Markets are on hold, watching for developments in Tokyo as contenders emerge to replace prime minister Ryutaro Hashimoto.

Hashimoto announced his resignation last week after the ruling LDP's loss in Upper House elections, taking the blame for his government's failure to spark an economic rebound. Foreign minister Keizo Obuchi, veteran politician Seiroku Kajiyama and health minister Junichiro Koizumi have declared themselvescandidates in the party vote on July 24.

The best Asia can hope for is the appointment of apro-reform successor to Hashimoto, which would appease markets and settle the yen. But even if this occurs and Japan manages to stage a recovery, the outlook for Asia remains bleak.

"Further significant yen weakness from current levels --and the regional instability that this would induce -- has the potential to derail the embryonic reform and restructuring across Asia," ING Barings said in a recent report. "The converse which serves as our baseline scenario -- a yen rebound delivered courtesy of a domestic economic upturn -- is unlikely to transmit a significant growth pulse to the rest of Asia and expedite the regional recovery."

Japan poses a threat to the rest of Asia through three routes: trade, investment and currencies.

Trade links are considered less important than currencies because the United States remains Asia's biggest trade partner in most cases, not Japan, as widely reported.

This suggests thatAsian trade with Japan will fail to lend great momentum to an Asian recovery, especially given the scale of domestic economic problems in the rest of the region.

But currencies pose a substantial threat. Now liberated from fixed links to the US dollar, many Asian currencies are showing an increasing sensitivity to the dollar-yen rate.

The outlook for the yen, once uniformly negative, is now mixed. Japanese capital continues to shun low domestic yields in favour of higher yields offshore, causing yen weakness. But some analysts are forecasting growing support for the yen as recent fiscal stimulus packages filter through the economy. If the new Japanese prime minister succeeds in winning the confidence of markets with an aggressive economic programme, analysts said the yen could consolidate -- or even improve. "A period of yen consolidation takes away fears of further currency weakness throughout Asia," ING Barings said. Financial links with Japan are the most important for the rest of Asia, analystssaid.

Japan would be in no position to play a significant role recapitalising or lending to Asia even if Japan recovers, raising questions about who will fill Japan's shoes as the region's largest creditor.

Japan is responsible for $250 billion of Asian debt, accounting for 40 per cent of the total Asian external liability. This huge debt overhang, which excludes even larger domestic debt burdens, is placing major constraints on Asia's recovery.

Tight liquidity, imposed by high interest rates required to support currencies, continues to deflate asset prices, compress domestic demand and worsen the bad loan position of Asian banks.

"With bad loans continuing to pile higher, domestic lenders are unable and unwilling to expand aggressively their loan book to exporters," ING Barings said. Without trade finance, Asia ex-Japan is simply unable to gear up industrial capacity and export its way out of economic disaster. And without financial help to resolve Asia's banking mess, the region confronts anextended downturn.

"Despite the prospects for economic recovery, the Japanese Financial system is unlikely to fill this role," ING said.