TOKYO, Japan - Prime Minister Naoto Kan and powerbroker Ichiro Ozawa faced off over fiscal policies on Wednesday in a battle for party leadership that is threatening a policy vacuum as Japan confronts a strong yen and weak economy.

The strife in the Democratic Party of Japan (DPJ), which swept to power one 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 economy.

It also coincides with a rise in the yen that threatens Japan's fragile economic recovery. A Bank of Japan decision on 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 Sept. 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 (from the problem)," Kan said in the statement.

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

Policy vaccum

The yen dipped a little after Ozawa's policy statement on intervention, with the dollar hitting the day's high of 84.58 yen following that. But the U.S. currency later trimmed some gains to stand at 84.46 yen, up 0.3 percent on the day.

"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.

A solid Kan victory would strengthen the premier's control over policy, but at present the race is too close to call.

"If Kan does get a big vote, I suppose he could be more aggressive, but I'd say the chances of that are not as great as the chances of the party imploding," said Jeffrey Kingston, director of Asian studies at Temple University in Tokyo.

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 parliament members, so public opinion will have an impact.

A defeated Ozawa could decide to bolt the DPJ and try to spark a realignment of party allegiances, though how many of his backers would follow suit is unclear.

Additional reporting by Elaine Lies, Writing by Linda Sieg, editing by Jonathan Thatcher