Scenarios: Japan PM in pinch over ruling party kingpin scandal

TOKYO (Reuters) - A funding scandal ensnaring powerful ruling Democratic Party Secretary-General Ichiro Ozawa is threatening the party's chances of winning a mid-year election for parliament's upper house, risking policy deadlock.

Below are scenarios for how the scandal could play out, and its policy and market implications.

OZAWA STAYS

Ozawa has denied intentionally breaking any laws and vowed to stay in his key post. Some Democrats are trying to persuade voters that the investigation is unfair and critics have suggested prosecutors are targeting Ozawa to foil the reform agenda, which includes a pledge to reduce bureaucrats' clout.

If voters remain unconvinced, they could deprive the Democrats of an outright majority in the upper house.

The main ruling party has a big lower house majority and can force through budgets, but needs the support of two small coalition partners, who differ on policies such as spending and diplomacy, to enact other laws smoothly, since the upper house can delay bills. Without an outright majority, coalition dynamics would continue to complicate policy decisions.

While the ousted Liberal Democratic Party (LDP) seems ill-placed to win a majority, the ruling bloc could lose control of the upper chamber. That would create a parliamentary deadlock and could put on hold efforts to address deep structural problems stemming from Japan's aging, shrinking population.

That situation could, in turn, spark a tug-of-war between the two major parties to attract support from the New Komeito, a former ally of the LDP, or members of smaller groups.

It could also prompt moves for a realignment of party allegiances, possibly but not necessarily along policy lines.

The resulting political jockeying would make policy decisions difficult if not impossible.

OZAWA GOES

Ozawa could step down in the face of the potential damage to the Democrats' election chances, as he did last May when a separate scandal forced him to resign as party leader.

That could deprive the Democrats of their master campaign strategist and risk a power vacuum inside the often fractious party, but some analysts say they are now experienced enough to survive the blow and could regain voter support.

Ozawa would probably want to see Hatoyama stay while he runs the election from the shadows, but his departure could put the premier at risk, given his staunch support for his No.2.

Deputy Prime Minister Naoto Kan, who took over the finance portfolio earlier this month, appears to be the front runner to succeed Hatoyama if he were forced to resign.

Still, if Ozawa waits to step down, damage to voter confidence might be too severe to repair ahead of the election.

POLICY & MARKET IMPLICATIONS

An extra budget for the current year to March 31 aimed at propping up Japan's weak economy seems likely to be passed, but political confusion might stall enactment of the budget for 2010/11, a negative factor for Tokyo share prices.

If the scandal drags out, it could distract policy-makers as they thrash out a medium- to long-term growth strategy for the long stagnant economy. Stock market analysts say investors need to see flesh put on that strategy to help sustain a recent rally.

Japanese government bond prices would face upward pressure if shares fell on scandal woes, but might fall if signs emerged the government might spend more to woo dissatisfied voters despite the country's huge debt. Finance Minister Naoto Kan said on Thursday he was not considering an extra budget for 2010/11 now.

Government pressure on the Bank of Japan to take additional steps to fight the deflation dogging the economy could increase if other policy options are foiled by the political upsets.

If the Democrats fail to win an outright majority in the upper house, continued reliance on their small coalition partners could also increase pressure to spend more.

(Reporting by Linda Sieg; Editing by David Fox)