic experience, said several people familiar with the process. They declined to be identified because the decision is still pending and discussions remain private.
Many within Abe's ruling party, including Finance Minister Taro Aso, feel the top BOJ job should go to someone with strong management and negotiation skills.
Muto, currently chairman of private think-tank the Daiwa Institute of Research, has long been considered a leading candidate to replace Masaaki Shirakawa, 63, who steps down with his two deputies on March 19.
He has close ties with ruling party lawmakers and past experience steering fiscal and monetary policies. He was the finance ministry's top bureaucrat and served as deputy BOJ governor between 2003 and 2008.
He has said the BOJ has room to boost its government bond purchases to pump more money into the economy.
But Muto has warned that underwriting government debt, or printing money to buy bonds directly from the government instead from the market, could backfire and trigger a sharp spike in bond yields, suggesting he would take a more cautious approach than other candidates.
"Muto is considered as someone who would only follow the traditional approach such as expanding the BOJ's asset buying program. It would merely be an 'enhanced' version of the conventional approach," said Norihiro Fujito, senior investment strategist at Mitsubishi UFJ Morgan Stanley Securities.
"We cannot picture Muto going bold like buying foreign funds, a move that could accelerate yen declines."
Muto may not be at the top of Abe's short list, which includes Asian Development Bank head Haruhiko Kuroda, Japan's former currency tsar, and Kazumasa Iwata, a former government economist who served as deputy BOJ governor alongside Muto.
Like Abe, Iwata has suggested buying foreign bonds is a policy option for the BOJ. He believes it is a step that would keep sharp yen rises in check.
Advocates say that by buying foreign bonds, the BOJ would sell yen for foreign currencies and thus help weaken the yen, giving Japan's exporters a competitive advantage. But doing so would require a revision to a law giving the finance ministry jurisdiction over currency policy and may draw criticism from G20 nations as quasi-currency intervention.
Under Shirakawa's leadership, the central bank has cut interest rates almost to zero and adopted policies that inject cash into the economy. But he has been criticized as having a cautious and gradualistic approach to stimulus.
(Additional reporting by Sumio Ito, Yuko Yoshikawa, Shinji Kitamura and Ayai Tomisawa; Writing by Neil Fullick: Editing by Kim Coghill)