Fiscal challenges loom for newly elected Japan Democrats

By Isabel Reynolds and Yoko Nishikawa

TOKYO (Reuters) - Japan's next prime minister began forming a government on Monday as investors worried the untested Democratic Party would overspend in a bid to revive the economy or would ruffle ties with Tokyo's closest ally, Washington.

Sunday's historic election win by Yukio Hatoyama's party breaks a deadlock in parliament and will usher in a government that has promised to focus spending on consumers, cut wasteful budget outlays and reduce the power of bureaucrats.

The defeated Liberal Democratic Party (LDP) was left to lick its wounds after its worst election performance since the conservative party was founded in 1955. The party had ruled Japan for almost all of the last half-century.

Hatoyama has cut a serious figure since voters gave the Democratic Party of Japan (DPJ) a sweeping mandate for change.

"The situation in Japan is not one that allows me to savor my happiness. Many Japanese people have suffered from politics and they therefore wanted the DPJ to do well and wanted a change in government," he told reporters.

"I have no time to be saying 'We did it, we did it.'"

The yen rose to a 7-week high, buoyed by the end of electoral uncertainty. Japanese stocks, after hitting a near 11-month high earlier in the day, closed slightly down as the stronger yen hurt shares of exporters.

Hatoyama is to set up a transition team to organize the change of government, but said he will not announce his cabinet until he is officially elected prime minister by a special session of parliament, probably in about two weeks.

The Democratic Party's landslide win in the lower house failed to lift a downbeat mood in a rainy Tokyo, where there was little post-election euphoria. Many voters and analysts said the victory was driven more by frustration with the LDP than broad support for the decade-old opposition.

"It's not that the Democrats were good. I voted for them as a punishment for the LDP. The LDP has to change," said Etsuji Inuzuka, 47, who works in the furniture business.

SPENDING WORRIES

Investors welcomed the end to a political deadlock that has stymied policies as Japan struggled with its worst recession since World War Two. The Democrats and its small allies won control of the upper house in 2007, enabling them to delay bills.

But many were concerned about whether the party would be able to maintain fiscal discipline after promising policies such as cash handouts for families with young children and the abolition of expressway tolls, a Reuters survey showed.

"Fiscal issues, together with diplomacy and security, will be a major issue," said Junko Nishioka, chief Japan economist at RBS Securities.

Media forecasts show the Democrats won about 308 seats in the lower house, nearly tripling their strength in the 480-member chamber. The LDP won only 119 seats, down from 300.