Japan's economy grew 1.2 percent in the first quarter, the biggest expansion in three quarters, on stimulus-driven consumption and solid exports to Asia, but market turmoil from the European debt crisis clouded the outlook.

The expansion in gross domestic product (GDP) translates into an annualized increase of 4.9 percent, smaller than a median market forecast of 5.4 percent but above the 3.2 percent growth in the United States.

The upbeat data will be some relief to the Bank of Japan, which is considering drawing up a new loan scheme to encourage banks to lend more to industries with growth potential in what it describes as a long-term approach to beat deflation.

The figures clearly indicate that the Japanese economy is recovering on the back of the expansion in exports, mainly to Asia, said Azusa Kato, an economist at BNP Paribas.

As long as the Asian economy holds steady, some decline in exports to Europe won't hurt very much, though it would be a different story if those problems started causing turmoil in financial markets and a plunge in European and U.S. stocks.

Finance Minister Naoto Kan said financial market developments and deflation remained risks to Japan's economy, which continues to pick up.

Japan is still in moderate deflation, Kan told reporters after the data release. I hope the Bank of Japan guides monetary policy appropriately and flexibly, he said.

The Bank of Japan concludes a two-day policy-setting meeting on Friday.

Private consumption, which makes up about 60 percent of the economy, grew 0.3 percent, Cabinet Office data showed on Thursday, partly due to a rush in demand for flat-screen televisions ahead of a change in April in a government incentive scheme for low-emission electronic goods.

The economy also benefited from strong growth in Asia, with external demand contributing 0.7 percentage point to GDP.

Solid exports to Asia have helped Japan's economy recover gradually after pulling out of recession in the second quarter of last year.

But analysts expect growth to slow in the coming months as the effect of government stimulus measures on consumption begins to fade. The European debt crisis and the ensuing market turmoil may also hurt overseas growth, and therefore Japanese exports.

The risk is in exports. Incomes and operating rates are rising because of strong exports, said Yasuo Yamamoto, a senior economist at Mizuho Research Institute.

If problems in the eurozone start to hurt overseas economies, then Japan will be affected.

The euro swung from a four-year low against the dollar to a session high on Wednesday in volatile trading as investors debated how a German ban on naked short selling of some securities will ultimately impact markets.

(Additional reporting by Leika Kihara, Hideyuki Sano; Editing by Charlotte Cooper)