TOKYO – Japan finds itself at another critical juncture in its history, and it’s anyone’s guess where the country and its powerful automotive industry will go from here.

The global recession has battered the nation’s exports and economy. Unemployment is hitting record highs. A “shift to thrift” is reducing consumer spending. Domestic auto sales are slumping toward their lowest level in 32 year; and new, untested political leaders now are in power.

“We are entering the realm of the unknown,” Prime Minister Yukio Hatoyama admits at a mid-September press conference here.

Hatoyama and his Democratic Party won a landslide victory in August, taking 308 of the 490 seats in the Japanese Diet (Parliament) and ousting the Liberal Democratic Party (LDP), which has ruled the country virtually without interruption since the end of World War II.

The Hatoyama government is proposing a sharp sea change, rejecting the past cozy trinity of politicians, bureaucrats and businessmen credited with guiding the country to postwar prosperity and blamed more recently for mismanagement and the economic malaise.

The new leaders are promising to address public needs, not those of big business, by increasing social benefit and stimulating consumer spending to reduce over-reliance on exports as the country’s main economic driver. But the challenges to these changes are formidable.

Chris Richter, a senior industry analyst with CLSA Asia-Pacific Markets in Tokyo, believes things will be harder for the auto industry, at least in the short to medium term.

“The Japanese economy is the deepest in debt country in the world,” he says. “The prescription is for a lot more government spending, a stronger yen, reduced labor-force flexibility and an increased risk of flight from manufacturing jobs.”

The ¥15.4 trillion ($162 billion) stimulus plan introduced by the LDP in April worked no wonders. Indeed, the Bank of Japan is forecasting a contraction of 3.4% for fiscal-2010, the second year in a row of negative growth.

Critics claim the new political leaders do not have a viable economic recovery plan to stop the down slide.

“The Japanese economy may have pulled back from the brink, but it is still loitering too close to the cliff edge for comfort,” says Michael Wynn-Williams, author of “Surfing the Tide” and a former senior auto analyst with IHS Global Insight.

“Any recovery depends on trade, and both exports and imports are in the doldrums,” he adds, noting exports dropped in August for the 11th straight month, down 36% year-in-year.”

Kota Yuzawa, a senior analyst with Goldman Sachs Japan, predicts the country’s global auto sales likely “will decline 7% this year and grow 1% in 2010 and 7% in 2011.”

The outlook is bleaker for the domestic market, where vehicle deliveries have plummeted from a peak of 7.7 million in 1990 to 5 million last year, reflecting an aging and declining population as well as a younger generation increasingly indifferent to car ownership.

The $3.9 billion now being spent on incentives for domestic-car purchases as part of the government stimulus program has helped sales but failed to end the long-term downward trend and is scheduled to end next March.

“The new government has other programs to pay for and will probably not extend the incentives, so the risk is for lower automotive demand next year,” Richter says.

Yuzawa expects domestic light-vehicle sales to drop 5% this fiscal year, with additional declines of 10% and 5% in the following two fiscal years.

Profits are suffering as well. “With the yen now around 95:$1, compared to ¥115 in 2007, auto maker earnings in the current fiscal year will be 70% below peak levels,” he predicts.

Yuzawa foresees Toyota Motor Corp. breaking even for fiscal-2010, far better than the auto maker’s gloomy forecast of a ¥750 billion ($7.89 billion) operating loss.

He expects modest operating profits for Honda Motor Co. Ltd. of ¥140 billion ($1.5 billion), Nissan Motor Co. Ltd., ¥70 billion ($769 million), and Suzuki Motor Corp., ¥50 billion ($549 million), while anticipating operating losses for Mitsubishi Motors Corp. and Mazda Motor Corp.

As bad as it’s been for the Japanese auto makers, they are beginning to recover and are in better shape than most, if not all, of their competitors. Of special concern are the implications of Hatoyama’s proposed “Green Car” policy.

“A 25% reduction in carbon-dioxide from1990 levels by 2020 is contingent on other countries doing the same,” says David Blume, managing director-Jaguar Land Rover Japan.

“But (Hatoyama) obviously is projecting a major shift in Japan’s auto population toward fewer, cleaner, more-economical, fuel-efficient vehicles, which will completely renew that population in 10 years.”

Yuzawa expects plug-in electric hybrids to become a mainstream technology in the next five years and foresees hybrids of all types accounting for more than 20% of total annual light-vehicle sales in Japan by 2015. But he has reservations about the green-car target.

