FACTBOX: Policy challenges facing new Japan PM

(Reuters) - Whoever succeeds Japanese Prime Minister Yasuo Fukuda following his sudden resignation faces policy challenges ranging from recession fears and ballooning public debt to sensitive ties with neighboring China.

The following will be key issues for the new leader, who will be chosen by the ruling Liberal Democratic Party on September 22.

ECONOMY

Japan's economy is seen as either heading into a recession or already in one as high raw material costs and a global slowdown hurt corporate activity.

The world's No.2 economy contracted in the second quarter at its sharpest rate in seven years as weaker U.S. and European markets hit factories and rising prices of daily necessities weighed on personal consumption.

With opposition parties holding a majority in parliament's upper house, uncertainty clouds the outlook for passage of an extra budget to finance a just-unveiled economic package to help ease the pain of high food and fuel costs, as well as a government pledge of temporary income tax cuts.

Japan defines a recession as a downturn in the economic cycle, which varies from the more widely used definition of two straight quarters of economic contraction.

FISCAL REFORM Due to large-scale spending to bolster the economy in the 1990s, Japan's outstanding public debt stands at roughly 1 times GDP -- the worst among major industrialized nations.

The immediate focus will be on whether a new prime minister will stick to a fiscal consolidation target despite the faltering economy. The government's goal is to shift the primary balance -- the budget balance excluding debt issuance and servicing costs -- into the black by the fiscal year starting in April 2011.

CONSUMPTION TAX

Raising the consumption tax from 5 percent has been seen by many experts as a painful but necessary step to finance rising social welfare costs in Japan's ageing society.

But any hike in the tax remains politically sensitive, especially as an election for parliament's more powerful lower house must be held by next September and could be much sooner.

The ruling coalition has vowed to review the consumption tax during annual tax reform debate late this year, but whether a new premier could decide the timing and scale of a tax hike remains in question.

BANK OF JAPAN

The political vacuum is unlikely to have any immediate impact on monetary policy. Many market players expect the Bank of Japan to leave interest rates at 0.5 percent for the time being, as the central bank tries to balance the risk of slowing economic growth and accelerating inflation.

Political wrangling has left two seats vacant on the BOJ's nine-member policy board. Government nominees to fill the vacancies need approval from both houses of parliament, but that appears unlikely to happen soon.