By Linda Sieg
TOKYO, Oct 19 (Reuters) - Japan's new government faces a dilemma over how to keep campaign promises while reining in huge debt, a strong yen that could hurt a fragile recovery and a central bank looking to exit emergency corporate funding support.
Investors watching Japan must also factor in policy gaps among Prime Minister Yukio Hatoyama's Democratic Party and two tiny but vocal coalition partners.
Following is a summary of key Japan political risks to watch:
* FISCAL DILEMMA
The new government is trying to put politicians instead of bureaucrats in charge of drafting budgets in order to reduce waste and reallocate funds to consumers from companies.
But cabinet ministers have presented budget requests totalling a record 95 trillion yen ($1 trillion) for the next fiscal year, starting April 1, 2010, up from about 92 trillion proposed by the defeated Liberal Democratic Party-led government.
Who will take the lead in forcing cuts is unclear.
Finance Minister Hirohisa Fujii has said he wants to limit new bond issuance in 2010/11 to below the 44 trillion yen earmarked for this year, but the goal looks in doubt given the size of the budget requests and falling tax revenues in an economy just emerging from a deep recession.
That uncertainty over issuance is weighing on government debt, helping push the yield on benchmark 10-year bonds to a one-month high of 1.335 percent on Monday.
Longer term, Japan faces burgeoning welfare costs of the world's fastest-ageing population, although Hatoyama has promised to keep Japan's broad sales tax at 5 percent for the next four years.
The government says spending more on consumers will boost domestic demand but critics say it lacks a broad growth strategy.
Key issues to watch:
-- The budget for 2010/11 is due by the end of this year and the focus is on whether the government can implement key campaign promises without issuing heaps of additional debt.
* EXIT STRATEGY DELAY?
The Bank of Japan is under pressure from outspoken cabinet ministers who worry that a quick exit from emergency steps to support corporate funding could hurt the economy, and especially smaller firms -- pushing up unemployment.
The BOJ's current plans are unlikely to worry investors as corporate finance conditions have eased since the financial crisis, but analysts want to see how the new government handles its relationship with the Bank of Japan.
Past government jawboning has been known to backfire by prompting the BOJ to act just to demonstrate its independence.
Key issues to watch:
-- Analysts expect the BOJ to unwind some emergency steps by the end of the year. BOJ policy board meetings are set for Oct. 30, Nov. 19-20 and Dec. 17-18.
-- A big output gap, falls in planned capital spending and the probability of prolonged deflation mean the BOJ will probably keep interest rates ultra-low for several years.
* CURRENCY - HOW STRONG IS TOO STRONG?
Finance Minister Hirohisa Fujii has said that currency rates should not be manipulated out of line with economic fundamentals, and his comments favouring a strong yen echo the government's desire to wean Japan from dependence on exports for growth.
Still, the new government, which took office on Sept. 16, appears reluctant to see the yen soar too quickly and endanger Japan's fragile, export-led recovery. Fujii has said intervention is an option if the currency moves too far, too fast.
Key issues to watch:
-- Attention will be on comments by Fujii and other government officials regarding possible currency intervention.
-- Picking a level that would trigger intervention is tricky as the dollar is weakening broadly and there is a global push to rebalance the world economy. The market is unlikely to get seriously worried about yen-selling intervention unless it becomes more volatile and approaches its all-time high of 79.75 per dollar.
* GOVERNANCE HEADACHES
Politicians' efforts to exert leadership instead of relying on bureaucrats have sown confusion over where control lies.
Added to this, Hatoyama's Democrats must put up with two tiny partners whose backing is needed in parliament's upper house to enact bills smoothly.
People's New Party chief Shizuka Kamei, a harsh critic of bare-knuckles capitalism, has been particularly outspoken on economic and financial matters, while gaps on security policies with the pacifist Social Democrats are another Achilles' heel.
Political funding scandals also haunt Hatoyama and his predecessor Ichiro Ozawa, now Democratic Party secretary-general.
Key issues to watch:
-- Two upper house by-elections will be held on Oct. 25, but Hatoyama will probably have to wait to see if his party wins a majority in a mid-2010 upper house poll before dumping the duo.
-- Hatoyama will face questions on the scandals in parliament due to resume on Oct. 26, and prosecutors might make fresh moves.
* SECURITY TIES
Hatoyama has vowed to deepen ties with Asia and steer a diplomatic course more independent of Washington, causing uncertainty about the U.S.-Japan alliance, pivotal in a region home to a rising China and an unpredictable North Korea, whose Rodong missiles can hit most of Japan.
Key issues to watch:
-- U.S. Defense Secretary Robert Gates' visit to Japan from Tuesday and President Barack Obama's Nov. 12-13 visit should provide clues to how the two governments will manage ties.
-- North Korean leader Kim Jong-il has said he is ready to resume nuclear talks, but with preconditions. Whether or when negotiations will resume remains unclear.
-- Ties with China have improved but bitter memories of Japan's wartime aggression persist, and Tokyo is wary of Beijing's military build-up. Bilateral feuds over marine resources and territorial sovereignty could flare up. ($1=90.87 Yen) (Editing by Rodney Joyce)