Yuzawa calculates this would require 2 million hybrid or other environmentally friendly vehicles to be sold domestically in each of the next 10 years – nearly half of the anticipated new-car sales.

This likely would be a far bigger boost in such sales than auto makers conveniently could handle and raises doubts about unrealistic political ambitions.

“We’re probably getting to the tipping point in alternative energy vehicles,” Richter says. “The push-and-pull of consumer interest and government policy will increase their share greatly. The savvier Japanese makers understand this is the wave of the future.”

As which car companies make what models where in the world becomes more complex, JLR’s Blume says new technology, know-how and value-added wrinkles still will originate in Japan.

However, he and other industry experts agree the main sales emphasis and action now will be overseas, especially in the U.S. and the emerging markets of Asia, South America and Eastern Europe.

“For Japanese auto makers, demand in Western Europe will be down 10% next year,” Yuzawa predicts. “The driving force for growth will be in Southeast Asia and the U.S. Their sales in China will grow, but bottom-line contributions will be less.

“And by 2011, (Japanese auto makers) will probably start to lose market share globally, because they can’t keep pace with the rapid growth in China and other emerging markets.”

Former Global Insight analyst Wynn-Williams agrees. “Over the long term, the only substantial growth in (vehicle) demand will occur in the emerging countries of the world, which are ambitious to develop their own automotive industries.”

With the yen currently hovering at about ¥90:$1, foreign-exchange risk has become ever more critical. Vehicle exports – 6.7 million units in 2008, 58% of total Japanese production – are becoming ever more expensive and less competitive.

“If the yen stays strong, Toyota and Honda may have to leave money on the table, because they can’t afford to export some models like the Honda Fit and Toyota Yaris,” Richter says. “They may decide (to) make them and other models, including the Prius and Insight, in the U.S.”

Japanese auto makers already can churn out more than 12 million vehicles annually in foreign plants. And although many now are running well below capacity, overseas production is becoming even more attractive.

For instance, Nissan recently shifted production of the March to Thailand and exports some units back home.

Tokyo’s Asahi Shimbun newspaper cites Honda CEO Takanobu Ito as saying his company plans to limit car production in Japan to 1 million units, disregarding the auto maker’s 1.3 million-unit domestic capacity and shifting more output offshore.

“Given the risks involved, most of the vehicles exported from Japan should be made overseas,” Richter asserts, noting the most likely targets as North America, Eastern Europe, Turkey and low-cost Southeast Asian countries such as Thailand and Indonesia.

“Japanese auto makers are perfectly capable of completing the shift within 10 years, but I don’t know if 10 years will be quick enough,” he adds.

China likely will overshadow the global industry in the next five to six years, says Ashvin Chotai, managing director for Intelligence Automotive Asia. He predicts nearly half of the industry’s growth – 9.5 million units out of a projected 20 million – will come from China.

Chotai says China this year will pass Japan as the world’s largest vehicle-manufacturing country, and “I don’t think Japan will ever regain top-production status.”

Wynn-Williams warns the new government dare not underrate the impact of a rapidly aging population and dwindling workforce.

“Japan has a demographic time bomb requiring urgent attention,” he says. “The population is steadily shrinking and, by 2050, nearly half the people will be ineligible for work, either because they are too old or too young.

“This will be an intolerable burden, so taxes need to start rising now in order to have the financial structure in place in time.”

This could add impetus to the offshore shift of vehicle production, but as global competition quickens, there is no agreement about how well Japanese auto makers will fare in the future.

“Nobody is better at squeezing the costs out of manufacturing,” Blume says of the country’s auto makers. “They will recover well.” Richter agrees: “The forecast is cloudy with hopes of clearing later, and they are poised to gain, not lose, global market share.”

Wynn-Williams’ view is more pragmatic. “The golden years for the Japanese car industry are now coming to an end,” he says. “The U.S. Big Three are leveraging their international contacts to develop vehicles that will challenge Japanese brands head-on. Europeans and South Koreans are hungry for more market share.”

But while Japan’s industry may be on the wane, Blume is not counting it out. “Japanese auto makers have some of the most-advanced, most fuel-efficient cars in the world,” he says.

“They solved the product-quality issue 20 years ago. In the latest hybrid technologies, Japan Inc. is generations ahead of almost everybody.”