New Refrain in Japan: It's the Economy, Stupid

Last year, Yukio Hatoyama was elected Japan's Prime Minister after promising to ease the pain of recession with programs such as better day care and cheaper highway tolls. Naoto Kan, who succeeded him after nine months, is betting a different set of issues will appeal to the beleaguered Japanese. Under Hatoyama, who resigned on June 2, "the No. 1 priority was social policies," says Jesper Koll, head of equity research at JPMorgan Chase (JPM) in Tokyo. "Now it's going to be economic policy." Adds Eisuke Sakakibara, one of Japan's best-known postwar finance officials: "Kan is a realist."

Kan, the former Finance Minister, takes office as the government prepares to announce by the end of the month its plan for reducing public debt and sustaining growth of 3 percent over the next decade, a pace unseen since 1991. Kan believes the key to growth is ending the deflation that has plagued Japan for much of the past decade. In April he caused a stir by calling for an ambitious inflation target of 2 percent. To reach that goal, Kan would likely need to pump more money into the economy. That's tough, given that Japan's public debt is nearly double the country's gross domestic product, the highest level in the developed world. "I don't think fiscal rehabilitation can be done overnight," Kan said on June 3. "At least I'd like to correct the trend in which the public debt keeps increasing endlessly."

To raise funds, Kan may raise the value-added tax, something Hatoyama had pledged not to do until at least 2014. Economists expect Kan to use some of the money to support industries with high growth potential, such as energy, green technology, and health care. The central bank is already doing its part: The Bank of Japan announced in May that it would offer low-interest loans to banks that agree to support the government's targeted industries. The BOJ is "really taking an active role in where credit is being allocated," says Nikhilesh Bhattacharyya, an economist with researcher Moody's Analytics (MCO). "Essentially they are picking winners."

Kan can't do much to help traditional powerhouses such as the electronics and auto industries. When he started as Finance Minister, Kan made headlines by trying to talk down the yen, which had risen sharply against the dollar, causing pain for Sony (SNE), Panasonic (PC), Toyota (TM), and other big exporters. Pursuing a weaker-yen policy now, though, isn't a realistic option, says Hiromichi Shirakawa, chief economist in Tokyo with Credit Suisse (CS). Japan has a current account surplus of 4 percent of GDP. Making it even larger by weakening its currency would antagonize the U.S. "Japan cannot boost exports," Shirakawa says.

The bottom line: As Naoto Kan takes over as Japan's Prime Minister, he'll likely focus on the economy. The country's huge debt will make his task difficult.

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