By Mayumi Otsuma and David Tweed

March 12 (Bloomberg) — The week after Toshihiko Fukui became Bank of Japan governor in 2003, he called an emergency meeting. The U.S. had invaded Iraq, the Nikkei 225 Stock Average was at a 20-year low and the economy was in a deflationary spiral.

Led by Fukui, the central bank’s board increased stock purchases from commercial banks, helping create the conditions for what became the longest economic expansion since World War II.

On March 19, Fukui, 72, will leave office with the economy on the brink of a recession, the yen, at an eight-year high, threatening exports — and, possibly, no successor to take the bank’s reins from him.

The opposition Democratic Party of Japan blocked the ruling Liberal Democratic Party’s nomination of Toshiro Muto, 64, as governor, and Takatoshi Ito, 57, as deputy governor in an upper house vote today. The result is that the world’s second-largest economy may be without monetary-policy leadership just as the Federal Reserve and central banks worldwide are coordinating efforts to contain a confidence crisis in credit markets.

“We’re at an important juncture for global economies and stock markets, and this drama regarding the central bank in Japan is not helpful,'’ said Quincy Krosby, chief investment strategist at the Hartford Financial Services Group Inc. in Hartford, Connecticut.

Backing Shirakawa

The DPJ backed the government’s other choice for deputy governor: Masaaki Shirakawa, 58, a former executive director at the bank. Shirakawa may be charged with overseeing monetary policy with the remaining six members of the board until a new governor and second deputy are selected and confirmed.

“Shirakawa has a good reputation, but he’s very much a technocrat,'’ said Takehiro Sato, chief Japan economist at Morgan Stanley in Tokyo. “That could make it difficult for him to pull things together.'’

Under Fukui, the central bank in March 2006 ended a five- year policy of pumping cash into the economy and keeping interest rates near zero. In July that year, the bank raised its key overnight lending rate for the first time since 2000, taking it to 0.25 percent, and then doubled it in February 2007.

“Fukui was clearly keen to normalize rates in Japan, but under him the Bank of Japan’s policy was fairly pragmatic,'’ said Ben Eldred, a senior economist at Daiwa Securities SMBC Co. in London, a unit of Daiwa Securities Group Inc., Japan’s second-biggest brokerage.

`Well-Established’

“Under his leadership, the Bank of Japan waited until Japan’s recovery was well-established before tightening policy, raised rates very gradually and paused as soon as the global economic situation worsened last year,'’ Eldred said.

Fukui argued at his last policy meeting on March 7 that growth will still spur wages and spending, pushing prices higher, even though Japan’s economic expansion is slowing — the same line he has used to justify the bank’s rate policy.

Gross domestic product expanded an annualized 3.5 percent in the fourth quarter, the Cabinet Office said today. That compares with an initial government estimate of 3.7 percent.

Not all market participants agree with Fukui. Investors see a 52 percent chance the central bank will cut the benchmark rate from 0.5 percent by the end of the year, according to JPMorgan Chase & Co. calculations.

Japan’s currency is hovering about 103 yen to the dollar, damping the earnings of exporters struggling to cope with rising raw-material costs. Corporate profits fell in the final three months of 2007, the first consecutive quarterly decline since Japan emerged from its most recent recession in 2002.

`A Temporary Recession’

“The Japanese economy is now in a temporary recession,'’ said Tetsufumi Yamakawa, chief Japan economist at Goldman Sachs Group Inc. in Tokyo. “Sluggish corporate earnings are curtailing capital spending.'’

The political standoff over Muto’s nomination comes as investors cope with a stock-market slump that sent the Nikkei and the broader Topix benchmark to two-year lows this week.

“There is a risk that political turmoil would prevent the government from implementing necessary policy steps, and that’s a problem for investment,'’ said Hideo Kumano, a former Bank of Japan official and now chief economist at Dai-Ichi Life Institute in Tokyo.

“The market wants to see a central bank chairman in Japan who is independent and can do what’s necessary to conduct viable independent monetary policy,'’ Krosby said.

Carl Weinberg, chief economist at High Frequency Economics in Valhalla, New York, recommended in a report yesterday that investors sell Japanese stocks, citing the gain in the yen, the chances of recession and longer-term concerns about the nation’s aging population.

“With just one week to go before Governor Fukui’s term ends, this leaves a big gap in Japan’s policy-making apparatus,'’ Weinberg said. “This is a mess.'’

To contact the reporters on this story: Mayumi Otsuma in Tokyo at motsuma@bloomberg.net; David Tweed at dtweed@bloomberg.net.