* BOJ to lend against wider range of municipal bonds
* Policy rate held at 0.1 pct; BOJ warns outlook worsening
* Shirakawa repeats no plan to end cap on JGB holdings
* Govt to unveil new stimulus package on Wednesday
By Leika Kihara
TOKYO, April 7 (Reuters) - The Bank of Japan said on Tuesday it would lend against a wider range of municipal debt in a move to support regional banks reeling from a domestic credit crunch and the worst recession since World War Two.
The central bank left interest rates on hold at 0.1 percent after a two-day policy review and focused on relatively minor moves to ease a credit squeeze on smaller banks and businesses.
The focus is now on fiscal moves to fight the deepening recession in a government stimulus package due on Wednesday, as BOJ Governor Masaaki Shirakawa said the outlook was darkening even more than in the dire forecasts made by the central bank less than three months ago.
"The March tankan showed Japanese corporate profits have decreased further and corporate sentiment has deteriorated significantly, while capital spending has fallen sharply," Shirakawa told a news conference.
Pessimism among Japan's big manufacturers, hurt by diving exports, hit a record low in the BOJ's tankan survey of business confidence issued last week.
Tuesday's announcement amounted to merely tinkering on the margins while the BOJ waits for the government to flesh out a $100 billion economic stimulus plan, analysts said.
Finance Minister Kaoru Yosano said the government would unveil the package on Wednesday, adding that it will have to increase debt issuance to finance the package.
"The BOJ appears to be standing still for the time being to see how measures it has taken so far will play out," said Kyohei Morita, chief economist at Barclays Capital.
The BOJ said it would accept privately placed municipal bonds as collateral. It has previously shunned the bonds, held mostly by small regional banks, because of poor liquidity and accepted only municipal bonds sold in public auctions.
The new measure adds about 4-5 trillion yen ($32-40 billion) of illiquid municipal bonds to the range of collateral the BOJ is willing to accept, which now amounts to around 110 trillion yen.
"The BOJ's move to widen the collateral it accepts is a preemptive action to help get credit flowing through regional banks," said Mari Iwashita, chief market economist at Daiwa Securities SMBC.
The BOJ moved closer to quantitative easing last month when it unveiled plans to expand by almost 30 percent its buying of Japanese government bonds. Shirakawa repeated on Tuesday he had no plan to raise this further.
The following is a link to a graphic on the BOJ's balance sheet and benchmark interest rates: http://graphics.thomsonreuters.com/apr09/JP_BOJ0409.jpg
LENDING TWEAK
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 accepting more municipal bonds would give some support to banks having problems in their funding, it is unlikely to unleash a flood of lending to hardpressed businesses, analysts said.
"Banks are more concerned about the higher credit costs that may arise from lending to small and medium-sized companies in this deteriorating credit environment, so the BOJ's decision to expand accepted collateral is unlikely to change their reluctance to lend," said Jun Oishi, a regional bank analyst at Fox Pitt Kelton Cochran Caronia Waller in Tokyo.
The BOJ has bought corporate debt from banks, offered subordinated loans to them and increased its purchases of government bonds.
The last move would effectively help to cap long-term interest rates, particularly at a time when the government must rely on borrowing to finance much of the $100 billion stimulus plan, although Shikarawa has said its bond buying is not meant to support the bond market.
"The problem is not the BOJ, the problem is that the politicians have not pushed reform," said Jesper Koll, CEO of investment consultancy Tantallon Research Japan.
"This (planned stimulus package) is the first time they are actively doing something."
Bond yields have risen on worries about bond oversupply as the government announced its plan on Monday for a new stimulus package worth more than 2 percent of GDP.
The benchmark 10-year government bond yield stood dipped to 1.425 percent on Tuesday after touching a 4-½ month high of 1.475 percent the previous day.
While the BOJ moves 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.
The BOJ repeated that Japan's economy is worsening but said exports and output were likely to pull out of a steep dive.
Japan's economy shrank 3.2 percent in October-December, the fastest pace since the 1974 oil crisis. It is likely to keep shrinking in the first half of this year, economists say, running up a record five quarters of contraction. ($1=100.60 Yen) (Additional reporting by Tetsushi Kajimoto, Editing by Dayan Candappa and Michael Watson)