As residents of the world's second-largest economy ring in the new year they are hopeful the protracted period of economic stagnation called Japan's "lost decade" finally may be ending.

The unemployment rate is easing, corporate bankruptcies have leveled off and the Japanese stock market has staged an impressive comeback, though the Nikkei 225-stock index is still half its high 10 years ago. Private economists predict economic growth, which shrank 1 percent in the most recent quarter, will expand by 1 percent to 2 percent in the coming year.

This modest short-term improvement has been accompanied by more complex--and potentially far more significant--signs of change in the structure of Japan's economy. This transformation is breaking down the historically close ties between government, corporation and worker and replacing them with an entrepreneurial spirit more familiar in the United States.

Leading this changing of the corporate guard are unlikely revolutionaries such as Shotaro Watanabe, the No. 3 man at soap and consumer products giant Kao Corp.

In many ways Watanabe, 64, is a typical Japanese manager. He has spent his entire career at the same company. He has never worked abroad. He greets foreign visitors with a polite bow and an apology for his inability to converse in English.

But get him talking about how he runs his business and suddenly Watanabe sounds as if he is channeling the spirit of General Electric Co.'s hard-charging chief executive Jack Welch. He speaks with near-religious zeal about "shareholder value," boosting "return on equity" and scrapping business lines which don't make money.

Watanabe's is the voice of a new Japan. His eager endorsement of competition and profits is one of many signals that inhabitants of this traditionally risk-averse, group-oriented society are learning to love, or at least to live with, freer markets.

Among other indications that Japan Inc. is giving way:

* Long-standing business groups known as keiretsu, many of them descended from pre-World War II industrial combines and laced together with intricate "cross-shareholding" agreements, are beginning to unravel. In September, for example, banks at the center of two of the nation's oldest keiretsu, Sumitomo Bank Ltd. and Sakura Bank Ltd. announced plans to merge, sweeping aside a rivalry that goes back centuries.

* The promise of lifetime job security is receding as companies such as electronics maker NEC Corp. and domestic phone giant Nippon Telegraph & Telephone Corp. shed workers and cut ties to unprofitable affiliates. Employers, meanwhile, wrestle with how to solve a $600 billion pension gap, while starting to reward workers on the basis of individual performance rather than seniority.

* Barriers to competition from foreign financial and manufacturing firms are falling. France's Renault SA is in the driver's seat at Nissan Motor Co. after acquiring a 37 percent stake in the ailing carmaker, while Ford Motor Co. runs the show at Mazda Motor Corp. Starbucks Corp., which opened its first location on the Ginza two years ago, expects to have 100 outlets in Tokyo by March.

* A new breed of upstart entrepreneurs--such as Masayoshi Son, the U.S.-educated founder of Softbank Corp., who is pushing for the establishment of a Japanese version of America's tech-heavy Nasdaq Stock Market--is shaking up Japan's stuffy corporate finance market. A key target is unlocking the estimated $12 trillion Japanese households hold in low-interest savings accounts. Adding to the turmoil is the appearance of venture capital firms, many of which are controlled by tech-savvy, profit-hungry U.S. investors.

Looking to America for Answers

Much as Americans agonized over the decline of the U.S. economy in the 1980s and sought to emulate Japanese manufacturing efficiencies, the Japanese now are questioning some of their most fundamental economic and social institutions. And though most loathe to admit it, they are looking to America for answers.

Not long ago, Watanabe's unabashed enthusiasm for rough-and-tumble capitalism would have prompted his Japanese peers to dismiss him as a kook. For decades, top business leaders in Tokyo preferred the philosophy of Mitsubishi Heavy Industries Ltd.'s former chairman Kentaro Aikawa, who stepped down last April.

"I don't give a hoot about things like 'return on equity,' " Aikawa declared in a 1998 newspaper interview, often cited here as the classic expression of how Japanese managers once saw their role. "Jobs are more important than profits. . . . I openly brag that I don't cater to shareholders."

Bragging rights these days are more often claimed by top executives at companies like Kao, Softbank or Sony Corp. With increasing boldness, they are branding the "traditionalists" as out of step. "Those guys at Mitsubishi Heavy," Watanabe said, shaking his head. "They're Japanese, I guess. But if you ask me, they're weird Japanese. . . . Among managers at the really good Japanese companies, hardly anyone thinks like that these days."

These changes are painful, of course, and many of the nation's business and political leaders are resisting. Prime Minister Keizo Obuchi, for example, pledges his commitment to economic restructuring. But the core of the "economic rebirth" program he's pushing through parliament is billions of dollars worth of old-fashioned pork barrel spending.

And just last week, Obuchi's ruling coalition postponed a key reform of the nation's deposit insurance system that would have put pressure on weaker banks. Similarly, Japan's political leaders have shied away from proposals for deregulating pampered, but politically crucial sectors, such as distribution, construction and agriculture.

Fear of corporate layoffs isn't making the adjustment any easier. The unemployment rate in November was 4.5 percent, down 0.4 percent from the record high reached in June and July, but still double the historic average.

Robert Feldman, chief economist at Morgan Stanley Japan Ltd., predicts the unemployment rate will soar to more than 7 percent over the next two years as businesses struggle to bring costs in line with earnings. He said his bleak assessment reflects the view that Japanese managers are finally ready to make difficult, market-driven choices that will leave the nation's economy stronger over in the long haul.

