NEWS ANALYSIS : Resignation of Hata Throws Japan for Loop : Economy: Turmoil around talks to choose a successor could threaten nation’s recovery.

As politicians negotiate to choose a successor to outgoing Prime Minister Tsutomu Hata, the renewed political upheaval clouds trade talks with the United States and may undermine prospects for Japan’s economic recovery.

The severity of the impact depends, however, on whether the current political confusion results in formation of a weak caretaker government composed of feuding factions, or leads instead to creation of a strengthened ruling coalition.

The Tokyo stock market responded with pessimism early today to Hata’s Saturday resignation and the dollar’s continued weakness against the yen. The 225-stock Nikkei index fell 448.09 points, or 2.2%, to close morning trading at 20,318.66.

“With the yen being so strong, it’s taken the steam out of any recovery in earnings for this year,” said Keith Donaldson, equity strategist at Salomon Brothers Asia Ltd. Economic fundamentals still point to a stronger dollar, but short-term currency trading is favoring the yen, he said. Hata’s resignation is just one factor in the yen’s strength, he added.

Faced with minority support in a fragmented parliament, which now has 15 different parties and groups, Hata won praise from some business leaders. By resigning rather than calling new nationwide elections, Hata left the choice of a successor in the hands of parliament and avoided creating a more serious political vacuum.

“That was the best decision that Mr. Hata could make,” said Shoichiro Toyoda, chairman of the Federation of Economic Organizations.

Parliament was scheduled to begin the process of choosing a new prime minister this afternoon, although days could pass before a vote is held. Hata and his cabinet remain in office until replacements are picked.

Japan’s latest round of political turmoil comes just as trade talks with the United States have intensified and the yen has reached unprecedented strength. Japan also appears to be coming out of a three-year recession, but any recovery remains fragile.

Tokyo and Washington still aim to reach some kind of trade agreement before the Japanese prime minister--whoever it is--meets with President Clinton in Naples immediately before the July 8-10 summit of leading industrialized nations. Prospects for anything very meaningful, however, seem to be fading because strong political leadership in Tokyo has generally been considered almost a prerequisite for achieving significant U.S.-Japan trade agreements.

Negotiators are focused on a few priority sectors: insurance, automobiles and auto parts, and government procurement of telecommunications and medical equipment. Even before Hata’s resignation, however, the two sides appeared to remain far apart in all these areas.

Tokyo also seemed to be falling behind on meeting an earlier pledge to announce a detailed economic stimulus package and market opening measures before the Naples summit. While some kind of announcement is expected, it may not break much new ground.

In addition to making it more difficult for Tokyo to show the flexibility and political strength needed to come to terms with Washington on contentious trade issues, political disorder in Japan may also provide a convenient excuse for inaction.

Many bureaucrats within the Japanese government believe that Washington’s demands are misguided in virtually all aspects of the trade talks, including calls for specific market-opening measures and stimulative tax cuts.

These officials generally wish to see the talks produce as little as possible. In their view, changes are already under way in Japan that will eventually reduce the country’s large trade surplus. This includes the aging of Japan’s population and the transfer of manufacturing capacity overseas by Japanese corporations.

The Ministry of Finance is much more concerned about balancing Japan’s budget in the early 21st Century than it is about providing further economic stimulus now through tax reduction. The Clinton Administration, on the other hand, is pressuring Tokyo to implement long-range tax cuts to stimulate domestic demand and thereby pull in more foreign goods.

A government advisory panel presented a vague compromise tax reform proposal last week. Japanese media interpreted it as suggesting that income tax cuts already implemented for this year be extended indefinitely, but that they be more than balanced with a sharp increase in consumption taxes starting April, 1997. The long-term effect would be a tax increase, but the proposal might have a short-term stimulative effect.

Failure to reach agreement with Washington on trade issues may create further pressure for continued strengthening of the yen against the dollar. Until recently, many market players believed that Washington favored a weaker dollar as a means to strengthen U.S. export competitiveness against Japan, which in 1993 ran a $60-billion bilateral trade surplus with the United States.

But now Tokyo and Washington fear any new climb in the yen’s strength. For the United States, any further dollar decline would increase pressure for higher interest rates, which could make the dollar more attractive on currency markets but might chill economic growth.

Japan fears the effects of a stronger yen on its export industries. A strong yen makes Japanese goods more expensive in overseas markets. While Japan is banking on growth in domestic consumption, rather than exports, to lead the way out of recession, any new blow to the profitability of exporting firms could hurt a recovery.