At first glance, things might seem to be looking up for Japan, and if so, Asia's hopes for recovery.

The yen is up almost 30% against the dollar from six months ago. A new stimulus package is moving forward. The new Financial Supervisory Agency appears serious about dealing with Japan's $1 trillion banking problem, recently taking over failing Nippon Credit bank. The ruling Liberal Democratic Party (LDP) has formed a new coalition government with the Liberal Party that should strengthen its hand. And Tokyo is forecasting 0.5% growth for 1999 -- which would mean an emergence from its worst slump since World War II.

Expect another shock

But hold onto your wallet. As they say in Japan, that is the tatamae (appearance). But the honne (underlying reality) is another matter.

The reality is that before the year is out, Japan is likely to make Brazil look like a poster child for safe investment havens. Few on Wall Street give much credence to Tokyo's rosy scenario, and even within Japan are plenty of doubters. In fact, if you are looking for the economic shock of 1999, keep your eye on Japan.

On close inspection the portrait that emerges is one of more government fingers in the dike. The Bank of Japan now holds more than 40% of all commercial paper, and other government financial institutions also are pumping large sums of money into the credit-crunched economy. Japan's debt exceeds the size of its gross domestic product (GDP).

These institutions are seeking to perpetuate the current system, not to seriously reform it. Despite massive overcapacity, the merger mania in Japan so prevalent in the West is not apparent. Unviable firms are too often propped up rather than consolidated, sold off or reformed.

Then there is the yen. The main reason the yen jumped from a low of 147 last August to a gain of 29% even after the government intervened in mid-January is that the government flowed a large issue of bonds in order to fund its stimulus package. This -- along with a host of margin calls-- collapsed the price of bonds, but doubled the yield. Such bonds are competitive in a deflationary economy like Japan's, triggering large-scale purchases of bonds, thus driving up the yen.

The domino effect

But this creates a new chain of problems. Higher interests rates have spiked mortgage rates and crimped already anemic investment further offsetting the stimulus package and will deepen its contraction in 1999. Unemployment has surpassed that in the United States for the first time.

What's more, the strong yen slows Japan's exports (the one vibrant part of its economy), increases deflationary pressures, drives down the Nikkei stock index. and undercuts the whole stimulus package. (Japan has spent some $800 billion on such stimulus packages since 1992 with few results.) That, in turn, puts more pressure on Japan's troubled banks, which still hold nearly $1 trillion in bad loans.

If the Nikkei moves down toward the 10,000 range, it will spark wide-scale bankruptcies and lead to more nationalizations of major banks as the government will be unable to funnel adequate funds to pretend they are still viable. Worse, Tokyo's powerful Ministry of Finance, mesmerized by the euro, confuses a strong yen with a strong economy, and has encouraged it in the apparent hope of bursting the Dow-Jones "bubble."

This all increases the prospects of a "hard landing" toward the end of this year when this scenario plays out. Such a scenario could push the yen back down to the 150 or above range. But if the "hard landing" scenario is somehow avoided, Japan will still be facing yet another year of negative growth.

Yet suppose Tokyo follows advice of prominent American economists like Paul Krugman and starts printing money. That would push the yen back down. That, in turn, would hurt other troubled Asian economies like Korea, and could put more pressure on China to devalue in the near term. Still it might be Japan's least bad option.

No easy way out

Japan's problems are profound, structural and long term. Notwithstanding the sage advice of U.S. Treasury officials, there is no silver bullet. Of course, Japan needs to clear the books on its financial mess, deregulate its economy and lower taxes as it is advised to do ad nauseum. The problem is not that no one has thought of such things. It is that each policy choice brings with it a different set of complications.

At bottom, the problem is an economic model that has outlived its usefulness. "Catch- up" state-directed collectivist capitalism worked well after the devastation of World War II. But it is now a burden on Japan. Yet the "iron triangle" of politicians-bureaucrats-industry has a stake in the status quo. The LDP is not particularly anxious to see construction firms on the receiving end of its pork (and vice versa) go under. So a moribund system drifts on.

But some positive trends are at play. Tokyo has created mechanisms to begin its version of the savings-and-loan bailout the United States underwent a decade ago. A planned merger of Mitsui Trust and Chuo Trust, two of Japan's largest banks, and the willingness of Nissan, with a massive $27 billion to sell a 33.4% stake, suggest more consolidation ahead as the private sector is forced to gradually face reality.

The pressures of a "graying" population led to the opening up of Japan's investment-management markets to the likes of Citibank, GE Capital, and Fidelity, allowing its citizens higher returns in dollar investments. This will likely lead to a steady exodus from troubled institutions as Japanese become more comfortable with foreign financial firms. That, in turn, will increase pressure to clean up Japan's financial mess in an orderly fashion. It will also counter the trend to bring money home from U.S. financial markets to put more fingers in the dike.

The world has a lot at stake in the fate of the world's second largest economy. But do not hold your breath. Japan's economic challenge may require political reform before the will can be mustered to take the painful steps necessary to move back to sustained growth. Yet it is difficult to see where the spark will come from to produce such change.

Instead, we are more likely to see incremental efforts -- unless there is an unforeseen economic shock. But in an already-volatile world financial system, that could trigger a new round of crisis just when many believe that Asia has stabilized.

The Great Fear of 1999 is that Japan's procrastination will make things still worse. Stay tuned.

Robert A. Manning, a contributing editor to IntellectualCapital.com, is a senior fellow and director of Asian studies at the Council on Foreign Relations. These views are his own, not the council's. His e-mail address is robertmanning@intellectualcapital.com.