By Linda Sieg

TOKYO (Reuters) - Japanese Prime Minister Shinzo Abe will likely pick ruling party policy chief Tomomi Inada as defense minister in a new cabinet, the Asahi newspaper said on Tuesday, which could upset China and South Korea given her conservative views on wartime history.

Abe is set to reshuffle his cabinet on Wednesday, retaining several ministers and picking a veteran lawmaker who favors big spending as ruling party number two.

Inada, 57, is a close ally of Abe and shares his goal of revising the post-war, pacifist constitution, seen by some conservatives as a humiliating symbol of Japan's World War Two defeat.

She regularly visits Tokyo's Yasukuni Shrine, which honors war dead and is seen in China and South Korea as a symbol of Japan's past militarism.

Japan's relations with Beijing and Seoul have often been frayed by the legacy of Japan's military aggression before and during World War Two.

"The mood now is to try to promote cooperation," Jeffrey Kingston, director of Asian studies at Temple University in Tokyo, said of relations between Japan and China.

"That could change if she makes a pilgrimage to Yasukuni in a couple of weeks."

Inada would be the second woman in the defense post after Yuriko Koike, newly elected as Tokyo governor, briefly held it in 2007.

Abe is trying to rev up economic growth and handle multiple diplomatic challenges as he eyes the possibility of staying in office after his term as president of the ruling Liberal Democratic Party (LDP) ends in 2018.

He is expected to travel to China in September for a Group of 20 summit, where he may have a meeting with Chinese President Xi Jinping.

Sino-Japanese ties have also been strained by a dispute over tiny isles in the East China Sea and China's growing assertiveness in the South China Sea.

Abe, who took office in December 2012, will retain his right-hand man, Chief Cabinet Secretary Yoshihide Suga, along with Finance Minister Taro Aso and Foreign Minister Fumio Kishida, media reported.

Economics Minister Nobuteru Ishihara may be retained along with Health, Welfare and Labor Minister Yasuhisa Shiozaki. NHK public broadcaster said Deputy Chief Cabinet Secretary Hiroshige Seko would become trade and industry minister.

Shigeru Ishiba, minister for regional revitalization, will decline to stay in the cabinet, media reported, in order to prepare for a run at replacing Abe as prime minister when his term as LDP leader expires.

On Wednesday, Abe will also recast the LDP executive line-up.

His expected appointment of Toshihiro Nikai, 77, a big spending advocate with good ties with China, as LDP secretary general was seen as signaling the premier's hopes for a third term. Nikai has indicated his support for an extension for Abe, which would require a change in party rules

On Tuesday, Abe's outgoing cabinet approved 13.5 trillion yen ($132.04 billion) in fiscal steps to try to revive the economy.

Some experts worry Abe will divert too much energy to trying to revise the constitution since his ruling bloc and allies now have the two-thirds majorities in both houses of parliament needed to start the process. Changes must also be approved in a referendum.

(Additional reporting by Kaori Kaneko; Editing by Richard Borsuk, Robert Birsel)