By Chisa Fujioka
TOKYO, Jan 18 (Reuters) - A funding scandal dogging the powerful No. 2 in Japan's ruling Democratic Party threatens the party's chances in a midyear upper house election, but is hardly the only headache for Prime Minister Yukio Hatoyama.
Hatoyama is also under pressure to boost a fragile economic recovery and to ease voter worries over a dispute with key security ally Washington about a U.S. military base.
Following is a summary of key political risks to watch:
* FUNDING SCANDALS
A political funding scandal ensnaring ruling Democratic Party Secretary-General Ichiro Ozawa risks stalling budget debate in parliament and threatening the party's chances of a midyear election win that could clear the way for smoother policy-making.
Opposition parties have threatened to boycott parliamentary debate on an extra budget to prop up the economy if the Democrats dodge questions about the scandal, involving a shady land deal by Ozawa's political funding group.
Media polls show a majority of voters want Ozawa to resign but Hatoyama has stood by his No. 2 executive, who has denied intentionally breaking any laws.
Ozawa is credited by many with engineering the Democrats' huge election win last August. His skills are thought vital to the party's campaign strategy ahead of the mid-year poll, as well as for passing laws and deciding policies.
The Democrats need to win an outright majority in the upper house election to reduce the clout of two small but vocal coalition partners whose cooperation is currently needed to enact legislation smoothly.
Hatoyama is also beset by a separate scandal of his own, although fewer voters are calling for him to resign because he is not seen has having acted for personal gain.
Key issues to watch:
-- Further falls in support for the Democrats ahead of the election could put pressure on Ozawa to resign. Hatoyama could also come under pressure to resign for having defended Ozawa.
* CENTRAL BANK INDEPENDENCE?
The government, wary of big spending given a public debt that is already approaching 200 percent of GDP, has put pressure on the Bank of Japan for a stronger policy response to deflation and the risk of a new recession.
The pressure is likely to grow further under new Finance Minister Naoto Kan, who took over earlier this month from an elderly predecessor who stepped down for health reasons. Kan is one of the most vocal cabinet critics of the BOJ.
Kan has toned down his criticism since the BOJ eased policy in December, but he is likely to call for further accommodative measures should the economy falter.
The BOJ is independent by law but is required to communicate closely with the government to align policies.
Key issue to watch:
-- Persistent deflation could put the BOJ under pressure to buy more government bonds or revert to quantitative easing.
YEN INTERVENTION
Comments by new Finance Minister Kan have led some analysts to argue the government will be less tolerant of a rising yen, although others say intervention is highly unlikely for now.
Kan jolted markets in his first news briefing as finance minister, saying he hoped the yen would weaken further and that many Japanese firms were in favour of dollar/yen around 95 yen.
He later toned down those comments, saying currency levels should be determined by markets, but many market participants still see Kan as favouring a weaker yen in contrast with his predecessor, who spoke of the benefits of a stronger currency.
Key issues to watch:
-- Attention will be on comments by government officials regarding possible currency intervention. Picking a level that would trigger intervention is tricky. Intervening could also be difficult at a time when the Group of Seven is encouraging flexibility in foreign exchange rates, particularly in China.
* ECONOMY, FISCAL DILEMMA
The government has been caught between the need to keep stimulating the economy to avoid slipping back into recession and the need to address concern among investors and voters about Japan's ballooning public debt.
Sliding tax revenues mean government income now covers less than half of spending. Efforts to cut budget waste to find funds for new programmes have so far fallen short of target despite the Democrats' pledge to boost growth without issuing much more debt.
The appointment of Kan to finance minister earlier this month has raised doubts over the government's resolve to keep spending down, since he has less hawkish fiscal views than his predecessor.
Key issues to watch:
-- Weak economic data could prompt calls for extra stimulus ahead of the midyear upper house election, although the government would be sensitive to any rises in bond yields in reaction to hints of increased bond issuance.
* U.S. BASE FEUD
A feud over plans to relocate a U.S. military base on Japan's southern Okinawa island has frayed ties between Japan and Washington, while raising doubts among voters over Hatoyama's leadership skills.
Hatoyama said ahead of his party's landslide August election victory that he favoured moving the U.S. Marines' Futenma airbase off Okinawa, and two tiny coalition partners insist he should honour those remarks.
But Washington wants Tokyo to stick to a 2006 deal to relocate base facilities to a less crowded part of the island. Washington is unlikely to agree to substantial changes to the plan, but sticking to it could cause rifts with Hatoyama's two small coalition partners, whose cooperation is needed to pass laws smoothly.
Key issues to watch:
-- A Jan. 24 mayoral election in Nago City, Okinawa, site of the original relocation spot, would complicate a decision if an anti-base candidate wins.
-- Hatoyama has promised to decide on the matter by May. (Editing by Jerry Norton)