Factbox: Key political risks to watch in Japan

TOKYO (Reuters) - Japan's government has vowed to cap new bond issuance and spending for the year from next April, but meeting the target will be tough given rising social security costs and political infighting after the ruling Democratic Party was thrashed in a July upper house election.

Following is a summary of key political risks to watch:

* BATTLE FOR LEADERSHIP OF RULING PARTY

A challenge to Prime Minister Naoto Kan by controversial party powerbroker Ichiro Ozawa in a September 14 ruling party leadership race means more political uncertainty for Japan, following July 11 upper house elections in which the Democrats fared surprisingly poorly and lost their majority.

Kan has put fiscal consolidation at the center of his agenda, and has said he would consider raising Japan's 5 percent sales tax to help tackle the country's vast debt level. But voters were not impressed and the poor showing in the July 11 elections has weakened his position in the party.

Ozawa favors cuts in wasteful government spending before any move to raise the sales tax and says he would cut income and residential taxes. He has been implicated in party funding scandals and his poor public image will affect his chances.

More change at the top -- the country is already on is fifth premier in three years -- would be another blow to Japan's image and clout abroad at a time when China's influence is rising. It is unclear whether replacing Kan would give the DPJ a boost among voters -- a general election need not be held until 2013. So far, the party leadership race appears to be too close to call.

What to watch:

-- In the best scenario for Kan, Ozawa loses and leaves the DPJ, but only 20-30 of the party's 412 lawmakers follow suit, spelling the potential end of Ozawa's four-decade career as opposition parties would likely shun his overtures. That would allow Kan to consolidate his control over the party and concentrate on his policy efforts to cut public debt.

-- Ozawa would have to persuade almost 70 DPJ lower house lawmakers to leave the party to deprive the Democrats of their majority in the chamber. Analysts doubt whether that many would be willing to join the opposition ranks. But if Ozawa took a large bloc of members with him, that could spark moves toward a realignment of party allegiances, spelling a prolonged period of political and policy uncertainty.

-- If Ozawa loses by a very narrow margin he may remain inside the party and use his influence to seek posts for himself and his followers. This would generate more bickering.

-- If Ozawa wins, he would probably become prime minister because Kan, as the defeated party chief, would resign and a vote would be held in parliament to pick a new leader. But the idea has been floated of splitting the party post from the premiership because of the scandal hanging over Ozawa. Ozawa might choose to let the leader of another political party become premier in order to forge a coalition to break the impasse in the upper house.

-- Ozawa's backers say he might be able to unify the Democrats and use his contacts and skills, honed over 40 years in politics, to do deals with the opposition and smooth policy implementation. But many analysts say opposition parties once willing to tie up with Ozawa are less likely to do so now given his image problems, making this optimistic scenario less likely.

-- The Democrat Party could split if divisions widen, leading to a political realignment that some analysts believe is Kan's real goal. In the short run, however, this would mean more political drift and uncertainty.

* FISCAL DILEMMA

Japan's huge public debt is a pressing policy problem. Government ministries have requested a record 96.7 trillion yen ($1.1 trillion) for the annual budget in the 2011/12 fiscal year, adding to debt problems. The government may struggle to trim the requests by December, when it compiles the initial budget.

The government has pledged to keep spending excluding debt-servicing costs at 71 trillion yen and cap new bond issuance at around 44 trillion yen, both the same as this year. It also plans to earmark 1 trillion yen or more to fund campaign pledges and policies in the government's growth strategy.

But some investors expect new bond issuance to exceed the cap by a few trillion yen or more, partly because welfare costs of an aging population rise around 1.25 trillion yen a year. Kan has yet to present a plan to lower the burden. Spending cuts elsewhere are unlikely to make up the difference.

Economists say raising the 5 percent sales tax, perhaps to as high as 20 percent, is crucial. But while Kan has championed a sales tax hike, he is vulnerable after the party's dismal performance in the July elections and may be unseated by Ozawa.

What to watch:

-- Whether the government can trim budget requests substantially by December.

-- Comments or downgrades by ratings agencies. Standard & Poor's has already warned it could cut Japan's sovereign rating due to political gridlock.

* YEN INTERVENTION?

The yen's surge to a 15-year high against the dollar threatens to cripple Japan's frail export-driven recovery and has sent Tokyo stocks .N225 plunging.

Government sources say intervention has not been ruled out. But coordinated action by the G7 looks highly unlikely, and intervention by Japan alone would be unlikely to have much impact, especially if not accompanied by bold measures by the Bank of Japan. The DPJ leadership race this month is also distracting the government from formulating a response to the yen's strength.

What to watch:

-- Further monetary easing is likely to be announced by the Bank of Japan after its policy meeting on September 6-7, but most analysts expect only a minor tweak of the Bank of Japan's funding framework instead of bolder steps like increasing its government bond purchases. This would be unlikely to have much impact.

-- Outcome of the DPJ leadership race. Ozawa has repeatedly called for intervention to stem the yen's rise.

* FUTENMA AIRBASE ROW

Tokyo and Washington basically agreed in May to implement a 2006 agreement to shift the U.S. Marines' Futenma airbase to the less crowded Henoko area of Japan's southern island of Okinawa, host to about half the U.S. troops in the country.

But the outlook for implementing the deal is cloudy after then-prime minister Yukio Hatoyama first raised and then dashed hopes of moving the base off Okinawa entirely, angering local residents, who associate U.S. bases with noise, pollution and crime. Hatoyama resigned abruptly in June after his perceived mishandling of the issue sharply eroded his voter ratings.

The dispute over the airbase has distracted the two security allies and could dent the 50-year-old alliance as they try to cope with an unpredictable North Korea and a rising China.

Doubts persist over how much progress can be made ahead of U.S. President Barack Obama's visit to Japan for a Nov 13-14 Asia-Pacific leaders' summit.

What to watch:

-- Whether U.S. and Japanese experts can work out details, such as the location and construction method of the relocation site for Futenma.

-- A September local assembly election in Nago, the site of the proposed relocation facility, will likely reflect the degree of local opposition, while a November 28 election for governor of Okinawa could affect the plans since the governor's approval is needed if building the new base involves a maritime landfill.

(Editing by Andrew Marshall)