FACTBOX-Challenges Japan's next government will face

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May 15 (Reuters) - Japan's main opposition Democratic Party is set to pick a new leader on Saturday, aiming to boost the party's prospects ahead of an election.

The winner of the election, which must be held by October, will have to deal with the country's worst recession in 60 years, a bulging public debt and sensitive ties with rising rival China.

A Democratic Party victory would end more than a half-century of almost unbroken rule by the Liberal Democratic Party.

Following are the main challenges for the new government.

ECONOMY

Japan's economy is mired in its worst recession since World War Two and has edged back into deflation, although recently there have been signs of a tentative recovery.

Aso's government has unveiled a record 15 trillion yen ($157 billion) spending package and some lawmakers are already asking for more, while the Democrats have called for 20 trillion yen in spending over two years. [ID:nT44794]

But past steps have left a mountain of public debt equal to more than 150 percent of GDP, the highest among advanced nations, constraining Tokyo's ability to spend its way out of recession and worrying financial markets about further debt issuance.

The Bank of Japan, with its key policy rate near zero percent, has taken a series of steps, including buying corporate debt and increasing buying of government bonds, to keep funding strains from further derailing the economy.

Japanese banks have limited exposure to toxic debt that has wreaked havoc among their U.S. and European peers, but their large holdings of shares make them sensitive to market swings and prone to curb lending when stocks fall.

AGEING POPULATION, SALES TAX DEBATE

One of Japan's biggest challenges is to revamp and find funds for its pension and social welfare systems, creaking under the weight of a fast-ageing population.

The country also needs to supplement a shrinking labour force by making it easier for women and elderly to work and welcoming more immigrants, another politically touchy step.

Economists say funding growing pension and health care costs will require raising the nation's 5 percent consumption tax, but the topic is politically touchy.

REFORM BACKLASH

Critics say five years of pro-market reforms under Junichiro Koizumi, prime minister from 2001 to 2006, have widened social, income and regional gaps, and both the LDP and the Democrats have sought to distance themselves from that reform platform.

The global recession has intensified such criticism and given some impetus to calls for re-regulation. Companies worry that trend would be stronger under a Democratic government, given the party's support base among labour unions.

FOREIGN RELATIONS

Japan's leader must address the challenge of China's rising regional clout, while keeping ties with its Asian neighbour, now Japan's biggest trading partner, on an even keel.

Sino-Japanese relations have improved recently after years of friction over Japan's military aggression in Asia before and during World War Two, but territorial and maritime disputes still simmer along with mutual mistrust over military ambitions. ($1=95.52 yen) (Reporting by Yoko Nishikawa, Editing by Linda Sieg and Jerry Norton)