TOKYO – Japan's next leader, Yukio Hatoyama, began talks on Monday on forming a government to tackle challenges such as record unemployment and a fast-aging society after voters gave his party a sweeping mandate for change.

Sunday's historic election win by the Democratic Party of Japan (DPJ) 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), which had ruled Japan for most of the last half-century, was left to lick its wounds after suffering its worst election performance since the party was founded in 1955.

It's taken a long time, but we have at last reached the starting line, Hatoyama told a news conference at his home in Tokyo on Monday. This is by no means the destination. At long last we are able to move politics, to create a new kind of politics that will fulfill the expectations of the people.

Hatoyama is to set up a transition team to organize the change of government, but has 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.

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 and were able to delay bills.

The yen rose to a 7-week high, buoyed by the end of electoral uncertainty. The Nikkei share average edged lower after hitting a near 11-month high as the stronger yen sent shares of exporters lower.

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.

The problem is how much the Democrats can truly deliver in the first 100 days. If they can come up with a cabinet line-up swiftly, that will ease market concerns over their ability to govern, said Koichi Haji, chief economist at NLI Research Institute.

For a graphic showing the change in lower house seats, click: http://r.reuters.com/cer83d

SPENDING WORRIES

Despite the Democratic Party's landslide win, 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.

The untested Democrats, who will face an upper house election in less than a year, will have to move quickly 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.

Falls in wages and retail sales in data released on Monday underlined the economy's weakness, although industrial output rose on the back of worldwide stimulus spending.

There are some signs the economy is bottoming out in Japan. But recovery is still weak and it's hard to believe that the worst is over, said Akihiko Tembo, president of the Petroleum Association of Japan.

The Democratic Party victory ended 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.

REFORMS IN QUESTION

Support for the LDP had been on a downtrend for years, but then charismatic leader Junichiro Koizumi steered the party to a big election win in 2005 with promises of market-friendly reform.

Those reforms came under fire even within the LDP for worsening social and income gaps and were further attacked after the global crisis tipped Japan into recession.

In an essay published in the New York Times, Hatoyama railed at unrestrained market fundamentalism of U.S.-led globalization but after the election victory he played down those comments.

We are not saying that the market principles are all bad ... But the current economic situation is one where there needs to be corrections in areas where reform went too far, Hatoyama said.

The Democrats want a diplomatic stance more independent of key ally the United States, raising fears about possible friction in the alliance. They have also vowed to improve ties with Asian neighbors, often frayed by bitter wartime memories.

Budgetary matters will claim much of the government's attention in its early days. Party leaders have said they might freeze or redirect some of the 14 trillion yen ($149.5 billion) in stimulus spending planned for the year to March 31, 2010.

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 Sophia University professor Koichi Nakano.

(Additional reporting by David Dolan, Yumi Otagaki, Yoko Kubota, Yoko Nishikawa and Risa Maeda, Editing by Dean Yates)

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