Japanese Prime Minister Junichiro Koizumi’s party suffered an embarrassing setback in a weekend upper house election that allows him to keep his job but weakens his ability to forge ahead with economic reforms.

Financial markets took the results in their stride yesterday, with stocks closing sharply higher and the yen hitting a two-week high against the dollar and a one-week peak versus the euro.

Koizumi, whose ruling coalition retained its majority in the parliamentary election on Sunday despite the poor showing of his Liberal Democratic Party (LDP), vowed to stick to his reform agenda and to continue Japan’s aid mission in Iraq.

“I think it’s necessary for Japan to conduct activities that will be viewed positively ... toward Iraq’s reconstruction”, Koizumi told a news conference. Japan has sent 550 non-combat troops to held rebuild Iraq and pledged $5 billion in aid.

Koizumi also indicated he would reshuffle his cabinet in September but gave no clues to the changes.

Official results have not yet been published but media said Koizumi’s LDP won only 49 of the 121 seats at stake in Sunday’s poll, missing its modest target of holding on to 51.

In addition to the 49 seats won by the LDP, its junior coalition partner, the New Komeito, won 11 seats, giving the ruling coalition 139 of the 242 seats in the upper house. Half of the upper chamber’s seats are contested every three years.

The main opposition Democrats, buoyed by voter dismay over pension reforms and the Iraq mission, made impressive gains, winning 50 of the seats contested, up from 38.

“I would like to firmly push forward reforms, viewing this as a voice from the public to make progress on reforms while paying heed to the views of the opposition”, Koizumi said.

The poor showing could reduce the prime minister’s clout within his party and cast a shadow over his economic reforms. But with no elections soon, Koizumi could still forge ahead, analysts said.

Koizumi, 62, sprang to power in 2001 on a groundswell of popular support for his promise to abandon the wasteful public spending that had inflated Japan’s government debt and to privatize debt-laden public corporations and postal services

Economists say Koizumi’s record is patchy and his support has fallen to half of the 80 percent of three years ago when he led the LDP to a solid showing in a previous upper house election.

The Democrats had criticized Koizumi’s record on reform as well as unpopular changes to the creaking state pension scheme and the dispatch of troops to Iraq. Democratic Party leader Katsuya Okada vowed to cash in on voter anger to set the stage for his party to win in the next general election.

Meanwhile, “Markets are reacting positively because they see political stability in the short term, but I believe the results weaken Koizumi’s longer-term drive for reforms,” said Kiichi Murashima, director of economic and market analysis at Nikko Citigroup.

Although the weak LDP showing would undermine the maverick Koizumi’s influence inside his party, there were virtually no calls for him to step down due to a lack of viable alternative.