(For more stories on the Japanese economy, click)
* Moody's foreign currency and domestic rating now Aa2
* Moody's says rating reflects indebtedness, recession
* Yen initially gains after falling on downgrade speculation
* Action raises questions about other triple-As - analyst
By Rika Otsuka and Shinichi Saoshiro
TOKYO, May 18 (Reuters) - Moody's Investors Service stripped the Japanese government of its last triple-A foreign currency credit rating on Monday in a move that could revive market speculation about the creditworthiness of other rich nations, especially the United States.
The two-notch downgrade to Aa2 from Aaa was a token censure for Japan which has almost no foreign currency debt exposure.
Moody's upgraded Tokyo's local currency rating to Aa2 from Aa3 saying the domestic bond market was able to cope with government plans for new borrowing.
The agency described the move as a largely technical one but also said Japan was in a worse situation than many other governments in its top ratings bracket.
"We know there are challenges in Japan. That's why we don't think Japan is an Aaa," said Thomas Byrne, senior vice president for Moody's in Singapore.
"We think that the two-notch differential between the triple-As such as the U.S., France and Germany are warranted," he told a news conference in Tokyo.
While Byrne played up the differences with other major economies, the widespread increase in debt issuance to fund massive stimulus spending and combat recession led others to see parallels with countries such as the United States.
"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 held only 7.9 percent of the total as of September 2008, while foreign investors held more than half of tradeable U.S. Treasuries.
The value of outstanding Japanese government debt is more than 170 percent of gross domestic product, making it the most indebted government in the Organisation for Economic Co-operation and Development, a club of industrialised nations.
The debt burden is a legacy of massive government spending to cushion the economy during a decade of deflation that began in the 1990s.
MORE BONDS
The government is selling even more bonds to fund a record $159 billion stimulus plan designed to pull the economy out of its steepest recession ever. Moody's said the domestic market for Japanese government bonds could absorb the new issuance.
"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.
While the government is deep in debt, Japan is a creditor nation with a pool of around $15 trillion in savings. Japan's last foreign currency bonds were retired in 1983, according to the Ministry of Finance.
Still, Moody's cited the level of debt, the expansion of government spending and the crumbling economy as reasons for its new rating.
"Given the size of Japan's overall public deficit it obviously should not enjoy the highest rating. Japan has fiscal obligations which will span generations but it is certainly not a dire outlook," Glenn Maguire, economist at Societe Generale in Hong Kong.
"The level of savings and forex reserves provide a significant buffer against any further downgrades on Japan's domestic debt."
The Japanese government bond market largely shrugged off the news, taking its cue from falling share prices. Moody's was the last of the three international ratings agencies to strip Japan of its triple-A rating. Fitch Ratings and Standard & Poor's both rate Japan's foreign debt at AA, the third highest level.
The yen initially climbed after the announcement, with some speculation beforehand that Moody's had called a briefing for a downgrade. It rose to 94.80 per dollar and 127.68 per euro from 95 and 127.92 respectively, but later reversed course, falling to 95.70 per dollar and 128.90 per euro.
Foreign exchange markets have repeatedly been spooked this year by speculation that the United States, once considered the world's safest borrower, could lose its AAA rating.
Outstanding U.S. Treasury debt was $5.9 trillion at end-2008 having ballooned 55 percent since 2003, according to the Securities Industry and Financial Markets Association.
A former U.S. government official's remarks in the Financial Times that Washington's rating was at risk helped push the dollar index, a measure of the currency's performance against six peers, to a four-month low last week. (Additional reporting by Satomi Noguchi in Tokyo and Kevin Plumberg and Umesh Desai in Hong Kong; Writing by Dayan Candappa; Editing by Rodney Joyce)