Japan’s government has announced it will press on with tax reforms to cut a huge public debt despite a stunning election setback, and was looking to two opposition parties to help drive policy change.

Prime Minister Naoto Kan’s ruling coalition lost its upper house majority in a weekend election, putting his policies to deal with debt and generate growth at risk and prompting warnings by credit rating agencies S&P and Fitch on Japan’s sovereign ratings.

His Democratic Party of Japan (DPJ) still controls the more powerful lower house. But it needs help from other parties to push bills through the upper chamber in the struggle to end decades of stagnation in the world’s number two economy.

“If we don’t see a credible plan come through by the end of the year, it will send a negative signal for its rating, adding pressure to the credit rating,” Andrew Colquhoun, Fitch Rating’s sovereign analyst for Japan told reporters.

Trying to soothe worries the election drubbing would sap political momentum for fiscal reform, National Strategy Minister Satoshi Arai said debate was still needed on a possible hike in the five percent sales tax, one of the lowest among major economies.

Kan had floated the possibility of doubling the tax as a way to bring down public debt about twice the size of the $5trn economy and to stave off a Greek-style debt crisis as social security costs soar to care for an ageing population.

Finance Minister Yoshihiko Noda conceded that Kan’s proposal may have turned off voters in the election campaign.

“But we must carry out an overhaul of the tax system including the consumption tax,” he told a news conference.

Unlike Greece, Japan’s public debt has long been financed from its massive pool of domestic savings that mostly sits in the banking system and is recycled into Japanese government bonds.

But fears are growing that the ageing population will start drawing on those savings, forcing Japan to rely on foreign investors to fund its debt and potentially creating market instability.

The change has already started and Japan’s savings rate has fallen to about three percent from over 10 percent a decade ago.

The Fitch warning of the higher risk of a ratings downgrade helped send September Japanese government bond futures to the day’s low at 141.33.

Tough challenge
In attempt to break the political deadlock, Kan told close aides he would ask the third and fourth-biggest parties in the upper house – the New Komeito and pro-reform Your Party – for policy-based cooperation, the Yomiuri newspaper reported, adding he was probably eyeing a formal coalition in the future.

But Kan, in office just since June, faces a tough challenge as the two parties have ruled out joining the government, pointing to a period of political manoeuvring and policy paralysis.

Your Party, which has 11 seats in the upper house after Sunday’s poll, could cooperate with the DPJ on getting the Bank of Japan to do more to fight deflation and on overhauling the country’s bureaucratic system.

But the party has said it would not join the debate on a possible sales tax increase, arguing that the government should first focus on cutting wasteful spending.

The Buddhist-backed New Komeito, which backs policies to fix the pensions system and social safety net, could agree to the debate on the sales tax but only if the government first tackles social security reform.

Bills at immediate risk in an extra parliament session expected in the coming months include one to scale back postal privatisation, sought by Kan’s current small coalition partner, the People’s New Party, but opposed by the Your Party.

Kan has a more pressing threat – a possible challenge from opponents in his own party including powerbroker and critic of the sales tax hike proposal, Ichiro Ozawa, ahead of a party leadership vote in September.

He could reshuffle his cabinet after the vote, Jiji news agency reported. He is already under pressure to replace his justice minister who lost her seat in the election.

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