If Japan was a ship, the captain, Prime Minister Junichiro Koizumi, would be giving orders to go full speed ahead. Captain Koizumi has turned the ship around: he won a second mandate for reform in the September 2005 elections, the Nikkei is up for the year, the economy is in recovery and the global economic environment remains conducive to Japanese growth prospects. Shortly following the elections, the new Diet passed the Postal Reform bill into law. Real estate prices have stopped falling and in some places are actually rising. The banks are now repaying government bailout money extended during the 1990s and the brokerages appear to be set to enjoy a good year.

Koizumi has reasons to be proud. The economy expanded at a 3.3% annual pace in Q2, driven by business and consumer spending. This is the first recovery since 1991 that is being driven by consumer and capital spending. In the past, economic growth was led by exports and government funding, which were unable to sustain momentum. In a critical break with the past, both external and domestic parts of the economy appear to be working in tandem. This has major implications for Japan as well as the global economy. Although we do not expect that Japan will entirely pick up the slack caused by Europe's slug-like economic performance, it will certainly help the rest of Asia, both in terms of an export destination and a source of foreign investment.

While the Koizumi "revolution" has brought significant change to Japan, there remains much more work to be done. Getting the postal reform bill passed is only a part of this. Koizumi also needs to move on other issues - reducing personnel costs for civil servants, consolidating government-affiliated financial institutions, improving the managerial efficiency of government assets and liabilities, and overhauling local government finances. Health care reform is also looming as a critical issue, especially as there is a pressing need for a better medical insurance program. And then there is the difficult issue of reducing public sector debt, expected to reach Yen 774 trillion ($6.7 trillion), or 151 percent of GDP by March 2006 (end of the fiscal year).

Because of the scope of reform still required for Japan, the question of who will succeed Prime Minister Junichiro Koizumi is so critical. The current head of government has done well by Japanese standards, having one of the longest stretches in office. One must look back to Yasuhiro Nakasone and Shigeru Yoshida to find anyone who has been in office as long. Although his leadership over the LDP has often been stormy, Koizumi has provided a high degree of political stability for the country. In turn, political stability created an environment conducive to painful structural reforms in the economy.

The late October 2005 cabinet shuffle has positioned three potential heirs - Shinzo Abe (chief cabinet secretary), Taro Aso (foreign minister), and Sadakazu Tanigaki (finance minister). Each is regarded as a Koizumi loyalist, with reformist credentials. They also are in highly visible positions. Abe must help maintain the government's overall momentum on the reform front, which means holding the various LDP factions together. Aso has the delicate task of dealing with China, Korea and the U.S. over a score of tough issues, and Tanigaki has a lingering number of financial reform issues, though the sale of Japan Post goes to Heizo Takenaka, newly appointed minister of internal affairs and communications.

Consequently, Japan's policy environment will be shaped by two forces - Koizumi's push to finish up as much reform as possible before he steps down and the competition to succeed him. Fortunately, it is in the interest of all parties to be as successful as possible. It also beneficial for the Japanese economy, something investors are increasingly recognizing. Japan has become a compelling investment story as Koizumi has managed to place a new generation of LDP politicians in place who are reform-oriented and likely to benefit from sustainable economic recovery. Indeed, he will need them in his final push for reform and to ensure that his legacy will be lasting.