Japan Yosano: must watch markets when issuing reconstruction debt

* Weak public finances make reconstruction spending difficult task

* Government trying to overhaul social security and raise taxes

* Moves to oust the prime minister pick up pace as parties eye grand coalition

By Stanley White

TOKYO, June 7 (Reuters) – The Japanese government needs to closely watch market moves when figuring out how much new debt it will sell to fund reconstruction following an earthquake in March, the economics minister said, as a fiscal policy crunch looms.

The government should keep a proposal to double the sales tax to pay for rising welfare spending separate from any debate on using tax increases to rebuild after the March 11 earthquake, tsunami and nuclear disaster, Economics Minister Kaoru Yosano said on Tuesday.

Yosano, who led a panel that proposed increasing the 5 percent sales tax, said the government will reach a final decision by June 20, but implementation of the plan is in doubt. The ruling Democratic Party is trying to push out the prime minister to form a coalition with opposition parties, but negotiations could drag on and put some fiscal policies on hold.

“We have to watch market moves closely to figure out how much debt we can handle,” Yosano told reporters after a cabinet meeting.

“Our plans for social welfare reform could affect how people perceive our levels of public debt.”

Japan’s public debt is already about twice the size of its $5 trillion economy and ratings agencies are threatening to downgrade the country, which makes it all the more difficult to plan reconstruction spending in response to what is the world’s costliest natural disaster.

A panel led by Yosano has also proposed overhauling social security by streamlining some programmes, increasing spending on others and using income from the sales tax to fund social security, which is a burden on public finances due to Japan’s aging and shrinking population.

Japan, which has the largest currency reserves after China, should avoid the temptation of dipping into these funds for fiscal policy, partly because the country is sitting on unrealised losses due to the yen’s strength, Yosano said.

Prime Minister Naoto Kan ordered his cabinet to speed up preparations on a second extra budget to rebuild the country’s battered northeast coast, Kyodo News reported on Tuesday.

Legislation to issue deficit-covering bonds for the current fiscal year that started in April and a bill to change the tax code have been stalled in parliament due to opposition criticism of Kan’s handling of the natural disaster almost three months ago. The Democrats need opposition votes to pass bills in a divided parliament.

Early compilation of a second extra budget could pave the way for Kan’s exit and a coalition government, but it is unsure whether opposition parties will insist that Kan leave his post before the second extra budget is complied.