Outlook: Japan's challenge; change in a country that's immune to it

Naoki Inose tosses another log on to the blazing fire behind him. The setting is incongruous, for we are sat in the basement study of Mr Inose's central Tokyo townhouse. Security in the narrow side street where the house is located is tight. In recent months, Mr Inose, a writer and adviser to the Koizumi government, has had several death threats. Mr Inose barks an instruction at his pretty young secretary, who beetles off to another room to fetch a copy of an article Mr Inose has just penned for a Japanese magazine. The headline translates as "The emperor has no clothes".

The description is aimed at Japan's prime minister, Junichiro Koizumi. Mr Inose doesn't mean it literally of course, but in the way the Hans Christian Andersen fairy story has come to be used as a metaphor for someone not being what he pretends.

Mr Koizumi was swept to power on a platform of economic, financial, social and industrial reform, yet despite his nearly three years as leader of the ruling Liberal Democratic Party (LDP), reaffirmed in recent lower house elections, there has so far been very little evidence of it. Years of marginal growth in the Japanese economy, or even outright recession, has made Japan no more amenable to change than it's ever been. The prime minister's reforming agenda seems to have run into the sand.

For Mr Inose, this is a huge disappointment. For years, he's been campaigning for privatisation of the four public highway corporations, and the related reform of the postal savings system that finances them. Yet despite Mr Koizumi's support, there has so far been no agreement within the LDP even on whether postal reform is a worthwhile thing to do, let alone how and when it should be done.

LDP officials talk vaguely about the possibility that maybe after next summer's upper house election, when half the councillors face the voters, Mr Koizumi might have mustered sufficient political support to push the reforms through. An outline privatisation scheme is promised for the spring. Don't hold your breath.

Japan still counts itself among the four most prosperous economies in the world in terms of GDP per head, yet change seems hard to achieve, verging on the impossible. So why am I singling out Japan as the most promising stock market bet for the coming year? The apparent contradiction requires some explaining.

Postal and highway reform is, to be frank, hardly the most pressing or important of the modernisations Mr Koizumi needs to address in the still mired Japanese economy. Yet it has become symbolic of the case for wider reform, a totem which, if toppled, would open the way to more root and branch liberalisation.

By Western standards, Japan's postal savings system is an anachronism of baffling proportions. Yet it is part of Japan's way of doing things, and to many in Japan's body politic it looks too costly and painful to reform. Originally initiated as a way of rebuilding infrastructure in the post war period, the postal savings system is the largest depository of private savings in the country.

Much of the money is lent to Japan's Fiscal Investment and Loan Program (FILP), which in turn has lent a massive 400 trillion yen (£2,000bn) to government agencies for investment in highways and other infrastructure projects deemed by bureaucrats to be beneficial to the Japanese economy. Result: a massive misallocation of savings capital in uneconomic public works, a snakepit of vested interest, and an open door to pork barrel politics. Unsurprisingly, the industries that service this spending are hugely inefficient.

Why does Japan find it so difficult to grasp this and so many other aspects of the deregulatory agenda? One reason finds its parallel in Germany. The Japanese are too well off and comfortable to make them want to give up their way of doing things. The social and economic system is widely recognised as unsustainable and unaffordable in the long term, but with unemployment still low by European and American standards and living standards still comparatively high, things are not yet bad enough to force the pace of change.

Perhaps as important, Japan's political institutions, the very fabric of its society, seem almost deliberately constructed to discourage change and ensure consensus. The LDP isn't a political party on European lines at all, but a collection of special interest groups. The ability of these interest groups - from industries to religious groups or professional bodies - to dictate to their representatives and make their voices heard in public policy - is less powerful than it was, but it is still very much dominant.

Furthermore, the difference between the LDP and the main opposition party, the Democratic Party of Japan (DPJ), looks to the outsider as marginal as the difference in name. The DPJ characterises itself the party of youth and the consumer against the LDP, which it calls the party of the producer and the industrialist. Yet the only two discernible differences in policy are that the DPJ is against the sending of a special defence force to Iraq and wants to abolish tolls on the roads.

Naoto Kan, the leader of the DPJ, wants a more Western system of government, where the elected administration establishes policy and the bureaucrats deliver, but then so does Mr Koizumi, and so far he seems to have made no progress at all in shifting the balance of power from the civil service to the politicians. Lobby groups looking for government handouts prefer to stand in line at the Ministry of Finance, knowing that the real power still lies with the bureaucrats, than waste their time with the politicians.

Nor is the prime minister of Japan a political leader on the Western model. He doesn't have the same degree of power. Every decision has to be agreed, making the emergence of a Margaret Thatcher, with the force of political will to drive through unpopular reform, extremely unlikely.

So am I serious about tipping the stock market of a country so mired in the past and resistant to change? Two reasons underpin the bet. One is that Japan is a tale of two economies. Much of the domestic economy, publicly financed or protected, still looks overmanned and inefficient by international standards. Some of these inefficiencies are more the result of cultural differences than over regulation, but let's leave that aside.

The other economy is a huge and diverse mass of highly productive and innovative export industries, capable of holding their heads high against the very best in the world. In many of these companies, the export of jobs to China and elsewhere seems to have been handled much more expertly than elsewhere, with commodity production delegated but the high value-added, cutting-edge work kept in Japan. Over the past three years, there has been a quiet, but massive restructuring of many of these companies, so that they are fully re-engineered for the 21 century. Corporate investment is now climbing back to record levels, leaving the country supremely well placed for the big growth markets of the future - China and India.

The other main reason for believing in Japan is that the economy is growing again, albeit marginally in nominal terms. Macroeconomic policy, both fiscal and monetary, is meanwhile set convincingly on the goal of ridding the economy of deflation. The recovery is at present export led and highly dependent on continued growth in China and America. Yet it also provides Japan with the window of opportunity it perhaps needs to begin the process of incremental reform and change.

Japan would never reform from a position of weakness. To do so would risk shattering the country's treasured social consensus. Nor is change ever likely to happen quickly. That too is not the Japanese way. But from a position of relative economic strength and as much galvanised by the threat of China as its opportunity, slow change does at last seem possible. As a relatively low risk, long term bet on the rise of Asia as the world's most powerful economic trading region, the Tokyo stock market looks hard to beat.

jeremy.warner@independent.co.uk