THE LAST, BEST HOPE

By FRANK GIBNEY JR./TOKYO

The clock is ticking ominously for Japan Inc. After six years of stagnation, the world's second richest nation is threatened by the financial crisis that has hammered and humiliated the wildfire economies of Asia. As South Korea slid close toward insolvency last week, the Japanese were looking toward their leaders, and foreign investors were looking to Japan for signals that the Pacific Rim's chief Asian power could buffer the quakes rattling the region's interlocking systems.

The signs were not good. Four major Japanese financial institutions collapsed last month, dragging the value of the yen to a five-year low. The Nikkei stock-market average ricocheted anxiously on every shred of news. The only figures on the rise were those for bankruptcies, unemployment and suicides. National confidence congealed into a deep gloom as headlines warned of the coming "Great Depression." The government that for so many decades guided the economy with an iron hand is floundering, seemingly at a loss for ways to yank the country out of its tailspin. Kazumi Ehara, an auto salesman in suburban Tokyo, speaks for many of his countrymen when he says, "The Japanese people have been told repeatedly by the government that the economy will get better, only to be betrayed. I can no longer trust them."

That sense of distrust was intensified by the spectacle of South Korea's continuing meltdown. Seoul jolted the world again last week when its largest state-owned bank halted efforts to raise $2 billion in desperately needed cash to pay off loans from Japan and other countries. The retreat, which came barely a week after the International Monetary Fund agreed to ride in with a $57 billion rescue package, raised the specter of a massive default by the world's 11th largest economy on its far-flung foreign obligations.

In one of the worst weeks yet in the region's financial turmoil, fears that the IMF's largest-ever handout would not salvage matters dragged down every Asian market and currency, especially Seoul's. That situation could reverberate ruinously in Japan. Not only is Korea in hock to Japan for at least $24 billion, but a further deterioration of the Korean won--which has lost a staggering 50% of its value against the U.S. dollar this year--would make it harder for Japanese products to compete with Korean exports, from cars to steel to electronics. That in turn would plunge Japan deeper into the recession that now looms as a strong possibility for next year.

The crisis is compounded by Seoul's paralyzed politics. The country will hold presidential elections this week, which leads the candidates to demagogue on the IMF deal rather than implement it quickly. Koreans who are not thoroughly disheartened by the implosion of their huge, highly industrialized economy are humiliated and resentful at the thought of a bailout from abroad. That makes it even harder for skittish politicians to impose the draconian remedies South Korea must swallow.

The main fire wall against a global financial crisis is still Japan. It has huge foreign-currency reserves and is the principal source of investment capital in the region. Seoul is looking desperately to Tokyo to roll over its credit. But Japanese banks, burdened with a quarter-trillion dollars of bad domestic debt, cannot easily risk more money in the South Korean sinkhole. Japan is also the origin of the very economic model that is causing the crisis. No one really knows, but many moneymen fear that Japan's own financial system could be as dangerously debt-ridden as South Korea's. The global economic network should be able to withstand even a wholesale default in Seoul, but failure in Japan would spread trouble everywhere.

In many ways, the crisis in Korea is a worst-case scenario of what could happen in Japan. Both economies are dominated by an unholy trinity of old-school politicians, bureaucrats and industrialists, whose "crony capitalism" has loaded up their respective countries with untenable debt. The crunch came in Korea when a wave of bankruptcies by conglomerates, or chaebol, crashed down on the country's banks, flooding them with write-offs for bad loans. Defaults of a comparable magnitude in Japan's $4.2 trillion economy, which is nearly 10 times the size of Korea's, could turn the so-called Asian Contagion into a worldwide pandemic that could even threaten the health of the soundest peacetime expansion in U.S. history.

The tremors beneath Japan's financial institutions got so bad last week that dithering politicians finally had to act. The ruling Liberal Democratic Party (L.D.P.) managed to commit itself to a controversial, publicly financed $80 billion scheme to shore up the banks. But that is as far as it got. If Prime Minister Ryutaro Hashimoto does not produce a rapid consensus on exactly how the money will be used or what drastic measures the government will take to resuscitate the economy, plummeting confidence will batter the markets further.

So Japan is in a race to reinvent itself. Unlike Korea, Thailand or Indonesia, whose recoveries depend humblingly on multibillion-dollar handouts from the IMF, Asia's first economic miracle baby has the wherewithal--financial and social--to do the job on its own. The world's biggest creditor nation has more than $11 trillion in household financial assets alone. Having gone through substantial reorganization in recent years, its top manufacturing companies can compete with the best of the rest.

