(For more stories on Japanese politics click [ID:nPOLJP])
* Slide in ratings threatened ruling party ahead of polls
* Finance minister Kan, fiscal conservative, likely successor
* Yen slips but market reaction mostly muted
* Election outlook could improve, but unclear how much (Updates paragraph 14 to say cabinet to be formed on Friday)
By Linda Sieg and Chisa Fujioka
TOKYO, June 2 Japanese Prime Minister Yukio Hatoyama and his powerful ruling party No. 2 quit on Wednesday to try to boost the party's fortunes in an election next month, less than a year after sweeping to power with promises of change.
The political turmoil could delay efforts to thrash out plans set to be announced this month to cut the country's public debt, which stands at about 200 percent of GDP, and a strategy to engineer economic growth in an ageing society.
But if, as many expect, fiscally conservative Finance Minister Naoto Kan takes the helm, that could raise the chances of bolder steps to rein in debt, including a pledge to consider raising the 5 percent sales tax.
Hatoyama's Democratic Party of Japan (DPJ) made history with a landslide election win last year, promising to change how Japan is governed after more than 50 years of cosy ties among bureaucrats, companies and lawmakers under the Liberal Democrats.
But after eight months of indecision and broken promises, the 63-year-old Hatoyama -- nicknamed "The Alien" for his quirky comments -- bowed to pressure from his party to quit ahead of an election for the upper house of parliament expected in July. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Graphic on Japan voter support: r.reuters.com/myv63g
Graphic on voting intentions: link.reuters.com/jev83j
For more stories on Japanese politics click [ID:nPOLJP]
Reuters Insider TV on PM quits: link.reuters.com/jaq67k
Reuters Insider TV on foreigners' Japan holdings may fall:
An election loss would not oust the DPJ-led government given its majority in the more powerful lower house, but the ruling bloc needs a majority to keep legislation from being stalled.
With tears in his eyes, Hatoyama told party lawmakers he and party secretary-general Ichiro Ozawa would resign.
Hatoyama said later that, without public support, the government could not meet its goals.
"So I decided that my resignation would serve this country's interests," Hatoyama, who becomes Japan's fourth leader to quit in less than three years, told reporters.
Hatoyama's ratings had nosedived because of voter doubts about his leadership. Ozawa's image as an old-style powerbroker pulling strings behind the scenes also eroded public support.
FINANCE MINISTER KAN NEXT?
Kan, seen as the frontrunner to replace Hatoyama, told reporters he would run in a vote among DPJ lawmakers on Friday.
"Unfortunately there wasn't enough time under prime minister Hatoyama to meet the expectations the people had when they voted for us last autumn, so I want to keep trying," he said.
No other candidates have yet raised their hands, although Kan's victory would not be a done deal if the still-powerful Ozawa backed someone else.
A new cabinet will then be formed on the same day, a DPJ official said, quicker than many had thought.
The yen JPY= slipped after the resignations but financial market reaction was mostly muted given the slim chance of radical economic policy shifts, persistent uncertainty about the election outcome and a deep sense of deja vu after another premier quit.
The likely selection of Kan, who made his name battling bureaucrats during a stint as health minister, would be welcomed by investors and voters worried about Japan's public debt, although lawmakers up for re-election will probably be cautious.
"Whether he gets his way at this juncture is hard to tell," said Koichi Nakano, a Sophia University professor.
The short-tempered Kan has in the past pressed the Bank of Japan to do more to fight deflation and been positive about raising the 5 percent sales tax in the future to fund bulging social welfare costs.
"If finance minister Kan takes over, it would be welcome news for the JGB market because Kan is more proactive about fiscal discipline and about raising the consumption tax than any other cabinet minister," said Hirokata Kusaba, economist at Mizuho Research Institute.
Kan surprised markets earlier this year by saying he wanted the yen to weaken more and that most businesses were in favour of a dollar/yen rate around 95 yen. Since then he has mostly toed the ministry line that stable currencies are desirable and markets should set foreign exchange levels.
The Bank of Japan, which wants a credible government plan to rein in the huge public debt, is worried a policy stalemate will delay fiscal reform. But the political vacuum will give the central bank breathing space and ease government pressure for more action on deflation, at least until after the election.
Some analysts said the change of the party's top two leaders would give the Democrats a boost before the election, but most expect the party and its small ally, the New People's Party, still to fall short of a majority in the lower house.
"A big reason for the falling support was the Hatoyama-Ozawa duo," said Tsuneo Watanabe, a senior fellow at the Tokyo Foundation think tank. "Now that they have gotten rid of both, they can appeal to voters that they can govern better."
Optimists say a new post-election coalition might even be more consistent on policies, such as the need to rein in debt.
But not all voters were impressed, and some are likely either to cast their ballots for one of the new small parties recently formed by Liberal Democratic Party rebels -- or stay home.
"This is making me lean towards neither the Liberal Democratic Party nor the Democratic Party. I might end up having no party to vote for," said Yoshimasa Muroi, a consultant.
A change in leadership is unlikely to alter Japan's ambitious goal to cut greenhouse gas emissions by 25 percent from 1990 levels by 2020, but could delay a law needed to implement it.
Hatoyama took office in September with ratings of more than 70 percent from voters hoping the party would make good on promises to cut waste, pry policy control away from bureaucrats, and put more money in consumers' hands to boost domestic demand.
But doubts over his leadership skills helped erode the government's approval ratings, with one poll showing support at just 17 percent after he failed to keep a campaign pledge to move a U.S. airbase off Okinawa island in southern Japan.
Japan's new leader will also face a tough task keeping ties with Washington on track, since Hatoyama's deal with Washington to shift the airbase to northern Okinawa is staunchly opposed by local residents and will be hard to implement.
(Additional reporting by Tokyo bureau; Editing by Charlotte Cooper and Paul Tait)