Japanese opposition leader Ichiro Ozawa said on Wednesday he would not resign over the arrest of a close aide in a fundraising scandal, but the affair cast a cloud over his party's prospects in a looming election.

Ozawa's Democrats have been looking increasingly likely to win an election that must be held by October, ending more than 50 years of nearly unbroken rule by Prime Minister Taro Aso's Liberal Democratic Party (LDP).

The latest twist in Japan's painful political saga raised concern among investors that an election would fail to break a deadlock in parliament that has stalled government efforts to rescue the economy from its worst recession since World War Two.

Political analysts said the arrest of the aide on suspicion of accepting illegal corporate donations could still prompt Ozawa to resign and upset predictions of a solid opposition victory in the election -- although few expect the struggling LDP to win big as a result.

"I myself have done nothing of which to be ashamed and the actions of my secretary were carried out properly in accordance with the political funding law and properly dealt with," Ozawa told a news conference.

"Therefore, it is not a matter of me doing this or that," he said, when asked whether he would step down.

An opposition victory in the next election would make Ozawa prime minister, although analysts have questioned how long he would stay in the job given his health problems.

The Democrats, in favour of reducing bureaucratic meddling in policy and a diplomatic stance more independent of Washington, have been ahead in opinion polls as voters blame Aso for policy inaction and flipflops during his five months in office.

Aso, whose popular support has dropped below 10 percent in one poll and is not much higher in others, is struggling to keep his own job and has faced calls from within his party to step down before the election.

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Aso's clout was put to test on Wednesday in a lower house vote to approve unpopular cash handouts for voters.

A potential rebellion fizzled when only former prime minister Junichiro Koizumi absented himself and one other LDP lawmaker walked out before the vote.

Still, it was unclear how much Aso's beleaguered government and the LDP would benefit from the opposition scandal involving a mid-sized contracting firm, Nishimatsu Construction Co Ltd.

Aso is Japan's third leader in less than two years. His two predecessors quit abruptly after their poll ratings sank in the face of a political stalemate caused by a divided parliament, where opposition parties control the upper house and can delay legislation and stymie policy.

"The market frets over cases like this as it signifies political uncertainty, while it leads to distrust in politics among the Japanese people," said Mitsushige Akino, chief fund manager at Ichiyoshi Investment Management.

"The situation could be even more chaotic as there's a risk now neither the LDP or the Democrats can win the election."

Ozawa, a former LDP heavyweight who fled the party in 1993 and helped to briefly oust it, has long struggled with competing images, one as a reformer intent on prying policy decisions out of the hands of bureaucrats and the other as an old-style backroom fixer with an autocratic management style.

But his skills at campaign strategy and his ability to hold the sometimes fractious Democratic Party together have been seen by many analysts as important, if not vital, to its success.

If Ozawa is forced to resign, the Democrats could still limit the damage by smoothly selecting a successor, some analysts said.

Indeed, the Democrats might even benefit if their next leader's image is more appealing to voters, some analysts said.

"The best scenario for the LDP is that Ozawa stays," said Columbia University professor Gerry Curtis, adding that the most the LDP could hope for was to limit the size of its loss.

"If Ozawa were to resign and someone ... who has an image of being clean were to come in, it would probably result in increased support for the Democrats," Curtis said.