UPDATE 2-Japan econ improving but BOJ on close watch-Shirakawa

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By Natsuko Waki and Naomi Tajitsu

LONDON, May 13 (Reuters) - Japan's economy is showing signs of recovery and is expected to start to stabilise towards the end of this year, but the Bank of Japan is closely monitoring developments, its governor said on Wednesday.

Speaking at an event in London, BOJ Governor Masaaki Shirakawa warned that an "adverse feedback loop" between the financial system and real economy persisted globally and he cautioned against complacency.

The BOJ has slashed its economic forecasts but projected a recovery by early next year in a half-yearly outlook report.

"The Japanese economy literally fell off a cliff... More recently, we have seen some positive signs as industrial production has increased for the first time in six months," Shirakawa said in a speech.

"Although we expect the pace of deterioration in economic conditions to moderate gradually and the economy to start to level out towards the end of the year, we are closely watching developments."

In Japan, bankruptcies and joblessness are on the rise despite the government's $156 billion stimulus package, suggesting that any economic recovery in Japan, in its worst recession since World War Two, could be slow and fragile as pain from the global financial crisis spreads.

Echoing other central bankers who have spoken out against excessive optimism in recent days, Shirakawa said policymakers should be watchful of downside risks.