The real test for Japan is whether the Old Guard bureaucrats and politicians still holding power have the courage to make bold, immediate repairs. Hashimoto, the first Prime Minister in a decade to last more than 18 months, came into his second term last year boasting that he would reform the system or "explode into a ball of fire." He proclaimed the most sweeping slate of changes Japan has seen in a century, committing himself to a six-point program to reduce the size of government, liberalize financial markets and unravel the country's byzantine web of economic regulations.

Before that, though, Hashimoto needs to save Japan's troubled banking sector. Last week's announcement that the ruling party is willing to use public funds to prop up the banks won only skeptical praise. Economists have long urged Tokyo to follow the U.S. method tested during America's savings and loan crisis: force the closing of weak and badly managed banks, use public funds to stabilize the system quickly and sell off all marketable assets. But Japanese citizens blame the debacle on corruption and fiscal mismanagement by the bankers, making any use of government funds politically difficult. "Why should the government protect people who made risky investments and lost?" asks Yutaka Hachiya, owner of a small clothing factory. "If my company went bankrupt, nobody would help me."

Japan's bureaucrats remain unwilling to surrender to market realities. When Yamaichi Securities collapsed on Nov. 24, the markets cheered, assuming that Japan's powerful Ministry of Finance was finally ready to let the international markets dictate which institutions should survive. Wrong. Even now, says Iwao Nakatani, an economist at Hitotsubashi University, "the L.D.P. and the Ministry of Finance still would rather hide the full extent of the bad debt."

Investors everywhere want to know just how bad it really is. At Yamaichi, bank officials finally admitted that most of the brokerage's $2.1 billion in failed loans had been hidden in five dummy companies established to conceal the losses of a host of select clients. Most analysts believe the government is well aware that many more institutions have the same kind of bad paper tucked away. Indeed, by the ministry's own estimates, the unpaid-loan tally could be as high as $250 billion; by private estimates, it could rise to $400 billion.

However gloomy today's outlook, a crucial grass-roots transformation is already under way, led by a new generation of politicians, bureaucrats and entrepreneurs who are thoroughly disillusioned with the status quo. More worldly, more independent, these Japanese are challenging the old, ossified way of doing things by starting up new companies, leading civic protests and figuring out on their own how to cut through Japan Inc.'s regulatory web.

Some Japanese banks are actually looking for new ideas on how to compete outside the old government cocoon. Last April, Nippon Credit Bank, coping with heavy debts and inadequate cash reserves, closed its overseas branches to trim costs. Who took over its foreign business? New York City-based Bankers Trust. Nippon Credit asked the American firm to help restructure its balance sheet; in return, Bankers Trust has an option to buy up to $125 million in shares in the Japanese counterpart. Bankers Trust has been helpful in setting up a computer model enabling the Japanese bank to calculate its holdings and risk worldwide--something most Japanese banks, reliant on the protective umbrella of the Ministry of Finance, have never bothered to do.

The companies most willing to adapt to globalization are Japan's top manufacturing firms. In the past several years, Toyota, Sony, Honda and Matsushita have restructured their management, streamlined decision making and even instituted performance-tied pay incentives. Japan's globalization urge also looks strong among the baby boomers who are going into business for themselves. These 30-to-50-year-olds launched 50,000 new businesses last year, more than at any other time since World War II.

This week Hashimoto's ruling party is scheduled to unveil a series of fresh steps to stimulate Japan's economy and stanch the banks' hemorrhaging. But what will those actions be? And will they provide strong enough medicine? A source close to the Prime Minister says it is "impossible" for the government to offer the kind of tax cuts that spur solid economic growth. "He will be able to offer a measure of confidence for the banking system," says the insider. "But we will not see economic growth for quite some time." Says former Prime Minister Kiichi Miyazawa, with characteristic understatement: "We will muddle through."

Japan will have to do better than that. It is vital for Hashimoto & Co. to show other Asian countries that they have the will to confront their financial problems. Otherwise there will be no one left capable of leading Asia out of its economic mess or of sparing the rest of the world similar trouble.

--With reporting by Hiroko Tashiro/Tokyo

With reporting by Hiroko Tashiro/Tokyo