By Leika Kihara
TOKYO, Jan 13 (Reuters) - Japan may face its own version of the U.S. "fiscal cliff" if Prime Minister Sanae Takaichi calls an early snap election, a move that could delay parliamentary approval of a bill that grants the government the right to issue deficit-covering bonds.
The yen and Japanese government bond prices fell after the Yomiuri newspaper reported on Friday that Takaichi might dissolve parliament this month and call a general election in February.
On Tuesday, the Kyodo news agency said Takaichi had conveyed to a ruling party executive her plan to dissolve parliament's lower house at the start of its regular session, setting the stage for a snap election.
If that happens, parliament will go into recess shortly after convening on January 23, delaying the passage of the state budget and other legislation.
By law, the government is prohibited from issuing bonds except for "construction" bonds aimed solely at funding public works projects.
As expenditure has grown for huge stimulus packages and rising social welfare costs for an ageing population, the government has circumvented the law by passing a separate bill allowing it to issue "deficit-covering" bonds as an exception.
The existing legislation's five-year term expires in the fiscal year ending in March, which means the government must pass a fresh bill through parliament to keep issuing enough bonds to fund expenditure for the fiscal 2026 budget.
Failure to pass the debt bill in time would leave the government lacking enough money to fund the big spending plans Takaichi laid out in Japan's record $783 billion budget.
Nearly a quarter of the budget will be funded by debt issuance. Of the 29.6 trillion yen ($186.4 billion) new debt scheduled to be issued in fiscal 2026, 22.9 trillion yen will be deficit-covering bonds, according to the government's plan.
Takaichi's ruling coalition holds a narrow majority in the lower house but not the upper house. An election win could boost Takaichi's hold over the powerful lower house, but still require her to seek opposition cooperation to pass legislation in the upper house.
Parliament approval of the debt bill was seen as a done deal with the opposition Democratic Party for the People (DPP) indicating its support.
But an early general election could antagonise the DPP, which would see its flagship tax break plans put on hold as a result.
DPP leader Yuichiro Tamaki said on Tuesday the decision on whether his party would cooperate in passing the debt bill was now "in flux," Kyodo reported.
"In terms of a snap election, there's little to be bullish about the bond market" due to heightening political uncertainty, said Keisuke Tsuruta, senior bond strategist at Mitsubishi UFJ Morgan Stanley Securities.
"Investors will be wary of taking on interest rate risk, which could put upward pressure on the yield curve," he said.
The yield on the benchmark 10-year Japanese government bond (JGB) hit a 27-year high on Tuesday on expectations a potential snap election could hand Takaichi a mandate to pursue aggressive fiscal stimulus.
Japan's debt, at twice the size of its economy, is the highest among major economies. Debt-funding costs now make up more than a quarter of total government spending and are likely to grow as the Bank of Japan raises interest rates.
($1 = 158.8000 yen)
(Reporting by Leika Kihara; Editing by Kate Mayberry)
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