The test Japan's leaders must pass

Frustration could easily build over the slow pace of reform. Obuchi needs to find answers quickly

IT HAS ALREADY been very much a baptism of fire for the newly appointed Prime Minister of Japan, the 61-year-old Keizo Obuchi. Mr Obuchi has taken over from Ryutaro Hashimoto, who resigned immediately after the Liberal Democratic Party's dreadful performance in the 12 July Upper House elections. He is Japan's sixth PM since Bill Clinton became US President back in 1992.

The LDP's poor showing in the July elections means that it is now significantly short of a majority in the Upper House, and will need to rely on the support of minor parties such as the Komei Party in order to get key legislation through the Diet (the Japanese Parliament) in coming months.

This will be no easy task; the Democratic Party of Japan currently has a very popular leader in Naoto Kan, and his party is beginning to represent far more effective opposition to the LDP than they have at any time in recent years.

Mr Obuchi's ascension as LDP leader and then Prime Minister was not as smooth as it normally is with these appointments. Because of the depth of concern shown by the electorate in the state of the economy, some of the LDP's newer and younger members pushed for a more reform-minded candidate. But Mr Obuchi ultimately won the leadership contest fairly comfortably.

Financial markets were initially hesitant about the prospect of Mr Obuchi becoming the next PM. His background is very much administrative, he is not especially literate in economic or financial affairs, and his consensual style was regarded as inappropriate for Japan's parlous economic circumstances.

Mr Obuchi has attempted to address these concerns in recent weeks. During the leadership campaign, he presented the most coherent set of policies of the three leadership candidates, including the promise of rapid action to deal with banking sector problems, Y6 trillion (pounds 25bn) in tax cuts, a Y10 trillion supplementary budget package, and postponement of the fiscal reform law implemented by Mr Hashimoto which had prevented earlier fiscal expansion.

The new PM also promised to appoint experts to the various Cabinet posts, rather than the traditional LDP approach of following factional dictates, and he has been true to his word, which has won plaudits from the corporate sector.

One of Mr Obuchi's key appointments was Kichi Miyazawa as Finance Minister. Initially reluctant to accept the post, partly because of both his age (he is 78) and his health, Mr Miyazawa finally relented.

He brings immense experience to the position, having commenced his career at the Ministry of Finance back in 1942: he was Finance Minister for two years from 1986-88, and Prime Minister from 1991-93. Although financial markets have some concerns about Mr Miyazawa, he is undoubtedly the most qualified candidate available within current LDP ranks.

Indeed, the Obuchi/Miyazawa combination is arguably the best which the LDP could muster in the current circumstances. As leaders of the two most powerful factions within the LDP, they have immense influence within the party, which will be needed in coming months as they attempt to gain support for key legislative measures.

Given the plunge in the LDP's electoral support and their lack of a majority in the Upper House, a risk still remains that the newer members will become disillusioned with the lack of policy action shown by the party. However, both Mr Miyazawa and Mr Obuchi possess finely honed negotiating skills and in the present environment, represent possibly the best chance for maintaining LDP party unity.

Nevertheless, the task faced by the two men is daunting. The Japanese economy is in the depths of a serious recession, one which at this stage shows no signs of ending. lndustrial production fell 5 per cent in the second quarter, both consumer and business confidence are extremely gloomy, capital expenditure plans have been put on hold and household saving has increased sharply.

The Bank of Japan has recently expressed concern that Japan may have entered a deflationary cycle. Unemployment is on the rise; indeed, the unemployment rate in July of 4.3 per cent was a record, and with the corporate sector set to continue restructuring in coming months, substantial layoffs are in store. Very soon, we may find that the Japanese unemployment rate will be above that of the US, a situation regarded as completely implausible even 12 months ago.

In the face of these enormous economic challenges, one of the first areas which Mr Miyazawa has concentrated on is banking sector reform. A good part of the explanation for Japan having fallen on such hard times is the explosion in bad debts held by the major banks: in response to this, banks have simply ceased providing credit, inevitably leading to a credit crunch.

The big banks accumulated significant debts after the collapse of the asset price bubble in the early 1990s. Recently, with the domestic economy again entering recession, and with many Asian economies also deteriorating, Japanese banks have been forced to declare an increasing volume of bad and doubtful debts, resulting in a significant diminution of their capital base. Not until this capital base is replenished can these banks again perform their normal function of credit provision.

Mr Miyazawa has already promised to introduce legislation to reform the banking sector as soon as possible. Indeed, we could see some legislation in this area introduced to the Diet very soon, which would be a positive step.

There are many unanswered questions regarding this legislation, including how aggressively the Obuchi administration will be prepared to push the top banks into declaring their true doubtful debts. Given the close relationship which the LDP traditionally has with the banks and the construction companies, they will be loath to pursue rapid rationalisation.

Another area which both Mr Obuchi and Mr Miyazawa have promised to address is taxation. Mr Obuchi promised large tax cuts in his LDP leadership campaign, although exact details of his tax proposals are still not clear. He has pledged to reduce the top marginal tax rate and to reduce the corporate tax rate to international standards.

Mr Miyazawa recently spoke about a two-stage tax cut totalling around Y6 trillion, the first part being a uniform tax cut. The large supplementary budget package which Mr Obuchi mentioned will be considered more seriously later in the year.

At this early stage of the Obuchi administration, it already appears that frustration could easily build over the slow pace of reform in Japan. The magnitude of the task facing the new leadership is enormous; moreover, they have the full weight of the international community, global financial markets, the Japanese electorate, and the rest of the LDP assessing their every move.

Moody's, the credit rating agency, can also be added to this list, given its recent announcement that it was reviewing Japan's credit rating for a possible downgrade because of concerns over its exploding fiscal deficit.

Japan is poised at a crucial point in its history; the Obuchi administration needs to come up with the answers and quickly, or else Japan's future economic course will be significantly altered.

Bronwyn Curtis is chief economist at Nomura International