TOKYO — In his first speech after taking charge of the world's second-biggest economy last week, Japan's new Prime Minister Naoto Kan identified his biggest challenge: ending two decades of stagnation.

"For the past 20 years, the Japanese economy has been at a standstill," said Kan, who, since the start of the year, served as finance minister in the short-lived government of his predecessor, Yukio Hatoyama.

"Growth has stopped. Young people can't find jobs. This is not a natural phenomenon. It resulted from policy mistakes," he said, referring to the half-century of conservative rule that preceded his centre-left party's election victory last year.

"I believe we can achieve a strong economy, strong finances and strong social welfare, all at the same time," said Kan, a former left-wing activist who has more recently earned a reputation as a fiscal hawk.

Even if Kan does not serve longer than any of his four predecessors, all of whom left office within a year or less, he is likely to preside over a sobering milestone for Asia's post-war industrial powerhouse.

Some time this year, economists predict, China, the low-wage population giant and "factory of the world," will overtake the high-tech island-nation of 127 million as the global number-two economy.

The dynamism of China today reminds many Japanese of where they were in the 1980s, when its auto and electronics exports dominated world markets and Japan Inc awed and scared the western world.

The investment bubble of those boom days popped in 1991, bringing in a cycle of recessions and a draining economic malaise, while ending the jobs-for-life model and heightening income divisions in Japan.

Although most Japanese remain comfortably wealthy, unemployment now stands at 5.1 percent and homeless people, once almost unheard of, are a common sight, sleeping rough under bridges and in city parks.

The Democratic Party of Japan (DPJ) last year pledged to help people cope with tougher times, with policies from higher child payments and free school tuition to scrapping highway tolls, a pledge that has since been dropped.

The threat is that the extra spending will add to the government's debt mountain, which is nearly double Japan's gross domestic product and by far the highest in the industrialised world.

Kan has advocated in recent months that Japan raise its its consumption tax from its present five percent. Asked about the issue on Friday -- shortly after taking office and weeks ahead of crucial upper house election -- he was cautious, saying only that he would make an announcement later.

The good news for Kan is that Japan's economy has started to recover, thanks to a resurgence in Japanese exports -- driving GDP growth to an annualised 4.9 percent in the January-March period.

The bad news is that the upswing has yet to filter through to the broader economy, long burdened by a stagnant jobs market, persistent deflation and weak domestic demand.

As finance minister, Kan has often warned about the dangers of Japan's crippling deflation, at times heaping pressure on the Bank of Japan to take action on falling prices.

Looking ahead, what most worries Japan's political and business leaders is the country's demographic time bomb, a result of one of the world's highest life expectancies and lowest birthrates.

The rapid greying of Japan is set to shrink the country's workforce and consumer market, leaving fewer workers to support more pensioners. On current trends, the population is expected to halve by the end of the century.

With its home market shrinking, corporate Japan is looking to China, which overtook the United States as Japan's top trade partner three years ago, and emerging Asia to keep its economy afloat.

"Japan is located in a very good region geopolitically," Kan said, echoing that view in his first press conference Friday.

"Asia has seen great development. Japan is part of it, potentially in a position to have a complementary relationship with developing China, India and Vietnam."

Copyright © 2010 AFP