The social, technological and economic forces that make it possible to even contemplate such wrenching changes in a carefully ordered economy aren't widely recognized outside Japan. In the West, the conventional wisdom still holds that real change comes slowly to these islands--if it comes at all.

Robert Zeilinski, Tokyo-based financial analyst for Lehman Brothers Inc. and co-author of a 1992 book describing how Japan's clubby financial system stymied competition, chuckles now as he remembers "the old axiom that 'America is always changing and Japan never changes' . . . and that's why the two countries will never understand each other."

But Zeilinski is one of many veteran Japan-watchers who think that axiom is outdated. "Japan is changing," he said. "It started about a year ago, and things are moving faster than I ever thought they could. Every day, I open the paper and it's something new."

Kao Corp. Rides the Boom

The experience of Kao Corp. illustrates some of the difficulties Japanese firms face. Kao sells about $8 billion of soap and cosmetics a year, making it about the size of Colgate-Palmolive Co. Kao sold Japan's first bar of soap in 1890 and the first domestically made shampoo in 1932. A relatively small company until the 1980s, its sales took off with the booming Japanese economy, rising by nearly 10 percent a year.

Kao hit the jackpot in 1988 with a product called Attack, Japan's first concentrated powder detergent. That same year, the company launched its drive for market share in the United States, buying out Cincinnati-based soapmaker Andrew Jergens.

Brimming with confidence, the company also rushed into a glamorous new new field in which it had no previous experience: manufacturing floppy disks. By 1990, it was a global leader in that market. But Kao managers lost sight of the fact that profits failed to keep pace with booming sales.

Watanabe had come to Kao from Waseda University, one of Tokyo's top private schools, and had an accounting certificate, considered rare at the time. He was quickly identified as a young star, and at 39 was named Kao's youngest board member in 1974.

The turning point in his attitude about paying attention to stockholders didn't come until 1993, however. That's when he took his first investor relations trip to New York. It was his and Kao's first exposure to foreign investment firms like Goldman Sachs Group Inc. and Merrill Lynch & Co. The encounter was a shock.

Watanabe was stunned and embarrassed by the barrage of blunt queries about Kao's business strategy: Why was Kao in the information technology business? Why didn't it have any investment in the fast-growing China market? Watanabe did not have good answers, but he recognized the impertinent foreigners were asking important questions.

Within a month, Kao announced plans for a subsidiary in China. It took five years to get out of the floppy-disk business, not nimble by U.S. standards, but far quicker than similar efforts at other Japanese companies. And Kao executives saw a tangible payoff: the stock price rose smartly following their retreat from the money-losing disk venture.

The share price has risen about 150 percent in the past five years. This year, Kao expects a 44 percent net gain in profits despite declining sales.

Kao's experience at Jergens taught Watanabe another important lesson. The American company hemorrhaged cash for years, until its managers embraced an American consultant's management technique. It helped Jergens' turn profitable within two years, and Kao now is implementing the tool in Japan.

The decade of poor profits and economic stagnation has eaten away at the structures and institutions insulating other Japanese managers from shareholders.

A Rise in Foreign Investment

Historically, Japanese executives didn't need to worry about quarterly profits and ups and downs of the market because majority of the typical company's stock was owned by stable shareholders--banks, life insurance companies, affiliates or other corporate partners. Even at Kao, banks and insurance firms still dominate the shareholders list.

Stable shareholders don't insist on big dividends or hefty capital gains--and corporate executives expect the same courtesy in return from those who hold their shares. For decades, such arrangements have been the linchpin of Japan's unique brand of capitalism.

Only a decade ago, there were the envy of many Western academics and politicians, who praised the ability of Japanese managers to put workers first and "plan for the long term." Try telling that to Watanabe. The cross-shareholding system, he said, "has ruined Japanese management."

Watanabe said he courts foreign investors because he fears his traditional Japanese stockholders face pressures to cash out. About 30 percent of Kao's stock now is held by foreign interests, up from 10 percent when Watanabe went to New York in 1993.

Other companies are scrambling to shore up their share price, too. Foreigners now own almost 20 percent of the Japanese stock market--up from less than 3 percent in 1990.

Tougher accounting rules are likely to create a $600 billion pension gap and force more change. Not surprisingly, Japanese firms and lawmakers are looking for ways to use their cross-shareholdings to plug the gaps. But if the shares are handed over to pension managers empowered to seek highest returns for workers analysts expect even more pressures for companies to perform.

Japan's individual investors remain a key variable in this equation. With assets of $12 trillion, they have accumulated one of the largest reservoirs of capital in the world. But nearly all of it sits in banks or the nation's postal savings system in the form of low interest time-deposits. Stocks account for only 6 percent of the average Japanese household's financial assets, much less that U.S. households.

Many analysts predict a shift in that allocation. Japan's "big bang" financial deregulation, completed this year, has sliced fees for trading stocks and cleared the way for hundreds of new online trading start-ups that have enticed millions of new customers since October.

All of this turmoil makes perfect sense to Kao's Watanabe. "Lifetime employment, putting workers first--it's all very well and good," he said. "But in the final analysis, you can't talk about those things until you've figured out to increase your company's value."

Special correspondent Akiko Kashiwagi contributed to this report.

CAPTION: Shotaro Watanabe, a career worker at consumer products giant Kao Corp., is the voice of a new Japan. He favors competition and greater profits in a freer marketplace.

CAPTION: Poised for a Comeback? (This graphic was not available)