Japan PM race tightens

TOKYO/WAKAYAMA, Japan (Reuters) - The race to pick a new Japanese leader tightened on Thursday after a report that a group loyal to a party powerbroker was backing a little-known rival to fiscally conservative Finance Minister Naoto Kan.

Japan's Democratic Party (DPJ) will vote on Friday to pick a new leader after unpopular Prime Minister Yukio Hatoyama abruptly quit this week to improve his party's chances in a July upper house poll the ruling bloc needs to win to avoid policy deadlock.

Investors worry that the political chaos could delay efforts to thrash out plans, due out this month, to cut a public debt already twice the size of Japan's GDP and to craft a strategy to engineer economic growth in an aging society.

Underscoring the urgency of the task, a Japanese central banker said she hoped the next leader would unveil a medium- and long-term fiscal reform programme as scheduled in June.

"Otherwise, trust in the government's policy may be affected," Bank of Japan policy board member Miyako Suda told business leaders in Wakayama, western Japan.

Finance minister Kan, 63, is still seen as the frontrunner in the race to pick Japan's fifth prime minister in three years, but the jockeying could ensure that party kingpin Ichiro Ozawa, who quit as secretary-general along with Hatoyama, still has clout.

That could affect how aggressively Japan tackles its debt.

Kan, a former health minister once known for battling bureaucrats, has forged an image as a fiscal conservative and occasional central bank critic since assuming the finance post in January.

If he becomes premier, that could spell bolder steps would be taken to rein in the huge public debt, although he would face opposition from many in his party ahead of the election.

NHK public television said a group loyal to Ozawa, a political mastermind seen as pulling the strings in Hatoyama's government, would back a little-known lawmaker, 50-year-old Shinji Tarutoko. Jiji news agency however said later group members could vote as they pleased.

"Kan is still expected to win, but if Ozawa's supporters back Tarutoko, it will be a show that there are forces against Kan and he may have to listen to their demands on who to appoint in the cabinet and in the party's top posts," said Tetsuro Kato, a political science professor at Waseda University.

CONFUSION OVER UNKNOWN

Choosing Tarutoko would jolt investors who hope Japan's new leader gets serious about fiscal reform. Many voters are also worried about the country's bulging debt.

"It is difficult to imagine Kan not winning. But if his opponent happens to win instead, there is likely to be confusion in the market since he is an unknown entity," said Nagayuki Yamagishi, a Mitsubishi UFJ Morgan Stanley Securities strategist.

"There is no guarantee that foreign investors will not sell Japan stocks in such an event."

Not much is known about Tarutoko's stance but he told a news conference on Thursday that, if elected, he would not raise Japan's 5 percent sales tax before the next general election, which must be held by late 2013. Ozawa also opposes pledging a hike in the 5 percent sales tax before the upper house poll.

"Whoever takes over, they cannot say they won't raise the sales tax, given the current national fiscal situation," Hajime Ishii, a DPJ heavyweight, told Reuters in an interview.

"But we must avoid a situation in which by raising the sales tax, we dampen consumption and the economy worsens greatly," he said, adding the party would not adopt a clear stance on the timing or scope of any rise before the upper house poll.

SHOT AT A MAJORITY?

Ishii said the party and its small conservative ally, the People's New Party, now had a good shot at winning the upper house poll, enabling it to pass legislation smoothly.

"We may fall short of a stable majority but in the remaining 40 days ... we want to make efforts to reach (that goal). It is possible," said Ishii, outgoing chairman of the Democrats' election campaign committee.

The political turmoil coincides with concerns over whether a recovery in the world's second biggest economy can stay on track.

In the most pessimistic view from a BOJ policy maker to date, Suda warned that fiscal woes in Europe would take a long time to fix, with the ensuing market turmoil and slowing euro-zone growth clouding Japan's economic outlook.

"Stock and currency markets are very unstable, and as a result not only Europe but also Japan may see a negative impact on consumption and capital spending via a worsening of household and business sentiment," Suda told business leaders in Wakayama, western Japan.

Suda said the central bank will maintain very easy monetary policy in an effort to pull Japan out of deflation.

But she said central banks should not give markets the impression they could directly underwrite government debt.

With the economy in relatively good shape and the BOJ having already taken several steps to try to beat deflation, a new government might not put pressure on the bank soon for further easing. But a new leader could quickly turn up the heat on the BOJ if the economy takes a turn for the worse.

The BOJ has kept interest rates at 0.1 percent, and eased monetary policy in December 2009 and again in March by setting up and later expanding a facility offering cheap funds to banks.

It also outlined last month a new loan programme aimed at encouraging banks to lend more to industries with growth potential.

(Additional reporting by Yoko Nishikawa, Shinichi Saoshiro, Kiyoshi Takenaka, Chisa Fujioka and Yoko Kubota; Editing by Paul Tait)