By Leika Kihara
TOKYO (Reuters) - The Bank of Japan will likely maintain its view the export-reliant economy is expanding moderately but warn of heightening overseas risks at next week's rate review, sources say, as China's slowdown and trade tension cloud the outlook.
Factories across the globe slammed on the brakes last month as demand was hit by the U.S.-China trade war, slowing global growth and political uncertainty in Europe ahead of Britain's departure from the European Union.
Such weak signs have forced major central banks to pause in raising interest rates and cast doubt on the BOJ's repeatedly-stated assessment that overseas economies "continue to grow steadily".
Japanese policymakers were caught off guard by the unexpectedly big hit from softening Chinese demand. In January, Japan's exports suffered their biggest decline in more than two years and factory output fell the most in a year as China-bound shipments tumbled.
Many in the BOJ expect Japan's economy to emerge from the current soft patch in the second half of this year, when Beijing's stimulus plans could lift Chinese demand and underpin global growth, say sources familiar with the central bank's thinking.
The BOJ is thus likely to maintain its assessment that Japan's economy "continues to expand moderately," though it may slightly modify the language to reflect heightening external risks, the sources say.
"Underlying data points to weakening growth that is hard to dismiss," one of the sources said.
"But the BOJ needs to look more at upcoming data to judge whether the weakness would persist," the source said on condition of anonymity, a view echoed by three other sources.
Any change in the BOJ's economic assessment likely won't trigger an immediate monetary easing, as risks to the outlook have not heightened enough to top up an already massive stimulus programme, the sources said.
At the two-day rate review ending on March 15, the BOJ is widely expected to keep unchanged its pledge to guide short-term interest rates at minus 0.1 percent and the 10-year government bond yield around zero percent.
Nodding to heightening uncertainty, the sources said, the BOJ may offer a bleaker view of the global economy than in January, when the central bank said it continued to grow steadily.
The central bank is also seen cutting its view on exports and output from the current assessment, which is that they are "increasing as a trend", they said.
The BOJ faces a dilemma. Years of heavy money printing have dried up market liquidity and hurt commercial banks' profits, stoking concern over the rising risks of prolonged easing.
And yet, subdued inflation has left the BOJ well behind other major central banks in dialling back crisis-mode policies, leaving it with little ammunition to battle the next recession.
Growing gloom over the global economy adds to the BOJ's woes, as domestic demand could lose steam when a sales tax hike planned for October hits consumers.
Former BOJ deputy governor Hirohide Yamaguchi, who retains close contact with policymakers, warns that rising global uncertainties could push Japan into recession and force the central bank to ramp up stimulus.
Given its dwindling ammunition, however, the central bank won't react immediately to small changes in the economy, he said.
"It will act only when the economy is hit by a severe downturn, and when the momentum for hitting its price target is broken," Yamaguchi told Reuters.
(Reporting by Leika Kihara; Editing by Richard Borsuk)