By Linda Sieg
TOKYO (Reuters) - Japan faced political gridlock after the ruling party's thrashing in an election on Sunday, which could thwart efforts to curb a huge public debt and get the economy in shape, and put Prime Minister Naoto Kan's job at risk.
Voters dealt Kan's Democratic Party of Japan (DPJ) a stinging rebuke, depriving it and a tiny ally of an upper house majority less than a year after the DPJ swept to power promising change.
The DPJ won just 44 seats, far short of Kan's goal of 54, and its partner the People's New Party got none, media said. The main opposition Liberal Democratic Party (LDP) won 51 seats.
The Democrats still control the more powerful lower house. But they need help from other parties to push bills through the upper house as they struggle to end decades of stagnation in the world's No.2 economy and to cut the massive public debt.
"We're likely to have lost another two years stuck in parliamentary gridlock rather than action," said Jesper Koll, director of equity research at JP Morgan Securities Japan.
Japan's economy is recovering but analysts wonder for how long. Japanese manufacturing confidence edged up in July to its best in 2- years, but the pace of gain slowed, a Reuters poll showed, in a sign companies may be wary of a slowing growth.
The election results also leave Kan vulnerable to a challenge from inside his own party, though he said he would stay in his job. Kan, in office just one month, is already the fifth prime minister in three years.
MARKETS BLASE, POTENTIAL PARTNERS COOL
Markets have taken the election outcome in their stride, for now. The Nikkei share average inched up after a weak start, the yen eased a tad against the dollar, and Japanese government bond futures edged higher.
The DPJ won power in a historic landslide only last year, ousting the long-dominant conservative Liberal Democrats with promises to cut waste and focus spending on consumers.
But public backing nosedived due to funding scandals, chaotic policymaking and mishandling of a feud over a U.S. airbase in southern Japan.
Public support for the DPJ rebounded when Kan took over last month, but it tumbled as soon as he floated a rise in the 5 percent sales tax, and then appeared to dither.
Many voters accept the need for an eventual sales tax rise given a public debt already about twice the size of the $5 trillion economy, but the Democrats failed to convince voters they had a coherent plan to cure the country's economic ills.
Kan now faces a possible challenge from party critics including powerbroker Ichiro Ozawa -- a critic of his sales tax hike proposal -- ahead of a September party leadership vote. Analysts noted, though, that Ozawa's clout had not been bolstered by the election, since many candidates he supported had lost.
The premier said early on Monday that the Democrats would ask opposition parties to cooperate on a policy-by-policy basis rather than invite them into a formal coalition right away.
Two potential partners, the Your Party - which favours small government and market-friendly reforms -- and the Buddhist-backed New Komeito, rejected the idea of joining the government anyway.
"Forming a coalition is like getting married. It has become clear that the Democrats are all talk and no action and I cannot marry a person like that," Your Party leader Yoshimi Watanabe told a morning TV talk show.
LDP leader Sadakazu Tanigaki also said his party was willing to talk about policies but ruled out any "grand coalition" -- although analysts speculated that might be the only way forward.
The government's most urgent task will be to draft budget guidelines for fiscal 2011012 from April 2011, and market players will be watching to see if they can hold the line on borrowing.
But even if they enact a budget, related bills needed to implement it would likely get stuck in the upper house.
"Voters were not trying to create political confusion, but that is the result," said independent political analyst Hirotaka Futatsuki, adding calls for a snap lower house election would likely grow. No lower house poll need be held until 2013.
Analysts have said opposition parties would drive hard policy bargains with the Democrats in return for any support, raising hopes among some experts that a deal with the Your Party would foster the deregulation many see as vital for growth.
(Additional reporting by Kiyoshi Takenaka, Yoko Nishikawa, Shinichi Saoshiro and Leika Kihara, editing by Jonathan Thatcher)
