* New PM Kan warns Japan must get fiscal house in order
* Bank min's departure improves fiscal reform outlook
* Small party to stay in ruling bloc after minister quits
* Democrat majority in upper house a long shot
* Govt in final stages of crafting fiscal reform plan
TOKYO, June 11 (Reuters) - New Japanese Prime Minister Naoto Kan, seeking to lay the groundwork for a future sales tax rise, warned on Friday that the country risked defaulting on its borrowing if it failed to rein in its massive public debt.
Kan, who took over the nation's top job after his unpopular predecessor quit abruptly last week, has made tackling a public debt that is already twice the size of Japan's GDP a top priority amid market concerns about sovereign debt risk.
"We cannot sustain public finance that overly relies on issuing bonds," Kan told parliament in his first policy speech.
"As we can see in the euro zone confusion that started from Greece, there is a risk of default if the growing public debt is neglected and if trust is lost in the bond market."
Kan spoke hours after his banking minister Shizuka Kamei -- an advocate of big spending, said he would quit the cabinet, improving the chances Kan can forge ahead with fiscal reform.
The departure of the outspoken Kamei, sparked by a spat over a controversial bill to roll back postal privatisation, removes one obstacle, but how aggressively Kan can implement fiscal reforms will depend on the results of an upper house election, likely on July 11.
Support for the Democrats, who must win the July vote, has jumped since Kan took over, and Kamei's resignation could be another plus, analysts said. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Graphic on voting intentions: link.reuters.com/jev83j
Graphic on Japan voter support: r.reuters.com/myv63g
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"It was a bit unusual for somebody from such a tiny political party to have this much importance, and with him gone the Kan administration is likely to strengthen its foundation going into the election," said Nagayuki Yamagishi, a strategist at Mitsubishi UFJ Morgan Stanley Securities
"This could perhaps even lead to Kamei's party leaving the coalition -- and while this might seem like political instability to some foreign investors, this will really allow Kan's government a chance to stabilise."
PNP Secretary-General Shozaburo Jimi, an upper house lawmaker, was expected to be given the portfolio, since Kamei's small People's New Party (PNP) remains in the ruling coalition.
FISCAL REFORM PLAN, GROWTH STRATEGY
National Strategy Minister Satoshi Arai told reporters the government was aiming to compile a medium- and long-term plan for reining in debt by June 22 at the latest, and that he wanted to base the programme on capping government bond issuance at 44.3 trillion yen ($484.6 billion) in the year to March 31, 2012. [TOE65909A]
Kan, Japan's fifth premier in three years, has called for a bipartisan debate on raising Japan's 5 percent sales tax to help fund bulging social welfare costs in an ageing society, while Kamei has been cautious about such a move.
Fiscal reformers in the Democratic Party want an election manifesto due out soon to include a reference to increasing the tax after the next general election, due by late 2013.
Rating agencies have warned they could cut Japan's sovereign debt rating unless Tokyo crafts a credible plan to rein in debt.
But analysts say the Democrats, who swept to power promising to put more cash in consumers' hands to boost domestic demand, would need to abandon some election pledges to slash spending.
Kan also needs to twin his fiscal plans with a formula for engineering growth after decades of stagnation, experts say.
"Ideally, the plan should be grounded in a broader economic policy framework including pro-growth structural reforms and clarity on the monetary policy objective," Andrew Colquhoun, director at ratings agency Fitch's sovereigns ratings team, said in an email.
Kamei, known for attacks on free-market capitalism and pressing the Bank of Japan to do more to fight deflation, formed the PNP in 2005 with other rebels from the then-ruling Liberal Democratic Party to protest plans to privatise Japan Post.
He resigned after the Democrats rejected his call to extend the current session of parliament, set to end on June 16, to enact a bill that would roll back those privatisation plans.
Democrats want the upper house poll soon to capitalise on a big leap in voter support after Kan took over, and extending the session would have pushed back the upper house vote.
Analysts still question whether the Democrats can win an outright majority in the 242-seat upper house.
But the party's chances have clearly improved since Kan took over from indecisive Yukio Hatoyama, who quit with his ratings in tatters just nine months after the Democrats swept to power.
"My sense is that Kamei leaving will probably increase public support for Kan, because it looks as though he isn't going to be pushed around by Kamei," said Columbia University professor Gerald Curtis.
"I wouldn't put any money on it, but I think there is a chance of a majority," Curtis added.
"It all depends on how effective Kan is as prime minister."
($1 = 91.40 Yen)