(For more stories on the Japanese economy, click
* Japan needs easier monetary policy - Your Party leader
* Warns Japan could become "third-rate" country
* Party could become key government ally
* Also wants weaker yen (Adds more Watanabe comments, background)
TOKYO, July 26 (Reuters) - Japan's government needs to weaken the yen and adopt more expansionary monetary policies to beat deflation, according to the leader of a small opposition party which is being seen as a possible government ally.
"What's needed to beat deflation is easier monetary policy, aggressive fiscal policy and policy that promotes a weaker yen," Yoshimi Watanabe, head of Your Party, told a news conference on Monday.
"As long as we leave the fight against deflation to bureaucrats, we cannot get away from debilitating deflation and Japan will eventually become a third-rate country."
Prime Minister Naoto Kan is expected to seek cooperation with Your Party and fellow opposition party New Komeito on various policies as he tries to avoid political deadlock after defeat in recent upper house elections.
Kan's Democratic Party of Japan (DPJ) and its small ally, the People's New Party, lost their combined majority in the upper chamber of parliament after Kan floated a possible doubling of the 5 percent sales tax to mend the country's tattered finances.
The DPJ still controls the more powerful lower house but it needs help from other parties to push bills through the upper chamber as it tries to rein in massive public debt and engineer growth in a rapidly ageing society.
Watanabe said further monetary easing by the Bank of Japan (BOJ) is also needed to overcome deflation, which has highlighted persistent weakness in the world's second-largest economy.
Analysts, however, doubt that the central bank can do much more to spur demand. It has kept interest rates near zero since late 2008 and eased policy last December and again in March, offering cheap funds to banks.
Watanabe also said the government needed to weaken the yen but did not elaborate.
Your Party Secretary-General Kenji Eda told Reuters last week the government should not intervene in the currency market to curb the yen's rise even if that could help ease deflation.
The euro hit a seven-week high against the yen on Monday, but the single currency is still down 16 percent from a year earlier, while the dollar traded at 87.32 yen down 8 percent in the last 12 months.
A firmer yen hurts the price competitiveness of Japanese exports and eats into exporters' overseas revenues when converted into the Japanese currency. Strong growth in exports this year has helped to offset stubbornly weak domestic demand, shoring up the fragile economy.
Watanabe, a former banking minister under the then-ruling Liberal Democratic Party, wants laws concerning the BOJ to be revised to have the central bank share a price stability target with the government.
He also said Your Party plans to propose to parliament's special session in the autumn a bill that promotes privatisation of Japan Post, which is the world's largest financial conglomerate with assets of more than $3.4 trillion.
The Democratic Party and its partner People's New Party aim to pass a bill to scale back postal privatisation in the same parliamentary session.
"By selling Japan Post shares, we can excavate at least 5 trillion yen and as much as 10 trillion yen in hidden assets," Watanabe said. "What the Democrats are doing is burying back that asset." (Reporting by Kiyoshi Takenaka & Yoshifumi Takemoto; Editing by Kim Coghill)