By Linda Sieg
TOKYO, Nov 2 (Reuters) - Japan's new government faces a dilemma over how to keep its campaign promises while reining in huge debt, a fragile economy that could slip back into recession, and strains in ties with close security ally the United States.
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 from companies to consumers.
But cabinet ministers have presented budget requests totalling a record 95 trillion yen 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. One of Fujii's deputies has also said new JGB issuance may have to rise to 50 trillion yen anyway this year to cover the tax shortfall.
That uncertainty over issuance is weighing on government debt, helping push the yield on benchmark 10-year bonds to a 2-½ month high of 1.425 percent on Friday.
Longer term, Japan faces burgeoning welfare costs of the world's fastest-ageing population. 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 new debt, or postpone keeping pledges without upsetting voters.
* CENTRAL BANK INDEPENDENCE?
The Bank of Japan began withdrawing from credit markets on Friday but extended a key loan scheme.
Reaction from Finance Minister Hirohisa Fujii suggested the central bank had prevented a rift with the government from getting worse, as policymakers grapple with an economy that has just emerged from recession but faces prolonged deflation.
What could now prove a bone of contention with the government is the BOJ's economic forecasts. Fujii had called into question the BOJ's economic outlook before Friday's policy board meeting, and after the central bank issued its half-yearly economic outlook report, the prime minister suggested it was too rosy.
Key issues to watch:
-- Persistent deflation could bring the BOJ under pressure to buy more government bonds or revert to quantitative easing.
-- 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.
* 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:
-- A feud over the repositioning of the U.S. Marines' Futenma air base on Japan's southern island of Okinawa is straining ties ahead of President Barack Obama's Nov. 12-13 visit. Foreign Minister Katsuya Okada will meet U.S. Secretary of State Hillary Clinton to discuss the matter in Washington on Nov. 6.
-- 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.
* 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.
In the past couple of weeks the yen has retreated, making its strength less of an immediate issue. But it remains within range of highs hit against the dollar during the global financial crisis and could quickly return to those levels if the dollar weakens.
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. The market is unlikely to get too worried about yen-selling intervention unless it becomes more volatile and nears 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:
-- The Democrats won two upper house by-elections 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.
The cabinet's ratings have fallen to around 60 percent, still high by Japan's standards, from about 70 percent earlier.
-- Hatoyama will face questions on the scandals in the current parliament session and prosecutors might make new moves.