Prime Minister Naoto Kan and rival Ichiro Ozawa clashed over fiscal priorities Wednesday in a battle for party leadership that threatens a policy vacuum as Japan struggles to tackle a strong yen and weak economy.

The strife in the Democratic Party of Japan (DPJ), which swept to power a year ago promising change, underscores a policy rift that could derail Kan's efforts to curb a public debt already twice the size of the $5 trillion (£3.22 trillion) economy.

It also coincides with a rise in the yen that threatens Japan's fragile recovery. A Bank of Japan decision Monday to boost a cheap loan scheme did little to weaken the currency, hovering near a 15-year high against the dollar hit last week.

In a platform released after registering for the September 14 DPJ leadership vote, Kan said he would consider drastic tax reforms including Japan's 5 percent sales tax.

I will tackle fiscal consolidation without running away, Kan said in the statement.

Kan later said on public broadcaster NHK that he does not think government bonds should be issued merely to fund campaign pledges, but added that he has not shifted to a fiscal tightening stance at this stage.

Ozawa, in contrast, said he would cut waste drastically to fund party pledges aimed at putting more cash in consumers' hands, and vowed in a statement to take all possible steps, including market intervention, to cope with rises in the yen.

We need to cut wasteful spending before debating a sales tax hike, and use the revenues to implement policies we've promised. This has been what we promised to the public, Ozawa told a joint news conference with the prime minister.

POLICY VACUUM

With the leadership race too close to call, Kan and Ozawa sought to zero in on each other's weak points, creating some tense moments in an otherwise bland performance by both.

The premier pledged clean politics -- a veiled swipe at his rival's scandal-tainted image -- while Ozawa said Kan had not done enough to put politicians in charge instead of bureaucrats.

Ozawa stepped down last year as party chief over a funding scandal and faces possible indictment over the affair, a big reason for his rock bottom rating among voters.

Frankly, I can't imagine Mr. Ozawa sitting through long budget committee sessions in parliament as the prime minister does, Kan said, prompting Ozawa to laugh and reply he had what it takes to do the top job.

Ordinary voters and financial market players worry the party battle is keeping the government from dealing with economic woes.

The big issue is that during this (election) period there risks being a political vacuum that could hamper policy-making, possibly encouraging speculators to sell the Nikkei, said Hideyuki Ishiguro, a strategist at Okasan Securities.

Ozawa's propensity for spending has been welcomed by some financial market players worried about Japan's faltering economy, but would also exacerbate concerns about mounting debt and so steepen the yield curve for Japanese government bonds.

It could be positive over the short term, Yutaka Miura, a senior technical analyst at Mizuho Securities, said of an Ozawa win. But over the mid- and longer-term it'd be negative, since there'd be more worries about an increase in debt.

The winner of the party race will likely become premier by virtue of the Democrats' majority in parliament's lower house.

Kan is already Japan's fifth leader in three years and if he loses the country could end up with its third premier in one year -- one reason a majority of voters favour Kan staying on.

DEBT WORRIES

Ozawa has criticised Kan for floating a possible rise in the sales tax ahead of a July upper house election that cost the ruling bloc its majority in the chamber, forcing the Democrats to seek opposition help to pass bills.

He also wants to stick to pledges made before last year's general election, raising concerns about inflating public debt.

The Democrats have stumbled on economic and diplomatic fronts, struggling to craft a plan to end decades of stagnation and straining ties with key security ally the United States.

Ozawa's admirers say the veteran political strategist's deal-making skills may be just what Japan needs to break through the political deadlock. Others say his leadership would likely spark confusion and worsen the policy gridlock.

Ozawa heads the biggest group in the DPJ, but local lawmakers and party supporters can take part in the vote, along with DPJ members of parliament, so public opinion will matter.

A defeated Ozawa could decide to quit the DPJ and try to spark a realignment of party allegiances, though he said on Wednesday he had no such plan in mind.

(Additional reporting by Leika Kihara, Elaine Lies, Yoko Kubota and Kiyoshi Takenaka; Writing by Linda Sieg; Editing by Alex Richardson)

Japan