Following is a summary of key political risks to watch:
* FISCAL DILEMMA
The government is trapped between the need to prevent the economy from slipping back into recession and Japan's huge public debt, already nearing 200 percent of GDP.
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 Naoto Kan as finance minister this month raised doubts about government resolve to hold down spending given his concern about deflation and the recovery, but Kan has also said fiscal discipline is needed.
Standard Poor's on Tuesday cut its outlook on Japan's AA long-term sovereign debt rating to negative, saying the policy bind could lead to a downgrade unless measures were taken to stem fiscal and deflationary pressure.
The sovereign credit default swap spread widened on the news, but the impact on JGBs <0#jpbmk=> was limited because the vast majority are held by domestic investors. By making JGBs less attractive to foreigners, the downgrade will be a long-term drag on JGB prices, however, analysts said.
What to watch:
-- The government aims to release a mid-term fiscal reform plan by May or June and to unveil a growth strategy in June.
-- Data showing a risk of persistent deflation could prompt calls for extra stimulus ahead of the upper house poll, although the government would be sensitive to any rises in bond yields.
-- A political funding scandal embroiling Democratic Party Secretary-General Ichiro Ozawa could also tempt the government to spend more to woo voters turned off by the affair.
* PRESSURE ON CENTRAL BANK?
The Bank of Japan said this week deflation would be milder than previously forecast but left the door open to further easing to support a fragile economic recovery. December data showed the biggest drop in consumer prices on record.
Kan, a vocal BOJ critic, said this week the BOJ could do more to fight deflation. The central bank could face extra pressure if the economy falters ahead of the mid-year upper house poll.
The government criticised the BOJ for being too rosy on the economy when the bank upgraded its assessment in November. The BOJ later caved in to pressure and last month adopted a new fund supply operation at which it offers 10 trillion yen ($111 billion) in three-months loans to banks at 0.1 percent. It then declared that it wouldn't tolerate deflation.
The BOJ is independent by law but is required to work closely with the government to align policy. Tension over strategy raise the risks for markets, making policy harder to forecast.
What to watch:
-- Persistent deflation could pressure the BOJ to buy more government bonds or expand the new fund supply operation. Increased JGB purchases would push up bond prices and so bring down long-term interest rates.
-- Government rhetoric on the role of the central bank will give clues on how much influence the Democrats will seek to have.
* YEN INTERVENTION
Finance Minister Kan's early comments 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 chief, saying he hoped the yen would weaken further and that many Japanese firms were in favour of dollar/yen around 95 yen JPY=. 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.
What 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.
-- Another way of countering a surge in yen strength could be for the Bank of Japan to take more easing steps as it did in December after the yen hit a 14-year high on the dollar. Possible steps could be increasing the amount of a new fixed-rate funding operation or extending its maturity; or increasing JGB issuance.
* FUNDING SCANDALS
The funding scandal ensnaring Ozawa is threatening the Democratic Party's chances of a mid-year election win that would clear the way for smoother policymaking. [ID:nTOE60L015]
Ozawa is credited by many with engineering the Democrats' big election win last August and his skills are thought vital to winning the mid-year poll, 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 parties whose cooperation is currently needed to enact legislation smoothly. A ruling bloc loss would create a parliamentary deadlock.
Hatoyama is beset by criticism over his own funding scandal, though fewer voters think he should resign, in contrast to the majority who want Ozawa to step down. [ID:nTOE60J03B]
What to watch:
-- Further falls in voter support for the Democrats could pressure Ozawa to resign; Hatoyama could also face calls to quit.
-- The scandal could delay passage of a $1 trillion budget for the year from April 1, though opposition parties risk a public backlash if they stall amid the weak economy.
* U.S. BASE DISPUTE
Hatoyama is in an increasingly tight spot over a dispute with Washington over a plan to relocate a U.S. Marine base to a less crowded part of Okinawa after an anti-base candidate's win in a local mayoral election on Jan. 24.
The dispute, which Hatoyama has vowed to settle by the end of May, has frayed ties with ally Washington and fanned doubts among voters about Hatoyama's leadership skills.
Some analysts say he may have to quit if he fails to resolve the row.
What to watch:
-- U.S. Assistant Secretary of State Kurt Campbell is expected to raise the issue when he visits next week.
-- Attention will be on comments by Hatoyama and other cabinet ministers in the run-up to May, when the prime minister may travel to Washington to meet U.S. President Barack Obama. (Additional reporting by Charlotte Cooper; Editing by Andrew Marshall)
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