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Last year was a modern record for Japan's advertising industry.

Spending rose 3 per cent to 5.86 trillion yen, ending a three-year slump.

The Japanese big guns fared well. Dentsu, for example, by far the country's largest agency, reported a group operating profit up 32 per cent from a year earlier. Western agencies generally had good years but, post-Sarbanes-Oxley, they no longer provide any financial details.

Despite this growth, total billings were still well behind those of 2000.

Now, with the economy in recession again and increases in personal taxation starting to bite, 2005 looks like being another difficult year. Dentsu forecasts growth of 1.4 per cent, but many are more cautious.

"I think the best we can hope for is a flat year, with little or no growth overall," Max Gosling, the president and chief executive of McCann Erickson, Japan's leading multinational agency, says. "The signs of growth last year were more export-led than a recovery in domestic demand."

Serious uncertainties about the future have become the norm in Japan, but did not dampen interest when Japan's second-largest agency group, Hakuhodo DY Holdings Inc, made its stock market debut on 16 February.

Its shares closed 14 per cent above their opening price, giving the agency a market capitalisation of about 250 billion yen, compared with 787 billion yen for Dentsu. The IPO was an opportunity for current shareholders, including the Seki family who founded Hakuhodo, to pare down their holdings.

Toshio Miyagawa, HDY's president, gave few details of the company's plans beyond saying he was looking to invest in China and internet-related businesses.

HDY was formed in October 2003 when Hakuhodo, Daiko Advertising and Yomiko Advertising integrated their media buying operations into Hakuhodo DY Media Partners.

Though HDY's market share of around 17 per cent is not large enough to challenge Dentsu's 26 per cent, it has had impact. "HDY is big enough to make a very competitive media offering," Andrew Meaden, the chief executive of MindShare Japan, says. "As a result, there have been a large number of pitches called by Japanese advertisers either to consolidate their business or to get a better deal."

Many long-standing relationships have perished as a result. Kyodo Advertising saw its largest client, Honda, decamp to Dentsu, which also wrested Honda billings from HDY. Other Dentsu media wins included McDonald's (from HDY), Nestle and AIG. HDY, meanwhile, picked up media business from IBM, Shell and Volks-wagen and held on to Vodafone. With media commissions spiralling downwards, Dentsu and HDY are driven to consolidate ever-larger volumes to maintain their revenues. The losers are the smaller Japanese agencies, which rely almost entirely on media commissions for their revenue.

Insiders say Dentsu and HDY may take on media buying assignments for no commission. By denying business to their rivals, increasing their volumes and therefore their rebates, both agencies can still find the kind of economic return that smaller buyers cannot. Whether this is true or not, it remains clear that Japanese advertisers are looking for efficiencies and economies of scale in media buying that only the biggest buyers can provide.

HDY's birth has posed problems for WPP's partner, Asatsu-DK. For years, ADK positioned itself as the third force that would one day unseat HDY and challenge Dentsu. With a market share some ten percentage points less than HDY, that is no longer a possibility. For most of last year, ADK edged closer to Dentsu, even forming a small creative joint venture, Drill, to explore "next-generation advertising". In return, Dentsu challenged ADK's hold on at least one of its key clients, AIG. Though by no means a small agency, ADK may prove too small to compete.

MindShare, like other Western media agencies, earns its money from planning, consulting and auditing rather than buying. Mostly its clients are the Western multinationals that use its services elsewhere. But some Japanese advertisers are becoming interested in media planning skills.

Fee-based business models are the norm for Western agencies in Japan and have enabled them to expand services into other disciplines. McCann Worldgroup provides the full spectrum of its services in Tokyo. Ogilvy's offer includes PR, OgilvyOne - its direct marketing arm - and design.

Grey has recently added healthcare to its menu. Japan's population is ageing and with further deregulation, healthcare should become a major new opportunity for agencies, Chris Beaumont, the president of Grey Japan, says.

The wider offerings not only bring in more revenue streams from the Western multinational advertisers that Western agencies predominantly serve, but also develop contact with Japanese advertisers seeking to go beyond the traditional use of traditional media. This is valuable because Western multinationals account for less than 10 per cent of spend in Japan. Apart from McCann Erickson, which ranks about ninth, Western agencies are small players in Japan. McCann owes its position to more than 45 years of cultivating Japanese advertisers. "We need to crack the local code," Miles Young, the chairman of Ogilvy Japan, admits.

Easier said than done. Japanese advertisers work in very different ways from their Western brands. Often assignments are awarded as short-term projects and are shared between agencies. The package any major Japanese advertiser brings includes an inordinate amount of leg work, frequent meetings, regular reviews and repitches once a year. "On a truly bad day," one HDY executive says, "at least a third of the agency's manpower could be working on reviews and presentations that earn no money at all."

