* Nikkei hit by profit-taking after 10-month high
* China limits on overcapacity, stronger yen add pressure
* Japan's national election on Sunday not strong factor
By Elaine Lies
TOKYO, Aug 27 (Reuters) - Japan's Nikkei average fell on profit-taking on Thursday after hitting a 10-month closing high the day before, pressured by a stronger yen and falls in Chinese shares, with trade wary ahead of Sunday's national election.
Exporters such as Canon Inc lost ground, while Nippon Steel Corp and other steelmakers slid after China said it would curb overcapacity.
Analysts said investors have factored in a big win by the opposition Democratic Party in Japan's Aug. 30 election and the focus is now shifting to post-election events, including who will be the next finance and economy ministers.
Shanghai shares pared losses to 0.8 percent after earlier falling nearly 2 percent, putting the Nikkei under additional pressure.
"There are no catalysts for buying now -- earnings are over and we have the election. Then there's China, which is basically setting the direction for the world at this point," said Koichi Ogawa, chief portfolio manager at Daiwa SB Investments.
The benchmark Nikkei pared losses to 1.6 percent or 165.74 points to 10,473.97, after earlier falling as much as 2.2 percent. The broader Topix lost 1.2 percent to 964.23.
"The external environment that had helped produce gains in the market has started showing signs of waning. The U.S. market could be entering a correction phase and the direction of Chinese stocks remains uncertain," said Tsuyoshi Segawa, an equity strategist at Mizuho Securities.
The Democrats lead Prime Minister Taro Aso's Liberal Democratic Party in newspaper polls ahead of the election. An opposition victory would end more than five decades of almost continuous rule by the LDP and raise the chances of breaking a stalemate in a divided parliament.
"Though the election is not that much of a factor at this point, nobody wants to buy ahead of it. What we're seeing today is people closing down long positions to take profits -- after all, the market did reach a 10-month high," said Hideyuki Ishiguro, a supervisor at the investment advisory department of Okasan Securities.
He said, and others agreed, that investors are probably close to neutral at this point in terms of the positions they hold.
WAIT AND SEE
"The big issue with the Democrats is that they're a party of contradictions -- sometimes they seem as if they're a pro-welfare party, with all their child support policies, and then at the same time they also want to guarantee sources of revenue," said Ogawa, at Daiwa SB Investments.
"It's very hard to know what they'll do."
Exporters lost ground, with Canon shedding 2.2 percent to 3,620 yen, Toyota Motor Corp losing 1.7 percent to 4,040 yen and Panasonic Corp down 0.7 percent at 1,478 yen.
Steel firms slid after China's state council said on Wednesday it would restrict licences for steel and cement production to clamp down on overcapacity.
Nippon Steel shed 1.9 percent to 371 yen, while JFE Holdings Inc lost 3.2 percent to 3,380 yen and Kobe Steel Ltd declined 2.8 percent to 177 yen.
Tokuyama Corp, Japan's biggest polysilicon maker, tumbled 8 percent to 672 yen after it said it plans to issue 65 million shares in a public offering and an additional 9 million shares in an overallotment option at the end of September, sparking dilution concerns.
Nippon Sheet Glass dropped 7.2 percent to 334 yen after chief executive Stuart Chambers said he will step down after a stint of a little more than a year as one of the few foreigners to head a Japanese firm.
Morgan Stanley lowered its rating on the company to "equal-weight" from "overweight" citing uncertainty caused by the resignation in the short term.
Temporary staffing group Pasona bucked the trend, surging 7.6 percent, or by its daily limit of 5,000 yen, to 70,800 yen after saying on Wednesday it was appointing Heizo Takenaka, an economist and former Japanese cabinet minister, as chairman of its board.
Trade was moderate, with 2 billion shares changing hands on the Tokyo exchange's first section compared to last week's daily average of 2.1 billion.
Declining shares outnumbered advancing ones by more than 3 to 1. (Additional reporting by Aiko Hayashi; Editing by Michael Watson)