Will a New Leader Help Japan?

As the LDP gears up to pick a new chief, one of the contenders is a serious reformer

A recent swing through Yamaguchi Prefecture of Southern Japan left Yoshimasa Hayashi plenty worried. After taking the pulse of the electorate, Hayashi, the local Liberal Democratic Party representative in the Upper House of the Diet, concluded that he could lose his seat when elections are held in June. Yamaguchi is Old Economy Japan, where Nippon Steel Corp. and scores of construction companies--most of them struggling--are big employers. They don't much like the reform talk emanating from Tokyo these days. Reform means restructuring--and that means layoffs.

Hayashi knows how crucial it is for the LDP to fashion coherent policies to avert another recession. "It's a critical time for the party," he says. "Basically we have a three-month window" to turn things around. The burning question is what a turnaround means for the ruling LDP: another package of bailouts that leaves the failing status quo intact, or a real effort to change the economy?

DYSFUNCTIONAL. The answer could become clear on Apr. 24. That's when the race for the presidency of the LDP will conclude in a vote by party Diet members and local party chapters. The winner will, as head of the LDP, automatically become Prime Minister and inherit the management of the developed world's most dysfunctional economy.

The contest has come down to two candidates. In one corner is the blustery Junichiro Koizumi, 59, who wants to get the economic pain over right away. His chief rival is self-assured former Prime Minister Ryutaro Hashimoto, 63. He is pitching a go-slow approach. The contest between the two men is being tracked not only by voters in Yamaguchi Prefecture but also by global investors and anxious policymakers in European capitals and the White House, who fret about the impact of a simultaneous downturn in the U.S. and Japan.

A big intra-party realignment led by Koizumi, who advocates a housecleaning of the banks' bad loans and more corporate restructuring, would surely cheer the markets--though it would also shove Japan back into recession in the short term. Koizumi's promise to smash the LDP's faction-ridden structure and end policy drift would also require a minor miracle to put into effect. To get there, he has taken the symbolic step of quitting the LDP faction led by outgoing Premier Yoshiro Mori. He vows to assemble a Cabinet full of experts, instead of party hacks. For Japan, it is a quixotic quest, a fact he freely concedes. Without a sea change in LDP thinking, he says, "I have no chance to prevail."

Indeed, Hashimoto, as chief of the biggest LDP faction, holds the best political cards. Like Koizumi, he realizes that without long-term fiscal reform and moves to shore up Japan's social security system, consumers aren't likely to spend because they "don't have any sense of security." But given the U.S. downturn, plus weakness in East Asia, the erstwhile fiscal hawk plans to spend the first 100 days of his government weighing another spending package and slashing Japan's 26% capital-gains tax to 20% to kick-start the Nikkei. He also doesn't rule out more money for the banks, but vows to keep the pressure on them to clear dud loans, even if it means layoffs.

While Koizumi is popular among voters, they are deeply divided over the wisdom of economic shock therapy. Representative Hayashi notes that in his district, steel execs and shopkeepers tell him they want stability, "while urban voters talk about big reforms."

Consider what's at stake. If Japan's banks foreclosed on their worst nonperforming loans, estimated to be worth $178 billion, Goldman, Sachs & Co. reckons that scores of companies would go out of business and 324,000 workers would lose their jobs--pushing the unemployment rate up a full percentage point, to 5.7%. Economic growth, now hovering between 0% and 1%, could plunge into negative territory. In short, Corporate Japan fears that shock therapy, poorly executed, would kill the patient. "We're definitely worried," says Fujio Cho, president of Toyota Motor Corp. "Too drastic a push to clean up the bad-loan mess could put a lot of companies out of business."

Koizumi thinks he has the answer. Short-term, he would push the banks to call in loans on unworthy borrowers. Then the government would spend up to $30 billion annually to expand jobless benefits and so cushion the economic pain of layoffs. Fiscal spending would be capped near existing levels and then gradually wound down, while Japan's public pension system, now headed for bankruptcy, would be reviewed for cost and benefit cuts.

Down the road, Koizumi wants to sever government control of the $2 trillion postal savings system, which has been used to finance all manner of public works. He also wants future Premiers directly elected by voters, rather than by faction bosses. Koizumi is appealing to the party's survival instincts. Japan's growing pool of unaffiliated voters is installing independents in local governments and shifting support to opposition parties in general elections. "They are clearly deserting the LDP," he says.

By contrast, Hashimoto is sticking to the party line. He supports a widely criticized, vaguely written banking scheme unveiled in early April to clear out bad debts over three years. He also likes the idea of a stock fund that would absorb shares cast off by banks to shore up their capital base, a plan Koizumi opposes. Hashimoto vows to quickly push through a measure to recapitalize the banks, which could include more public money. He is also sympathetic to tax cuts or another supplementary budget to goose the economy. Hashimoto is even reserving judgment on multiyear spending cuts to rein in the budget deficit, now around 10% of gross domestic product.

"GRIDLOCK." The LDP's big political challenge is to convince skeptical voters that it remains the best party to lead Japan out of this morass. But Democratic Party of Japan leader Yukio Hatoyama reckons his and other opposition parties will grab a 10-seat margin in the upper house. Then he hopes to use guerrilla political tactics to frustrate the next government's legislative agenda, forcing it to call a general election sometime in the fall.

Can the LDP make the wrenching changes needed to head off the opposition? The more likely outcome, admits Hayashi, "is policy gridlock." That's what Japan can least afford.

By Brian Bremner and Ken Belson in Tokyo

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