A new phrase has entered Japan's vocabulary: 'corporate zombies' now stalk the land. The living dead are giant, loss-making companies with irreparable balance sheet problems. An example would be Daiei, a huge retailer that posted losses of $3,700 million last year on turnover of $13,700 million. With a total staff of about 96,000, Daiei has been described by Economy, Trade & Industry Minister Takeo Hiranuma as being simply too big to fail. As businesses they are dead, but as employers the corporate zombies live on.

For the Japanese financial sector, these zombies are the cause of a non-performing loan (NPL) crisis of almost unimaginable proportions. Some analysts say Japanese banks have about $1,000 billion of bad debt on their books - the equivalent of 25 per cent of gross domestic product (GDP). For the economy as a whole, they are stifling any return to growth and prolonging the decade-long period of stagnation. For the politicians, they are threatening the very consensus on which Japan's post-war progress was built.

Reform

And the storm is about to break. On taking office in spring 2001, Prime Minister Junichiro Koizumi seemed to be the harbinger of a new age in Japanese politics. Outspoken, dynamic and colourful, his political agenda was built on the three Rs: reform, reform and reform. Nineteen months later and the charge is that only one R has been delivered: rhetoric.

The most recent, and perhaps most important failure came in late October with the unveiling of a diluted banking reform plan. Koizumi had raised expectations with the appointment of maverick economist Heizo Takenaka as a financial services minister in September, having seemingly given him a mandate to apply a short, sharp shock to the crisis-ridden banking sector. However, the widely anticipated proposals for forcing corporate failures, for massive provisioning and for the effective nationalisation of some banks did not emerge, and in its place came a weak plan to halve NPL levels by March 2005.

Takenaka's opponents - and they were numerous within his own party - maintained that his reforms would have further raised unemployment levels, already approaching record highs. Some analysts forecast that 2.4 million jobs could have been lost, and warned that the overall impact would have been to further reduce consumer spending, weaken already low business confidence and extinguish hopes of an economic recovery.

Takenaka's supporters largely agreed, but argued that the process was necessary if a real and sustainable economic recovery was to be launched. The talk in Tokyo is of discarding dead wood, pruning, trimming away the fat. The disappointed promoters of radical reform have reacted to the diluted banking proposals viciously, describing them as tainted by the 'same procrastination that has marred the last decade' and warning that 'Koizumi has been emasculated: his reformist credentials have been tarnished'.

The fact that Koizumi and Takenaka were forced back from the radical reforms originally mooted underlines the opposition the prime minister faces within his own party, the LDP. The balance that lies at the heart of Japanese politics is becoming increasingly precarious. The LDP, which has been in power since 1955, is increasingly reliant on Koizumi for electoral victory. Its popularity as an institution has been on the wane for a decade, not least because of the government's apparent inability to solve the economic problems that have plagued the country since the early 1990s.

Equally, Koizumi has had his reforming urges tempered by the political and bureaucratic elite that has a vested interest in the status quo. The formulation and enactment of policy has become a sophisticated game of poker. Some bluffs have been made, some have been called, some hands have been won and some have been lost, but both sides need to keep the other in the game or it will end disastrously.

Popularity

The tension persists within the LDP, with both Koizumi and his opponents carefully tracking the prime minister's personal popularity. From record highs 18 months ago it began to dip as dissatisfaction over limited economic progress set in.

However, the re-opening of dialogue with North Korean President Kim Jong-il has given Koizumi a new stage on which he can display his charm. His response to the revelation that Pyongyang has made significant progress with its nuclear weapons programme, and the extraordinary story of North Korea's kidnapping of Japanese citizens for its spy-training programme 25 years ago, have seen Koizumi's popularity once again surge. But clearly not enough to give him the confidence to push through Takenaka's banking reforms.

'There has been more talk than action so far, and political leadership is needed in the area of economic reform,' says a senior bureaucrat in Tokyo. 'Koizumi has the right instincts but the LDP is holding him back. Radical reforms will be painful in the short term and there is entrenched opposition within the party to driving out businesses, many of whom support the party financially. At the moment, the LDP is scared of losing power by implementing painful reforms, but the dangers of not reforming are growing greater.'

To call it a time bomb would be an exaggeration, but the ill-health of the world's second largest economy is an issue that will not go away. Erratic and unimpressive economic growth has dogged Japan for a dozen years, and since 1999 the threat of price deflation has become a reality. Add to this the agonising collapse of real estate and equity bubbles - the Nikkei index is languishing near 20-year lows, unemployment figures that have risen for 18 consecutive months, slowing domestic production and even the threat of stumbling exports as the global economy stutters - and the full context of the political struggle is visible.

The argument for extreme reform is gaining strength, not least because many of the alternatives have already been deployed and found to be wanting. For most of the 'lost decade', as the 1990s have become known, different governments pursued aggressive Keynesian policies in an attempt to kick-start the economy.

However, massive spending rounds have achieved little other than transforming the profile of Japanese government debt: it has soared from 60 per cent of GDP in 1991 to over 140 per cent, and debt service is a swelling line in the budget. The exploding debt pile has not gone unnoticed by the international credit rating agencies: Fitch has downgraded Japan twice in the past four years and in the immediate aftermath of Takenaka's bank reform package announcement said 'Japan is going nowhere fast when it comes to banking and economic policy . Given our opinion of the need for immediate remedial policy action, a continuation of the piecemeal 'muddle through' approach of recent years will result in Fitch taking more negative rating actions.' The growing concern is that inactivity will only see the situation going from bad to worse.

Since the Asian financial crisis of 1997, weak regional markets have closed the door to the old 'trade your way out of trouble' solution. The rash of currency devaluations has made it much harder for Japan to sell products or services to its neighbours.

Close ties

Perhaps the silver lining to this cloud has been a rethinking of relations with the Middle East. 'As a result of our energy dependency on the region, we need to have close political and economic ties with the region,' says Kazuhiro Morimoto, director of the Middle East & Africa office of the Trade Policy Bureau at the Ministry of Economy Trade & Industry (METI). 'Politically, we have sought an active role in the peace process and are part of the four-plus-four initiative. We have engaged with Iran in particular and developed a good relationship there. For the business angle, we need long-term relationships built on strong investment programmes and long-term contracts.'

While Japan has noticeably flown in the face of US foreign policy in its approach to Iran - President Khatami has been feted in Tokyo - it has maintained a low profile on the Iraq question. 'The government policy is that Iraq should accept existing UN Security Council resolutions and that, if possible, any dispute should be resolved peacefully,' says Morimoto. Greater support has been given to the US' 'war on terrorism'.

A parliamentary vote is imminent on whether Japan will extend for another six months its commitment to provide fuel for the US fleet conducting operations in Afghanistan.

Add the North Korean situation and ever-present concerns about China, and Prime Minister Koizumi might be tempted to focus his government on foreign policy issues. But try as he might, domestic economic problems will continue to haunt him. In his dreams the corporate zombies have their arms outstretched and are relentlessly advancing towards him.

Exchange rate: $1=Y 122