(Reuters) – Japanese Prime Minister Naoto Kan’s government suffered a major blow in Sunday’s upper house election, threatening a policy deadlock that could thwart efforts to curb massive public debt and engineer growth.

Voters dealt Kan’s Democratic Party of Japan a stinging rebuke in the election, depriving the DPJ and its tiny ally of a majority less than a year after the Democrats swept to power with promises of change. [ID:nTOE66A02V]

The Democrats still have a dominant grip on the more powerful lower house. But they will need to seek new partners to control the upper chamber, which can block bills.

Below are key policies that could be affected by the outcome of the election:

FISCAL POLICY

Debt woes in the euro zone have turned the spotlight on Japan’s own massive debt, which the International Monetary Fund put at 217.7 percent of gross domestic product last year, far worse than Greece’s debt-to-GDP ratio of 115.1 percent. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on Japan's debt woes: r.reuters.com/sez92m Graphic on Japan poll results: r.reuters.com/sax86m More stories on the Japanese politics [ID:nPOLJP] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Most of Japan’s debt is held by domestic investors, who are less sensitive to credit ratings agency downgrades than foreign investors, but that is slowly changing as the population ages and household savings fall.

Kan, a former finance minister, had made fiscal reform a top priority, floating a possible doubling of the 5 percent consumption tax. The main opposition Liberal Democratic Party also favours a rise in the sales tax to 10 percent, but the poor election results could make it harder for Kan to push forward debate on the politically touchy topic.

The government last month unveiled a mid- and long-term fiscal reform strategy. But the plan lacked specific ideas on how to meet ambitious targets such as balancing the budget and reducing its debt-to-GDP ratio. [ID:nTOE65L01H]

A majority of voters agree fiscal reform is needed. But his apparent flip-flopping on a possible additional tax burden has put off many voters.

MONETARY POLICY

The Bank of Japan, which has stressed the need for a credible plan to cut back public debt, sees little need to ease monetary policy and feels it has done enough for now by outlining a loan programme aimed at supporting industries with growth potential.

Political instability after Sunday’s election means it would be difficult for the government to carry out steps to support a fragile recovery in the world’s No.2 economy. That could renew government pressure for a more aggressive monetary policy. While the BOJ is independent from the government by law, direct pressure from the premier might be hard to resist.

The opposition Your Party, seen by some as a potential DPJ ally after it won 10 seats in Sunday’s poll, wants to revise the law governing the central bank to seek stronger government-BOJ cooperation to end deflation by making maximum employment one of the BOJ’s objectives, similar to a law governing the U.S. Federal Reserve.

YEN POLICY

Investors remain reluctant to test the government’s tolerance for a strong currency, although Tokyo has not intervened in the market since early 2004.

Kan caused a stir in January when he said he would work with the BOJ to weaken the yen, and that “it would be nice” if the Japanese currency slipped further.

He has subsequently toed the government line that stable exchange rates are desirable but levels should be set by the markets — but noted after becoming prime minister that there was a general view that a weaker yen would be better for Japan’s export-driven economy.

CLIMATE POLICY

Kan has stuck to a 2020 goal to cut Japan’s greenhouse gas emissions by 25 percent from 1990 levels, premised on an international framework in which major emitting countries would agree on ambitious targets.

The more powerful lower house passed a climate bill including that goal and a shortlist of domestic measures to achieve it, but the upper house ran out of time to enact the legislation. But the fate of the legislation is murky after the ruling coalition suffered a major setback in the poll.

POSTAL REFORM

The parliament session ended in mid-June without passage of a bill to scale back postal privatisation. Kan has said he will resubmit the legislation, sought by his tiny coalition partner the People’s New Party, in an extra session in the autumn.

But without a coalition upper house majority, it looks almost impossible for the legislation to be enacted any time soon.

Not all Democratic Party lawmakers are keen on the legislation and banks complain it would give Japan Post an unfair advantage because of an implicit government guarantee.

Japan Post, which has retail banking and insurance services, is the world’s largest financial conglomerate with assets of about 300 trillion yen ($3,387 billion) and its fate could sway financial markets and industry.

The United States and Europe have said the draft legislation had not addressed their concerns about what they see as the preferential treatment that Japan Post receives compared with private-sector companies.

DIPLOMACY, SECURITY POLICY

The election defeat of the ruling coalition is unlikely to shift Japan’s foreign and security policies drastically.

The Democrats took power promising to steer a diplomatic course more independent of close ally the United States, but efforts by Kan’s predecessor Hatoyama to do so hit a roadblock when he failed to find an alternative to keeping a U.S. Marine airbase on the southern Japanese island of Okinawa.

Tokyo and Washington have basically agreed to implement a 2006 agreement to shift the Marines’ Futenma airbase to a less crowded part of Okinawa, host to about half the U.S. troops in the country.

But local opposition clouds the outlook for implementation, and experts worry that Hatoyama opened a Pandora’s box by fanning anti-base sentiment that could undermine the 50-year-old alliance.

The government will also likely keep stressing the need to deepen ties with other Asian countries including China, given Japan’s increasing reliance on the region for economic growth. ($1=88.56 Yen) (Compiled by Leika Kihara, Hideyuki Sano, Charlotte Cooper, Yoko Nishikawa, Risa Maeda and Linda Sieg; Editing by Michael Watson)