(Recasts, adds stimulus package, fresh quotes)
By Yoko Nishikawa and Leika Kihara
TOKYO, Dec 12 (Reuters) - Japan expanded a fiscal stimulus plan and bolstered a war chest for bank rescues to $131 billion, but kept markets guessing on whether it would intervene to stop a surging yen from pushing the economy deeper into recession.
The abrupt rise in the yen prompted investor speculation that authorities could try to stop the currency's ascent that Finance Minister Shoichi Nakagawa said was undesireable and which he was watching "with great interest".
Also on Friday, Japanese Prime Minister Taro Aso, whose approval ratings have fallen sharply ahead of an election due by September, mapped out wide-ranging tax cuts to combat a deepening recession. He said he still wanted a long-mooted rise in consumption tax to happen in three years time.
The yen strengthened to fewer than 89 per dollar, threatening to further cripple exporters struggling with the worst global downturn in decades that has knocked the United States, Japan and Western Europe into recession.
"Big moves in markets will have undesirable effect on the economy," Nakagawa said. Asked whether Japan will intervene to stop the rise, he said: "I'm not thinking at all about whether or not we would intervene."
Indeed, markets appeared to be overreacting to the failure of a $14 billion U.S. carmaker rescue, said Naoyuki Shinohara, vice finance minister for international affairs, said.
"We will act appropriately depending on the market situation," he told reporters, when asked about the possibility of intervention in currency markets.
Analysts said that if Japan was to intervene, it would likely go it alone, given that the U.S. dollar has been broadly firm against other currencies.
"It has come to the point that Japanese authorities may take some measures, such as the Bank of Japan lowering rates to near zero or increasing the monetary base," said Hiromichi Shirakawa, chief economist at Credit Suisse. "Japanese intervention in the currency market will also be an option."
WOES
Japan's economy sank deeper into recession in the third quarter, fuelling fears that the world's second-largest economy is facing its longest contraction ever combined with a return to deflation.
Japan's Nikkei stock average slid 5.6 percent as the dollar sank to 88.1 yen, its weakest since 1995, while Japanese government bond futures jumped more than a point.
"The worst-case scenario for Japanese authorities is that the yen's appreciation pushes down Japanese share prices which will further aggravate the economy, and they see it happening now," said Masafumi Yamamoto, head of foreign exchange strategy for Japan at RBS.
In the latest plan to boost the economy, the government would increase spending to ease the pain from a worsening job market and cut taxes on purchases of low-emission cars.
It would also strengthen an already announced package of economic measures worth 27 trillion yen ($295 billion), which included 5 trillion yen in new spending and featured payouts to families, tax breaks on mortgages and relief for small firms.
In addition, the government plans to expand its bank rescue scheme to 12 trillion yen ($131 billion) from 2 trillion yen.
Aso also said the government will set up a scheme by March to buy up to 3 trillion yen ($33 billion) in commercial paper through a state-backed lending institution to ease tight funding conditions. A seized-up commercial paper market has forced many companies to boost borrowing from banks at a record pace as they set aside cash at the year-end, when demand for funds increases.
YEN CORPORATE THREAT
The collapse in global demand has forced leading Japanese companies such as Sony and Canon to slash jobs and investments and the yen's strength is threatening to further erode their export earnings.
Japanese car companies Toyota Motor Corp, Nissan Motor Co and other Japanese carmakers have already cut production in the face of sliding car sales globally, and their shares fell more than 10 percent on Friday.
The stocks were hit both by the yen's jump and fears among analysts and auto executives that a bankruptcy of a U.S. auto maker could cause failures at parts suppliers, hurting other automakers.
The U.S. dollar has held ground against other currencies in past months while the yen has been under upward pressure from the unwinding of risky trades financed by the low-yielding Japanese currency, but Friday's move was still a surprise.
"It comes just when sentiment among institutional investors had been starting to calm down, but now it is as if cold water has been poured over their heads," said Kimihiko Tomita, head of foreign exchange at State Street Global Markets. ($1=91.55 Yen) (Writing by Jan Dahinten; Editing by Dayan Candappa)