The Nikkei stock index lost nearly 1,000 points, or 5 per cent of its value, to close at 18,353 as the governing and opposition parties bickered over a face-saving compromise to avoid dissolution of the Diet and elections.
At a tense news conference, Ichiro Ozawa, the mastermind behind Mr Hosokawa's reformist administration, said he believed a compromise was still possible. When asked what would happen if no agreement was reached, he replied curtly: 'I don't answer 'what if' questions.' But everyone in Japan was asking 'what if?' last night. Neither the government nor the Liberal Democratic Party wants another election.
Meanwhile, businessmen and economists were asking their own question: what if political confusion is dragged out, delaying a promised economic rescue package, and allowing the recession to deepen further?
In two weeks Mr Hosokawa is due to travel to the United States to meet President Bill Clinton. Will he still be prime minister, and will he have any power to address US concerns over Japan's record trade surplus? Or will he be just another Japanese lame duck?
Mr Hosokawa pledged at the start of his government last August that he would clean up Japan's notoriously corrupt political system. Survey after survey has shown that voters want change.
In the Diet the two parties who benefited most from the old status quo, the LDP and the Socialists, have tried to block reform. Mr Hosokawa's deadline is Saturday, when the Diet session is dissolved. If no reform laws have been passed by then, he will probably be forced to step down.
The most likely way out of the impasse is for a joint committee of
20 Diet members to agree on a watered-down version of the reforms.
Both sides have an interest in a deal. The coalition does not want to have to leave office after six months. The LDP does not want to be seen as having derailed reform; it could face a revolt of reform-minded members and further loss of electoral support.
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