Japan's central bank said in its monthly report that the prospects for a sustained economic recovery remained bright on Friday as a Japanese hostage crisis in Iraq ruffled local financial markets.
The yen and Japanese share prices slumped after news that militants in Iraq had taken hostage of three Japanese civilians and were threatening to kill them unless Tokyo withdraws its troops from the war-torn country within days.
But the central Bank of Japan (BoJ) said it would take no immediate stimulative action and would remain calm despite the crisis as it released the glowing report on the outlook for the world's second largest economy.
"I have always considered geopolitical risks a risk factor for the sustainability of a Japanese economic recovery," BoJ governor Toshihiko Fukui said.
"This unfortunate incident made me deeply realize that geopolitical risks have not decreased. The financial markets showed their strength to absorb the shock [on Friday] but we will continue watching."
The Arab satellite television station Al-Jazeera aired a video of two Japanese men and a woman, surrounded by armed men who warned Tokyo they would be burned alive unless Japan pulled its 550 troops out of Iraq. The soldiers have been there on humanitarian duties since the start of the year.
Prime Minister Junichiro Koizumi said on Friday Japan would not give in to the terrorists' threat.
The hostage crisis hurt financial markets with the Japanese yen falling early in the day before steadying and the Tokyo Stock Exchange's benchmark Nikkei-225 index staying down after slumping on opening.
The yen weakened to 106.78 against the dollar in early local trading before recovering to 106.34 in late in the afternoon while the Nikkei-225 shed 1.61 percent to close the day at 11,897.51 points.
In contrast, Japanese government bond prices closed higher as geopolitical concerns prompted a flight to safety, with the yield of the benchmark 10-year 1.5 percent bond falling to 1.485 percent from 1.490 percent on Thursday.
Forex market traders also played down the long-term impact of the Japanese hostage crisis in Iraq.
"The hostage crisis is unlike a massive terror attack on Tokyo that would have caused direct damage to the economy and raised scepticism about government," said Hideyuki Tsukamoto, manager at Mizuho Bank.
In the monthly report, the BoJ, for the first time in the current expansive business cycle, said domestic demand was gaining strength on booming exports to Asia.
"Japan's economy continues to recover gradually and domestic demand is becoming firmer," the bank said in its April report on recent economic and financial developments.
"Corporate profits continue to increase, and improvements in business sentiment have been spreading across industries."
Going forward, the central bank predicted Japan's economy would "gain further momentum gradually as it continues to recover moderately for the time being."
The BoJ was also increasingly optimistic about the labor market, which had been stagnant as deflation squeezed corporate profits and sparked layoffs, although the scale of year-on-year retail price drops was shrinking.
"Although firms are determined to continue restraining their labor costs, the increases in production and corporate profits are expected to exert positive effects gradually on employment and income situations," the bank said.
The bank, however, remained cautious about the exodus out of the deflationary cycle.
Its policy board voted unanimously to leave its stimulus monetary policy unchanged after a two-day scheduled meeting.
The BoJ has been fighting deflation and supporting Japan's export-led recovery by securing ample supplies in the short-term money market, repeatedly saying it will continue to take all possible action to ensure a sustained recovery despite bright prospects.
"The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the bank at around 30 to 35 trillion yen (US$282 to US$329 billion)," the bank said.
It was the fourth time in a row the BoJ has left its monetary policy unchanged. The bank last increased the upper limit of market operations on Jan. 20 as part of easy credit policy.
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