(Updates after announcement)
By Rika Otsuka and Shinichi Saoshiro
TOKYO, May 18 (Reuters) - Moody's Investors Service cut Japan's foreign currency credit rating on Monday, but upgraded local bonds, saying the domestic market was able to absorb new borrowing from the most indebted government in the industrialised world.
Moody's downgraded the foreign currency rating to Aa2 from AAA and raised the domestic debt rating to Aa2 from Aa3. The outlook in both cases was stable.
"Moody's believes the domestic market will absorb the record level of bond issuance this year to fund the government's economic stimulus programme," the agency said in a statement.
"However, the rating also reflects the risks of Japan's high level of debt, which leaves the country's fiscal position vulnerable to shocks or imbalances that would cause a sharp rise in interest rates."
The yen rose against the dollar and the euro after the announcement. It earlier came under pressure when Moody's announced a news briefing, triggering speculation that a downgrade was in the works.
The foreign exchange market has repeatedly been spooked this year by concern that triple-A rated governments such as Japan, the United States and Britain could face credit ratings downgrades as they borrow heavily to spend their way out of recession.
"The move to lower Japan's foreign currency bond rating from Aaa opens the way for speculation about whether Moody's will take similar actions on other triple-A ratings," said Kenro Kawano, senior rates strategist at Credit Suisse in Tokyo.
"Also, with Moody's citing as Japan's strengths its funding ability, it also fuels speculation about a cut to a triple-A rating on a country which cannot fund itself."
Ministry of Finance data on Japanese government bond holders shows foreigners hold only 7.9 percent of the total as of September 2008, while foreign investors hold more than half of tradeable U.S. Treasuries.
Japan's government debt exceeds 150 percent of GDP. The government is planning record bond sales this fiscal year to fund $159 billion stimulus plan, the largest in the country's history. (Additional reporting by Satomi Noguchi in Tokyo and Umesh Desai in Hong Kong ; Writing by Dayan Candappa; Editing by Rodney Joyce)