TOKYO (Reuters) - If the cronyism scandal that has paralyzed parliament in Japan ends up swallowing veteran Finance Minister Taro Aso, a government hooked on radical reflationary polices would lose its strongest defender of fiscal prudence.

FILE PHOTO: Japan's Deputy Prime Minister and Finance Minister Taro Aso speaks to reporters in Tokyo, Japan March 12, 2018. REUTERS/Toru Hanai/File Photo

Investors should watch out. The scandal has still to play out and markets haven’t priced in just how much damage it could inflict on Prime Minister Shinzo Abe’s government.

“Aso has been a restraining voice against growing calls in the administration for big fiscal spending and radical steps,” said Koichi Haji, chief economist at NLI Research Institute.

“If Aso were to resign, the next finance minister would have big shoes to fill.”

Abe and Aso are under fire over the finance ministry’s admission that it had altered records of a discounted sale of state-owned land to a school operator with ties to Abe’s wife.

Opposition lawmakers have called for Aso’s head and are boycotting parliamentary debate over budget proposals for the coming financial year.

With his enemies circling, Aso has refused to step down and Abe has defended an ally he was counting on to help him secure a third term as leader of the ruling Liberal Democratic Party (LDP) when the party votes in September.

But there are growing calls even from within the LDP for Aso to fall on his sword. A public opinion poll by Sankei showed 71 percent of respondents thought he should go.

“This is a serious threat to democracy,” Yoshimitsu Kobayashi, chairman of Japan’s influential business lobby Keizai Doyukai, told a news conference on Tuesday. “If you’re a head of a private company, you would resign regardless of whether you had knowledge of the misconduct or not.”

It is an awkward time for export-driven Japan to have a finance minister’s future hanging in the balance, with the world fearful that U.S. President Donald Trump may have fired the first shots in a global trade war by placing hefty tariffs on steel and aluminum imports.

Aso already appears set to skip a Group of 20 finance leaders’ gathering next week. Though no date has been set for the next meeting of a U.S.-Japan bilateral economic dialogue, Aso is supposed to head the delegation in Washington that will come under pressure to reduce Japan’s trade surplus with the United States.

‘LISTEN TO ELDERS’

Even if Aso survives this scandal, some analysts fear he would be so politically damaged that he could lose his clout.

Aged 77 - old even by Japan’s standards - Aso’s political shelf life could be running out.

But as a former premier himself and the leader of a powerful faction within the LDP, Aso still has enough political heft to tell a prime minister who is 14 years his junior to think twice before making fiscally risky moves.

“The premier doesn’t take Aso’s views lightly,” said a government official placed well enough to know. “The fiscal debate could be affected depending on how the scandal unfolds.”

While Abe has made breaking the economy free of a long, debilitating deflationary phase its priority, Japan can ill afford any laxity when it comes to keeping a lid on debt levels that are the highest of any major economy.

When he came to power in 2012, Abe embarked on a mix of ultra loose monetary policy, fiscal stimulus and reforms.

But the central bank’s 2 percent inflation target remains elusive even as the economy enjoys its longest run of growth - albeit at low levels - in 28 years.

Driven by the need to see “Abenomics” succeed, the prime minister hasn’t always listened to the cautionary words from the oldest member of his cabinet. Abe’s decision to delay a sales tax hike in April 2017 went against Aso’s advice.

Late this year, Abe must decide whether to proceed with the twice-delayed increase in the sales tax in October 2019. Most analysts expect him to go ahead this time, as the revenues are already earmarked to cover planned spending.

But some analysts say there is a danger that without Aso’s counsel, Abe could lack resolve if his popularity is waning and he feels politically vulnerable.

“Abe has never been a fan of a sales tax hike,” said another official in the inner circle of policy-making. “You never know what could happen.”

NO ROOM FOR BACKSLIDING

Japan’s public debt, at twice the size of its economy, is the largest among major industrialized nations as a rapidly aging population boosts welfare spending.

In January, Japan pushed back by two years the timing for achieving its fiscal discipline target in a sign of the difficulty of restoring fiscal health.

Based on the new timeframe, the government will draft in June new fiscal guidelines that will influence state budgets for coming years.

Addressing a Columbia University seminar in New York a year ago, Aso spelt out what any loss of fiscal prudence could mean for Japan.

“If we abandon our efforts on fiscal discipline, that could invite a bust in Japan’s finances or runaway inflation that would have a detrimental effect on the general public,” he said.

It’s not just on fiscal policy that Aso’s conventional approach acts as a brake on more radical thinkers.

If Aso left the finance ministry, the Bank of Japan would lose a backer in seeking a slow but steady exit from its huge monetary stimulus. Aso has said there were limits to how much monetary policy can do and ramping up stimulus further will have little benefit for the economy.

Aso was opposed to radical steps like “helicopter money,” under which the central bank directly underwrites government debt, so his departure could embolden advocates of such steps.

“Without Aso, Abe’s administration will lose restraint on fiscal and monetary policy,” said Yasunari Ueno, chief market economist at Mizuho Securities, noting that any faltering in the economy could expose those risks.