(Reuters) – Japan’s government, its support rate dropping ahead of a mid-year election, faces soaring public debt, leaving it with few options to tackle deepening deflation.

World | Japan

Standard and Poor’s in January threatened to cut Japan’s credit rating, prompting sovereign credit default swap spreads to widen to 90 basis points — the most in 10 months. They now trade around 67 basis points.

Following is a summary of key political risks to watch:

* FISCAL DILEMMA

A record $1 trillion yen budget for the year from April 1 was enacted last month with an all-time high of 44.3 trillion yen ($477.6 billion) in new bond issuance, but the government is resisting pressure to spend more for the fragile economy.

The government’s ability to prevent the economy from slipping back into recession is severely constrained by the 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 programs have so far fallen short of target.

Finance Minister Naoto Kan in February broached the sensitive topic of consumption tax, saying the government would start discussing tax reform in March. But the government is sticking to its pledge not to raise the tax at least until the next general election, mandated by late 2013.

What to watch:

– The government aims to release a mid-term fiscal reform plan and to finalize a growth strategy in June. Failure to make those policy guidelines credible could disappoint nervous bond investors and push up JGB yields. Japanese media have reported the fiscal plan would include incremental goals to reduce reliance on debt, but analysts doubt it will be enough to allay concerns.

– Data showing deflation has persisted for a full year could prompt calls for extra stimulus ahead of the upper house election in July, but the government would be sensitive to rises in bond yields.

– Prime Minister Yukio Hatoyama has approved a plan to raise the limit on deposits at Japan Post, a move some fear could be a ploy to subsidize more bond issuance.

* PRESSURE ON CENTRAL BANK?

The BOJ forecasts three years of deflation and says it is committed to keeping interest rates near zero as long as necessary. Kan, a vocal BOJ critic, says he would favor inflation of 1 percent, roughly matching the central bank’s view, and has urged the BOJ to do its part to achieve that goal. However, the BOJ is not keen on setting an inflation target.

The BOJ eased its ultra-loose monetary policy in March by doubling the size of a funding operation launched in December to 20 trillion yen ($216 billion). But the board was split in its decision and some market players say that means the BOJ may not meet future government demands for easier monetary conditions. Though independent by law, the central bank is required to work closely with the government to align policy and has in the past caved in to government pressure. The current tension makes it harder for markets to forecast policy.

What to watch:

– Persistent deflation could put pressure on the BOJ to buy more government bonds or extend the duration of loans to six months from three.

– Government rhetoric on the role of the central bank will give clues to how much influence the Democrats will seek to have.

* YEN INTERVENTION

Finance Minister Kan’s early comments led some analysts to argue the government will be less tolerant of a rising yen, although others say intervention is highly unlikely for now.

Government officials say currency levels should be determined by markets, but traders still see Kan as favoring a weaker yen.

What to watch:

– 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 against the dollar.

* FUNDING SCANDALS

The funding scandal ensnaring powerful ruling Democratic Party Secretary-General Ozawa is threatening the party’s chances of the mid-year upper house election win that would clear the way for smoother policymaking.

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.

What to watch:

– Further falls in voter support for Hatoyama’s government, already below 40 percent, could pressure Ozawa to resign; Hatoyama could also face calls for him to quit.

– Ozawa’s departure could push up voter support temporarily but may delay policymaking because he is seen by many as the real power behind the government and can make tough decisions when others can’t.

* 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 as he approaches a self-imposed deadline at the end of May. The dispute 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:

– Comments by Hatoyama and other cabinet ministers ahead of an expected visit by the prime minister to Washington in April for a nuclear security summit.

(Editing by Andrew Marshall)