The move underscored the view that the BOJ will keep monetary settings unchanged next week, barring any fresh bout of volatility in global financial markets.

BOJ Governor Masaaki Shirakawa warned that Europe's debt crisis remained the biggest risk to Japan's economy and could potentially affect its financial system, signaling readiness to act if any market turmoil threatens the fragile recovery.

But he stuck to the BOJ view that the world's third-largest economy is on the mend as exports and factory output pick up, suggesting that the central bank sees little need to offer the economy additional stimulus for now.

"Global financial markets remain jittery over worries about Europe's debt problem, so we need to keep a close eye out for the time being," Shirakawa said in a speech to a quarterly meeting of the BOJ's regional branch managers on Thursday.

"Japan's economy, for its part, is gradually starting to pick up on firm domestic demand due to reconstruction spending."

In a sign the positive momentum was broadening, the central bank revised up its assessment for all nine regions of the economy in a quarterly report, the first time it has done so since October 2009.

"Many regions said their economies have been recovering moderately or picking up," the central bank said in the report, which was issued at the meeting of regional branch managers.

Convinced of Japan's recovery prospects, the BOJ is expected to hold off on easing monetary policy next week unless Europe's debt crisis or Friday's U.S. payrolls data trigger a sudden spike in the safe-haven yen, sources familiar with its thinking say.

RECOVERY FRAGILE

Japan's economy is expected to outperform most of its G7 peers this year with growth of around 2 percent, helped by reconstruction spending.

While slowing growth in big markets like China clouds the outlook, the pain has been limited so far with Monday's tankan survey showing that companies were more upbeat about business conditions and planned to increase capital expenditure.

That gives the BOJ some breathing space after having eased monetary policy in February and April to show its determination to beat deflation that has plagued Japan for more than a decade.

But any recovery will likely be fragile.

Most regions in Japan are relying on temporary support from reconstruction and solid domestic car demand, which is being driven mostly by government subsidies that are set to expire soon.

Japanese manufacturing activity shrank in June for the first time in seven months, a survey showed lsat week, in a sign that the boost to the economy from rebuilding is starting to wane.

Growth in the Kinki western Japan region, home to electronic giants like Panasonic which are vulnerable to slowing global demand and a strong yen, remained stagnant despite some signs of pickup, the BOJ said in the quarterly report, warning that exports and output have yet to pull out of the doldrums.

"We're seeing some signs of pickup in the IT and electronic industries, but conditions remain severe," Masayoshi Amamiya, Osaka branch head who oversees the region, told a news conference.

"What's most important is for global growth to pick up and the key risk to this is developments in Europe," he said.

(Editing by Eric Meijer & Kim Coghill)

• A Permanent Economic Emergency