By Linda Sieg and Yoko Nishikawa
TOKYO (Reuters) - Ratings agency Standard & Poor's warned on Monday it might cut Japan's sovereign grade as the ruling party's mauling in a weekend election posed new hurdles for Prime Minister Naoto Kan's plans to cut huge public debt.
Voters dealt Kan's Democratic Party of Japan (DPJ) a sharp rebuke, depriving it and a tiny ally of an upper house majority less than a year after the DPJ swept to power for the first time promising change from decades of conservative rule.
The Democrats still control the powerful lower house. But they will 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 fix tattered public finances.
Kan, who took over from his unpopular predecessor just last month, rejected calls from opposition parties for a snap lower house election. No lower house poll need be held until 2013.
"Only about one month has passed since the launch of my administration and I want the chance to firmly manage this administration with the people of Japan watching," he told reporters.
Noting the new political hurdles to fiscal reform, S&P warned it might cut Japan's sovereign ratings if its fiscal position eroded further or steps were not taken to curb debt.
Optimism was in short supply.
"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. Manufacturing confidence edged up in July to its best in 2- years, but the pace of gain slowed, a Reuters poll showed, a sign companies may be wary of slowing growth.
The election also leaves Kan open to a challenge from inside his party, though he says he will stay in his job. Kan is the fifth prime minister in three years.
MARKETS BLASE, POTENTIAL PARTNERS COOL
Markets took the outcome in stride, for now.
The Nikkei share average closed slightly lower and the yen eased. Government bond futures edged up.
The DPJ won power in a landslide last year, ousting the long-dominant conservative Liberal Democrats with promises to cut waste and focus on consumers. But government ratings nosedived due to funding scandals, chaotic policymaking and mishandling of a feud over a U.S. airbase in southern Japan.
Support rebounded when Kan took over, but tumbled once he floated a rise in the 5 percent sales tax and appeared to dither.
Many accept a sales tax rise is needed, with public debt about twice the size of the $5 trillion economy. But the DPJ did not convince voters it had a plan to cure Japan's economic ills.
"It's not that the voters don't want strong leadership. It's that there aren't strong leaders that the voters want," said Columbia University professor Gerry Curtis.
Analysts said likely policy deadlock had boosted chances that the government would lean on the Bank of Japan to put the economy in shape, partly because other steps would stall and partly because a potential ally, the small Your Party, wants more aggressive central bank steps.
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 received no boost from the election, as 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.
LDP leader Sadakazu Tanigaki also said his party was willing to talk about policies but ruled out any "grand coalition" -- although some analysts said that might be the only way forward.
The government's most urgent task will be to draft budget guidelines for fiscal 2011/12 from April 2011, and the market will watch to see if it can hold the line on borrowing. But bills to implement a budget could get stuck in the upper house.
Analysts say opposition parties will drive hard bargains with the Democrats, raising hopes among some experts that a deal with the Your Party would foster the deregulation many see as vital.
(Additional reporting by Kiyoshi Takenaka, Yoko Kubota, Shinichi Saoshiro, Benjamin Shatil and Leika Kihara, editing by Ron Popeski and Andrew Marshall)