Fortunately, there is an easier path to growth than pursuing Japan's major advertisers. Many smaller companies, which may spend no more than £25 million to £50 million on advertising, find they can't always get the attention their businesses need from Dentsu or HDY. Some are worried about account conflicts that are the norm at the Japanese giants. For these, Western agencies are an increasingly attractive partner. Even if they decline to have a meeting every day, at least they are thinking about your business. Such a strategy has helped Ogilvy increase its local business from 5 per cent to 20 per cent of the total over the past year.

Winning Japanese clients helps with more than revenue. It also helps recruit Japanese creative talent. Most Western agencies are perceived as shops that do little more than adapt work from other countries or find local interpretations of global strategies developed elsewhere. The opportunity to develop creative for Japanese clients from scratch while using the tools and disciplines of a modern agency can prove irresistible.

The ferocious battle for media buying mass that pre-occupies Dentsu and HDY does create new opportunities. Historically, the giant Japanese agencies controlled access to media space and time on their terms. That business model is crumbling as advertisers increasingly call the shots, demand accountability and talk about ROI.

Hitherto, Japan's ad industry has resembled a sumo ring where two huge wrestlers, Dentsu and HDY, are locked in endless struggle, egged on by their major clients. "But Western agencies have a chance to stand out in the ring, not by size but on performance," Alejandro Lopes, the president of Beacon Communications, says. "However, it may take a generational shift in corporate management before the power of these foreign 'karate fighters' is recognised."

JAPAN'S LEADING CREATIVE LIGHTS

Dentsu Japan's most-awarded creative agency has no creative philosophy. In a year-long process that owes much to Zen, young creatives are encouraged to find their own pathway to excellence while their elders place hidden challenges along their way. Many who come through this spend their entire careers there, a few move on to form creative boutiques or, more occasionally, work for another agency. Dentsu employs more creatives than any other agency (it is the single largest agency brand in the world) and regularly helps itself to the lion's share of awards.

Hakuhodo

Trailing Dentsu is Hakuhodo, which positions itself as the creative, gentlemanly, client-oriented alternative to Dentsu's raw aggression. But despite acclaimed work, such as a campaign to highlight the dangers of a growing hole in the ozone layer, times have changed, Akira Odagiri, Ogilvy's chief creative officer, says. Until he left a few years ago to work as an illustrator, he was one of Dentsu's supreme creatives. "Dentsu and Hakuhodo have moved closer together," he says. "They used to have such different values that their differences sparked creative innovation. All that has faded."

Ogilvy

Asked by friends, former colleagues, and young creatives to find a way to inject a new spirit into the industry, Akira Odagiri elected to join Ogilvy as its creative supremo. "Japanese advertisers feel Dentsu and Hakuhodo are no longer doing enough. There's need for a different offering, a force of change, and we will provide that," he says. Ogilvy's new work has a sparkle it lacked before, although there is some way to go before the Japan office can match the creative reputation of other Asian outposts. But with Odagiri on board, the agency's ambitions deserve to be taken seriously.

McCann Erickson

While Ogilvy's promise is about the future, McCann is delivering outstanding work today. "Morning", a 60-second spot for Nestle, scooped all Japan's major awards last year and was honoured internationally. A widely known and much-loved Japanese poem about morning breaking around the world is superimposed over shots of an early morning sky. The brand appears only in the closing shot. For Nestle, the ad was bang on strategy to associate a widely known brand of coffee more strongly with the morning and develop emotional bonds with consumers.

TBWA

TBWA is another agency where planning and consumer insight are processes that drive creativity. In cities such as Tokyo and Osaka, high population densities enable outdoor media to reach vast audiences. When giant hoardings sport bungee-roped footballers kicking a ball around or sprinting up a skyscraper, the streets become stadia filled with spectators while media coverage expands the audience further. These, and other remarkable TBWA events last year for Adidas, were all integrated with more conventional media in ways never before attempted in Japan.

Beacon

Western agency disciplines and the professional rigour of working for Procter & Gamble give Beacon Communications strengths that are the foundations of increasingly creative work. Formed from the merger of Bcom3's Burnett and D'Arcy shops in 2000, the agency is breaking the mould by winning Japanese clients such as Aiful and Asahi Beer, which now provide 18 per cent of the agency's business.

Work for its Japanese clients regularly features in the top-ten CM index, a monthly ranking of popular commercials based on consumer surveys.

Fallon

Fallon Japan is one of Japan's few creative-led agencies. It was formed in 2003 when Fallon invested in Gram, an independent creative boutique. "We are not a Fallon branch," Tamio Koshino, one of the two creative partners, says. "Many Western agencies made the mistake of coming here only to take care of their head office clients - that kind of agency never attracts good people. We are a Japanese agency and we win clients based on our own strengths." Apart from United Airlines and Citibank, all Fallon's clients, including Sony, Volkswagen and Dyson, are home-grown.