(For more stories on the Japanese economy, click [ID:nECONJP])

* BOJ governor still gloomy about Japan’s economy

* Shirakawa warns of severe financial conditions

* BOJ cuts views on seven of Japan’s nine regions

* Some regions say inventory cuts may halt output drop

* Govt upgrades view on consumer confidence

By Leika Kihara

TOKYO, April 17 (Reuters) – Japan’s economy will continue to worsen as consumption weakens and companies slash capital spending, the governor of the Bank of Japan said, adding that he was watching how falls in share prices could hurt the nation’s financial system.

Japanese banks, facing losses when they report earnings in the coming weeks, are large holders of shares and the central bank fears a sliding stock market will force them to cut lending, further hurting an economy in its worst recession since World War Two.

“Commercial paper and corporate bond issuance is improving. But Japan’s financial environment remains severe as a whole with more companies, regardless of their size, saying funding conditions and banks’ lending attitude are severe,” BOJ Governor Masaaki Shirakawa told the bank’s regional branch managers in a speech on Friday.

Japan’s economy shrank 3.2 percent in the last quarter, the fastest contraction since the 1974 oil crisis. It is likely to keep shrinking for the first half of this year, economists say, running up a record five quarters of contraction.

Illustrating the pain, the BOJ cut its view in its regional report on seven of the nation’s nine regions, saying economic conditions have been deteriorating significantly, although there were slight regional differences.

BRIGHT SIGNS?

In a sign Japan’s worst recession in decades may be moderating, however, some regions reported production shows some signs of stopping falling thanks to progress in inventory adjustments. The Kinki region of western Japan reported that an increase in inventories was levelling off.

Hideo Hayakawa, an executive director who heads the BOJ’s branch office in the western city of Osaka, home to many electronics manufacturers, said there were signs the region’s production and exports are brighter.

“I expect production to stop falling sometime between spring and the middle of this year,” Hayakawa told a news conference.

The government upgraded its assessment of consumer confidence on Friday after releasing figures showing it rose in March from a record low three months earlier. [ID:nTKU103369]

But analysts shrugged off signs of optimism.

“It doesn’t mean something is turning better,” said Kyohei Morita, chief economist Japan at Barclays Capital, adding that hefty cuts in production will put downward pressure on jobs and income conditions and household spending.

“The government data only showed the speed of deterioration in consumer confidence has slowed. As for production, companies will have no choice but to depend on demand from China as they have no driving force to boost output here in Japan.”

The BOJ has cut rates twice since October to cushion the economy from the shock of the global financial crisis triggered by the collapse of the U.S. mortgage market in 2007.

It has also moved to prevent credit to companies from drying up after Western bank failures spooked Japanese lenders and bankruptcies in the country soared as an export slump slashed sales and profits.

While the measures have allowed funding to flow to big firms, many smaller firms remain strapped for cash as banks hesitate to take on risk. Companies surveyed in the BOJ’s March tankan survey of corporate sentiment said funding in the market was at its tightest ever. [ID:nT189222]

The central bank is set to cut its growth forecasts when it releases its twice-yearly economic and price outlook report on April 30. At the policy meeting, it is widely expected to keep interest rates on hold at 0.1 percent.

But some analysts say the BOJ could do more in the future to ease the pain from the global credit crisis, such as increasing further its purchase of government bonds. (Editing by Michael Watson)