Strolling through Tokyo's buzzing Harajuku district, there is little evidence that the world's second-largest economy is hovering on the brink of recession Along the trendy Omotesando Street, all the leading designer brands, including Gucci, J Crew and Benneton, are visible in shop windows. Tills ring merrily and the upmarket and outrageously expensive coffee shops and restaurants are packed with fashion-conscious teenagers and 20-somethings.

Japan has always been a master at hiding its economic woes and resorting to short-term diagnosis to cure its financial ailments. But, underneath the healthy exterior, it is crisis time again in Tokyo.

The US slowdown is seriously hitting exports. The stock market has hit its lowest level in 15 years, interest rates are barely above zero per cent and the value of the yen plummeted this week.

There is more. Consumer prices and industrial production collapsed in January, unemployment is at a record 4.9 per cent and there are serious concerns about the health of the banking sector. Signs of deflation have triggered warnings from the international community.

Figures published on Monday offered only a slight respite. They showed that Japan skirted recession at the end of last year, with growth of 0.8 per cent for October-December. This compared to a contraction of 0.6 per cent for the previous quarter.

But despite better than expected GDP results, ministers and analysts alike are still concerned and fear deflation and a global downturn could drag the economy down.

Some economists viewed the GDP rise as a once-off and predicted the economy was in danger of grinding to a halt as companies cut production and scaled back investment.

As if the economy was not bad enough, Japan is also in political turmoil with its 10th prime minister in 13 years on the verge of resigning after a disastrous gaffe-prone term in office. Mr Yoshiro Mori is reported to have done a deal with the ruling Liberal Democratic Party that will see the party elect a new leader in April and Mr Mori step down.

According to political commentators here, there is no indication at this early stage in the behind-the-scenes leadership race that there is a candidate willing to take the harsh long-term reform measures necessary to bring Japan out of trouble. Since the beginning of the 1990s when growth began to stall, successive governments have drawn up no fewer than 13 rescue packages, pumping hundreds of billions of dollars into the economy. None has had any lasting effect, apart from creating a mountain of public debt.

The Japanese finance minister did not help an already volatile market last week when he admitted that the country's public finances were "on the verge of collapse".

Financial analysts in Tokyo this week have been arguing that Japan's biggest mistake has been to keep propping up a once triumphant economic system. While it would be painful in the short term, many urge that the economy be allowed collapse to foster real growth though more productive ventures in the long term.

One of those holding this view is economist Mr Yashuhiko Shibata of the Yomiuri Research Institute. He suggested that a crisis would be good because "it would provide an excellent opportunity to rebuild the economy".

Plans to rescue Japan's banks have come and gone and the banking sector is sickly as ever. Since the last banking crisis in 1998 the government has pumped $61 billion (P56.6 billion) into the big lenders.

Despite this, banks are taking a huge hit on their stock and are expected to write off $10 billion in debt this year. However, that is still a quarter to one-third of what they wrote off in 1998.

Banks are dumping stocks they have held in their client companies for decades to free up capital for more rational investments. But some analysts warn they are selling in a rush and many are sitting on big stock losses.

These losses are expected to reduce earnings and the ability to provide for bad loans. It is predicted that some small banks may even go under.

The Bank of Japan is clearly worried that fears of a repeat of the 1998 banking crisis would put off investors. It cut the overnight rate to 0.15 per cent and the official discount rate to 0.25 per cent last month in the hope that cheaper money would make it easier for investors to borrow to buy stock. The Central Bank has promised to offer generous loans to banks in trouble.

The head of Japan's financial watchdog, the Financial Services Agency, Mr Hakuo Yanagisawa, is pressing banks to write off bad loans completely, seize collateral and sell for what they can get. He hopes to win Government approval for his plan later this month.

The fear is that such harsh measures will have grave implications for Japan's already overextended businesses. Once officially in default of loans, they will have to restructure to profitability to qualify for new credit.

The downsizing required would drive Japan's unemployment rate to 6 or even 7 per cent, according to some analysts, risking more bankruptcies, an even more depressed stock market and lower land prices.

The concern is that there are few signs that any of the players are willing to deal with the situation in a co-operative and constructive manner. One possibility is for co-operation between the Financial Services Authority and the Bank of Japan. Recent comments by the central bank's policy board members suggest room for a deal whereby banks would act aggressively on their bad loans and the Bank of Japan would ease monetary policy to alleviate the impact of further deflation.

However, such a deal would require strong political leadership, and there is no sign of that at the moment. Senior Liberal Democratic Party (LDP) members say deflation can be dealt with through monetary policy and that this will cushion any impact from bad loan write-offs by the banks. They want a return to a zero-interest rate policy.

"If we leave the current deflationary trend unaided, land prices will fall further and the amount of [banks'] non-performing loans will snowball," LDP policy chief Mr Shizuka Kamei warned this week.

Mr Kamei and other politicians want a more gradual approach to dealing with the non-performing loans to avoid the threat of bankruptcies among smaller companies in particular.

Many Japanese companies have started the difficult task of corporate restructuring but they are reluctant to use Draconian western-style measures such as shedding jobs to cut costs. Instead they are turning to management buyouts as a form of business reform.

When you wander away from the buzzing trendy districts of Tokyo you can find one clear sign of the economic doldrums hitting the city. Once barely noticeable in this rich nation, there are more homeless people on the streets.

Figures released this week reveal that Tokyo's homeless population has nearly doubled over the past five years to some 5,700 people. Sixty per cent are aged between 50 and 64 years old, while 70 per cent say they are looking for work.

The city is planning to build more homeless shelters, with 60 per cent of homeless currently living in parks. The metropolitan government will build a shelter for 300 people starting in April because existing facilities are unable to keep up with rising numbers of homeless, according to the welfare bureau.

Japan's bubble is bursting. The eyes of the world will be watching to see how this great economic giant reacts.