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 with Prime Minister Shinzo Abe to pick a nominee as early as this week, sources close to the process told Reuters.
The choice of Muto, 69, would suggest the Bank of Japan will intensify stimulus efforts to reflate the economy, which has struggled with deflation for years, but refrain from the more radical measures advocated by other candidates.
Some policymakers and government officials worry that radical measures could unsettle markets. A sharp yen decline since Abe started pushing for bold BOJ measures has already sparked global criticism of Japan's policies.
"The choice of Muto appears to be gaining momentum," said one of the sources familiar with the selection process. Still, Muto's selection is not a done deal given the political maneuvering needed to ensure parliamentary approval.
Abe and his advisers have cut the field of final candidates to two or three and have excluded academic and private-sector economists in favor 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.
Muto 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, having moved up the ranks of the powerful finance ministry and serving as deputy BOJ governor between 2003 and 2008.
Japan's Nikkei stock average <.N225> fell on Friday and the yen rose when Reuters first reported Muto was the front-runner, as investors scaled back expectations of aggressive monetary easing given his relatively more moderate views compared with 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."
Abe, who led his party back to power in December with promises of aggressive monetary and fiscal stimulus, has said he wanted the new BOJ governor to pursue bold monetary easing.
That gave rise to the view he may choose dark-horse candidates from academia who have advocated unorthodox policy measures, such as economics professor Kikuo Iwata. It also pushed the yen lower and boosted the stock market on the prospects for exporters to benefit from the weaker currency.
But 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.
The prime minister's short-list 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.
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.
After intense pressure from Abe, the central bank agreed last month to its boldest measures yet. It doubled its inflation target to 2 percent and promised to adopt "open ended" asset buying from next year to achieve it.
OPPOSITION SUPPORT KEY
Abe will need the approval of both houses of parliament for his nomination. His Liberal Democratic Party (LDP) lacks a majority in the upper house, so needs the cooperation of opposition parties.
The biggest opposition party, the Democratic Party of Japan (DPJ), has indicated it would support a former bureaucrat like Muto, but has given the LDP no assurances it will cooperate. Some fringe parties, on the other hand, have opposed the idea of selecting a former financial bureaucrat.
Muto has said the BOJ has room to boost government bond purchases to pump more money into the economy. But he has also warned that printing money to finance public debt could backfire and trigger a sharp bond yield spike, suggesting he will take a more cautious approach than other candidates.
Muto has also played down the idea advocated by some lawmakers that the central bank should buy foreign bonds to curb the strength of the yen.
Currently chairman of private think-tank the Daiwa Institute of Research, Muto was the Ministry of Finance's top bureaucrat. He was nominated to head the BOJ by the LDP in 2008, but his candidacy was struck down due to opposition by the DPJ.
Abe's push for more aggressive BOJ action has driven the yen to three-year lows and pushed the stock market to its highest levels since late 2008.
(Additional reporting by Sumio Ito, Yuko Yoshikawa, Shinji Kitamura and Ayai Tomisawa, writing by Leika Kihara and Tomasz Janowski; Editing by Neil Fullick and Dean Yates)