* BOJ upgrades economic assessment; keeps rates on hold
* BOJ Gov Shirakawa says Japan economy no longer in freefall
* Central bank sees export, output declines levelling out
* To accept foreign debt as collateral to ease funding crunch (Adds details)
By Stanley White and Hideyuki Sano
TOKYO, May 22 (Reuters) - The Bank of Japan upgraded its assessment of the economy for the first time in three years on Friday, saying a rebound in global demand could mean the record contraction last quarter was the worst of the recession.
The BOJ also said it would start accepting foreign bonds as collateral for loans to ease strains on the banking system, but analysts said its more upbeat tone on the economy suggested it may put any plans to return to full quantitative easing on hold.
The bank kept interest rates on hold at 0.1 percent, having cut it twice since the collapse of Lehman Brothers in September triggered a financial firestorm that pushed the global economy into meltdown.
"There have been expressions like free-falling or cliff-diving. We are no longer in that sort of situation," BOJ Governor Masaaki Shirakawa said after a two-day policy meeting
"The economy has been moving in line with the projection we made in the outlook report" in April, Shirakawa told a news conference.
That report predicted the world's second-largest economy would slowly recover later in 2009 amid an expected pickup in the global economy.
Shirakawa said gross domestic product (GDP) would improve sharply in the second quarter, but did not elaborate. Economists polled by Reuters last week predicted growth of 0.1 percent for the current quarter if global demand for Japanese exports starts to improve.
In the past few months, some signs have emerged that the global economy is stabilising, with steep declines in Japanese exports leveling out and industrial output rising 1.6 percent, the first gain in six months.
Shirakawa said the recent uptick in demand was mainly due to companies replenishing depleted inventories, and it was too early to tell if there would be a sustained recovery in consumer spending, which is essential for a global recovery.
"The key is how strong final demand will be after inventory adjustments are over. But there is a lot of uncertainty over this point. So we will carefully watch downside risks," he said.
"Thus, we think consumption and capital spending will be weak for the time being."
For a graphic of Japan's export and output trends, click: http://graphics.thomsonreuters.com/059/JP_BOJ10509.jpg
Data this week showed Japan's economy shrank by a record 4.0 percent in January-March as a plunge in demand for Japanese goods from cars to flat-screen TVs prompted firms to slash capital spending, damping the domestic economy.
POLICY PAUSE?
The BOJ moves on Friday, which had been widely expected, echoed more upbeat assessments of the recession-hit global economy by a chorus of other policymakers around the world in recent weeks who are pinning their hopes on tentative signs of recovery.
World Bank President Robert Zoellick said on Monday the global downturn was abating and growth could resume this year or next and the Organisation for Economic Cooperation and Development said on Fruday the "free fall" was over.
But the Federal Reserve, in minutes released from its April policy meeting, cut its outlook for U.S. growth over the next three years and said a full recovery could take 5 or 6 years.
Like the Fed, the BOJ has been buying government bonds, corporate debt and other assets to revive bank lending that collapsed during the financial crisis.
The BOJ said on Friday it would expand the range of collateral it takes for its market operations to include U.S., UK, German and French sovereign debt, indicating it was still concerned about Japanese banks' ability to raise funds as credit markets remain tight.
"Accepting foreign bonds as collateral is a way to refrain from buying more Japanese government bonds. There's some speculation that the BOJ may go for quantitative easing and purchase more JGBs, but money supply is already increasing, and the BOJ is unlikely to go that far," said Seiji Adachi, senior economist at Deutsche Securities in Tokyo.
Despite the moves to buy assets, BOJ officials have said they were not ready to return to quantitative easing, a controversial policy Japan used between 2001 and 2006 to flood the banking system with cash to pull the economy out of a decade of deflation.
Shirakawa said there were signs that the pace of bank lending growth has accelerated, but companies with lower credit ratings were still struggling to get funds.
The central bank did not announce any changes to its forecasts for growth or other key indicators, or mention if its less bearish outlook had affected its views on whether it should buy more Japanese government bonds.
In April it predicted the economy would contract 3.1 percent in the year to March 2010, down from January's forecast of a 2 percent slump, and said core consumer prices would fall 1.5 percent, taking Japan deeper into deflation than earlier thought.
(To read the BOJ statements on policy and collateral guidelines, click and for all news on Japan's economy RTRS-LEN-
(Writing by Kim Coghill; Editing by Neil Fullick)