TOKYO - Japan's next prime minister began forming a government on Monday as investors worried the untested Democratic Party would overspend in a bid to revive the economy or would ruffle ties with Tokyo's closest ally, Washington.

Sunday's historic election win by Yukio Hatoyama's party breaks a deadlock in parliament and will usher in a government that has promised to focus spending on consumers, cut wasteful budget outlays and reduce the power of bureaucrats.

The defeated Liberal Democratic Party (LDP) was left to lick its wounds after its worst election performance since the conservative party was founded in 1955. The party had ruled Japan for almost all of the last half-century.

Hatoyama has cut a serious figure since voters gave the Democratic Party of Japan (DPJ) a sweeping mandate for change.

The situation in Japan is not one that allows me to savor my happiness. Many Japanese people have suffered from politics and they therefore wanted the DPJ to do well and wanted a change in government, he told reporters.

I have no time to be saying 'We did it, we did it.'

The yen rose to a 7-week high, buoyed by the end of electoral uncertainty. Japanese stocks, after hitting a near 11-month high earlier in the day, closed slightly down as the stronger yen hurt shares of exporters.

Hatoyama is to set up a transition team to organize the change of government, but said he will not announce his cabinet until he is officially elected prime minister by a special session of parliament, probably in about two weeks.

The Democratic Party's landslide win in the lower house failed to lift a downbeat mood in a rainy Tokyo, where there was little post-election euphoria. Many voters and analysts said the victory was driven more by frustration with the LDP than broad support for the decade-old opposition.

It's not that the Democrats were good. I voted for them as a punishment for the LDP. The LDP has to change, said Etsuji Inuzuka, 47, who works in the furniture business.

SPENDING WORRIES

Investors welcomed the end to a political deadlock that has stymied policies as Japan struggled with its worst recession since World War Two. The Democrats and its small allies won control of the upper house in 2007, enabling them to delay bills.

But many were concerned about whether the party would be able to maintain fiscal discipline after promising policies such as cash handouts for families with young children and the abolition of expressway tolls, a Reuters survey showed.

Fiscal issues, together with diplomacy and security, will be a major issue, said Junko Nishioka, chief Japan economist at RBS Securities.

Media forecasts show the Democrats won about 308 seats in the lower house, nearly tripling their strength in the 480-member chamber. The LDP won only 119 seats, down from 300.

For a graphic showing the change in lower house seats, click: r.reuters.com/cer83d
It's going to be crucial how they spend the first year in office, so in that sense they have to get focused very quickly, said Koichi Nakano, a professor at Sophia University in Tokyo.

The Democrats, who will face an upper house election in less than a year, must move fast to keep support among voters worried about a record jobless rate and a rapidly aging population that is inflating social security costs.

Japan is aging more quickly than any other rich country. More than a quarter of Japanese will be 65 or older by 2015.

Analysts say the Democrats' spending plans might give a short-term lift to the economy, just now emerging from recession, but worry that its programs will boost a public debt already equal to about 170 percent of GDP.

Ratings agency Standard & Poor's said some of the spending policies could lead to higher fiscal deficits.

STRAINS IN U.S. TIES?

A fourth-generation politician, Hatoyama is known less for economic policies than for his stance on security and diplomacy.

He has advocated revising Japan's pacifist constitution to acknowledge the nation's right to defend itself and said Tokyo's foreign policy was too subservient to Washington.

Tokyo's contributions to U.S. military operations abroad as well as the status of U.S. bases in Japan could cause friction under the Democrats, although the party has stressed continuity in ties with Washington.

Hatoyama himself raised eyebrows this month in an essay that railed at the unrestrained market fundamentalism of U.S.-led globalization. He has sought to play down those comments since the election win, saying on Monday he was not anti-American.

Washington can take some comfort from knowing that dire predictions of a dramatic leftward-course shift from the Japanese ship of state are wrong, said Bruce Klingner of the Heritage Foundation think tank in Washington.

But even minor policy changes or alterations in tone will have far-reaching implications and cause strains.

The Democrats have also vowed to improve ties with Asian neighbors, often frayed by bitter wartime memories. Hatoyama said he spoke to South Korean President Lee Myung-bak by phone and the two agreed to cooperate in dealing with North Korea.

The Democratic Party's victory could end the iron triangle -- a three-way partnership between the LDP, big business and bureaucrats that turned Japan into an economic juggernaut from the ashes of the country's ruin in World War Two.

That strategy foundered when Japan's bubble economy burst in the late 1980s and growth has stagnated since.

(Additional reporting by David Dolan, Yumi Otagaki, Yoko Kubota, Risa Maeda and Paul Eckert, Editing by Dean Yates and Hugh Lawson)

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