* BOJ should set inflation target - aide to Ozawa
* Need to include Asian currencies in FX reserves - aide (Adds comment, background)
By Yoko Nishikawa
TOKYO, Sept 10 (Reuters) - The Bank of Japan (BOJ) should expand its outright buying of long-term Japanese government bonds (JGB) to help beat deflation, an aide to the ruling party powerbroker challenging Prime Minister Naoto Kan said on Friday.
Tsutomu Okubo, who is helping to form economic policies for the challenger, Ichiro Ozawa, also said Japan should consider ways, such as setting up currency swap agreements, to diversify its massive foreign reserves and include Asian currencies to match its trade weightings.
Ozawa is challenging Kan in the Democratic Party's leadership vote on Sept. 14 that underscores a rift over fiscal priorities as Japan confronts a strong yen and weak economy.
The race is still too close to call but whoever wins will face a raft of policy challenges and a divided parliament that threatens more policy deadlock.
"The BOJ's balance sheet has been shrinking by around 25 percent since its peak in 2005, effectively tightening monetary policy," Okubo told Reuters in an interview. "It should increase its outright buying of long-term government bonds."
Okubo said the BOJ should review its self-imposed rule that the balance of JGBs it holds should not exceed the amount of bank notes in circulation.
The BOJ has consistently defended this rule to avoid the perception that it is directly underwriting government debt.
The BOJ currently buys 21.6 trillion yen ($260 billion) of long-term government bonds outright from the market each year.
While noting that his recommendations have not been authorised by Ozawa, Okubo said the BOJ and the government should set an accord to share policy goals to show resolve to overcome deflation, including setting an inflation target.
ASIAN CURRENCIES IN FX RESERVES
The BOJ held its easy monetary policy unchanged this week after bowing to government pressure to expand its fund supply tool at an emergency meeting last month. It says the current amount of its government bond purchases is appropriate.
Ozawa has said that, given Japan's low interest rates, there is limited room for the BOJ to fix the yen's rise to a 15-year high against the dollar. He has urged authorities to consider currency intervention to stem the yen's strength.
Okubo did not rule out such intervention. But he said the BOJ data, which he obtained, showed the current dollar exchange rate of about 84 yen would be equivalent to 123 yen in 1995, when the dollar fell to a record high of 79.75 yen, as Japan's prices fell by an annualised rate of 0.1 percent over the past 15 years.
"The problem is what has the BOJ been doing over the past 15 years, leaving deflation alone."
Okubo, a former investment banker, said Japan should negotiate with China on allowing Japanese purchases of Chinese bonds, which he said could help curb the yen's surge.
"We should shift the component of our foreign reserves in line with our trade weightings. For that, we should increase Asian currencies," he said, adding that managing high-yielding Asian currency-denominated securities could also boost interest rate income on foreign assets in the reserves.
He added that some dollar assets in the reserves could also be used to help dollar financing of Japanese firms that are seeking to invest in foreign resources via the Japan Bank for International Cooperation, a government-backed agency.
Tokyo does not give a currency breakdown of its $1 trillion foreign reserves, but historical data on currency intervention shows most of them are held in dollars and some are in euros. ($1=83.86 yen) (Editing by Chris Gallagher)