FACTBOX: New Japan govt faces tough short-term challenges

Thu Oct 8, 2009 4:16am EDT

By Linda Sieg

TOKYO (Reuters) - Japan's three-week-old government faces a rising yen, a central bank looking to unwind some of its financial crisis funding measures and a fiscal time bomb -- all with the economy teetering between recession and modest growth.

Investors watching Japan must also factor in uncertainty over who decides what in Prime Minister Yukio Hatoyama's novice cabinet while eyeing an upper house election next year.

A loss by the Democratic Party-led ruling bloc in the poll would re-create the parliamentary deadlock that stymied policy under the past three short-lived administrations. Below are challenges the government faces and the policy risks that could result.

COALITION HEADACHES, POLICY GAPS

Despite a huge majority in parliament's powerful lower house, the Democrats must put up, for now, with two tiny partners whose backing is needed in the upper house to enact bills smoothly.

People's New Party chief Shizuka Kamei, a harsh critic of bare-knuckles capitalism, has already upset financial markets with a proposal for a loan moratorium to aid small firms, while gaps on security policies with the pacifist Social Democrats are another Achilles heel.

The partners' influence will be weakened if the Democrats win two upper house by-elections on October 25, but Hatoyama will probably have to wait to see if his party wins a majority on its own in a mid-2010 poll for the chamber before dumping the duo.

STRONG YEN, BUT HOW STRONG?

Forex markets were jolted when Finance Minister Hirohisa Fujii appeared to contradict himself with comments that first appeared to favor a strong yen and then to backpedal by hinting at intervention after markets sent the yen soaring.

Analysts say, however, that Fujii has been consistent in saying that as a general principle currency rates should not be moved artificially, while his comments that a strong yen is "basically" good for Japan echoes the government's desire to wean Japan from export-dependence in the longer term.

Still, the new government appears reluctant to see the yen soar too quickly and endanger Japan's fragile, export-led recovery, so authorities could well intervene if the currency moves too far, too fast. Picking a level that would trigger intervention is tricky, though, because the speed of moves would probably be as, or more, important as absolute levels.

EXIT STRATEGY DELAY?

Market players must also ponder the possibility of government pressure on the central bank to delay phasing out emergency steps to support corporate funding.

Kamei this week engaged in blatant jawboning against the Bank of Japan (BOJ). While analysts say his heavy hand probably does not represent government policy, Fujii seems to have sent a similar if more subtle message.

Analysts generally expect the central bank to let some steps expire by the end of the year, and whether the BOJ would let itself be swayed by government pressure is an open question.

Government jawboning has been known to prompt the BOJ to act in the past just to demonstrate its independence.

FUNDING WOES, ECONOMY RISK

Experts worry the government will have to add to Japan's already huge public debt to finance programs aimed at putting more money in the hands of consumers.

Cabinet ministers have so far identified about 2.5 trillion yen worth of projects that can be frozen or canceled in an already-enacted 14 trillion yen extra budget for the year to March 31, so the funds can be used to help pay for new programs worth 7.1 trillion yen in the next fiscal year.

But analysts say the government will probably need to issue more debt to cover falling tax revenues due to Japan's worst recession in 60 years, from which the economy is just now emerging, and may need to borrow as well to fund pet projects.

Hatoyama may also come under pressure to craft new steps to prevent the economy from slipping back.

The funding pinch could force Hatoyama to delay or even scrap some promised steps when the government drafts the budget for 2010/11, starting next April 1, disappointing voters. Analysts say a public backlash could be limited if he gives a convincing explanation.

POLITICAL FUNDING SCANDALS

Prosecutors have begun questioning people incorrectly listed as donors to Hatoyama in his funding reports, Japanese media say.

Hatoyama has admitted that an aide filed false reports, but said the funds came from his personal accounts.

Political analysts say the impact of the scandal depends largely on whether further damaging details emerge and whether prosecutors decide to press charges, both of which could at a minimum distract the government from urgent policy matters.

Hatoyama took over as party leader in May after predecessor Ichiro Ozawa resigned over another funding scandal. Fresh revelations in that affair could jolt the party since Ozawa retains hefty clout in his current position as secretary-general.