For years, the price of pharmaceuticals in Japan has moved in only one direction: downwards.

As a result, the Japanese market, still easily the world's second largest, has shrunk from 22 per cent of global sales to about 13 per cent. According to Osamu Nagayama, president of Chugai, it could whither still further by 2004 - perhaps to as low as 10 per cent.

Since the 1980s, the government has imposed sharp price cuts at least once every two years and sometimes every year, bringing hitherto exceptional pharmaceutical margins into line with western norms.

John Wilson, Tokyo-based analyst at HSBC, estimates that average margins for prescription drugs sold in Japan have dropped below those of the US, but have stayed above those in Europe.

The government's prime price-cutting motivation, in addition to the country's declining economic fortunes, has been the rapidly ageing population. By 2005, a quarter of the population will be over 65 against 14 per cent today and a world average for 2005 of 8 per cent.

Given that older people require far more medication, the demographics will put enormous strain on the already creaking health budget.

"The big issue is the expansion of healthcare costs," says Katsuhiko Asano, vice-president of the pharmaceutical division of Kirin brewery. "Healthcare insurance is in a bad condition, so the government is keen to cut the price of drugs."

Yet the headline figures obscure a more subtle story.

One of the reasons for - and mechanisms of - price cuts has been to remove from the healthcare system a perverse incentive for doctors to over-prescribe. Traditionally, doctors and hospitals have dispensed, as well as prescribed, medication.

By negotiating discounts from wholesalers, physicians have made substantial profits on the difference between the discounted price and the government-set resale price.

That differential - effectively the physician's profit on dispensing - is known in Japan as the R-Zone. Successive price cuts have squeezed this differential, gradually removing doctors' incentives to over-prescribe.

As a result, according to HSBC, the percentage of the total healthcare bill spent on drugs has been slashed from an incredible 46 per cent in the mid-70s to a more normal, though still high, 20 per cent.

Per capita spending on pharmaceuticals of about $130 a year has fallen below US levels of $157. (The UK spends $67 per capita).

As prices have fallen, the R-Zone has been cut from about 20 per cent at the start of the decade to less than 5 per cent. "The financial incentive to over-prescribe has not quite disappeared, but it is now relatively small," says Mr Wilson.

That leaves the government, which has previously based its cuts on these differentials, in need of a new price-cutting mechanism for the next pricing round, expected to be revealed this year and introduced in 2002.

"The government will not stop cutting prices," predicts Kenjiro Nagasaka, chairman of Banyu. "But the R-zone cuts are coming to an end."

That, strangely, could be good news for overseas companies and those Japanese groups capable of producing innovative medicines.

The reason is that many local observers predict the government will start cutting the prices of older drugs more aggressively than those of newer ones, particularly those that are genuinely innovative.

The traditional Japanese pricing structure has favoured small-step innovations that suited local companies, according to Mr Wilson. But consensus seems to be building that pricing should reflect innovation and penalise older products.

"We insist there should be special rewards for innovative drugs," says Mr Nagasaka of Banyu.

The government has a big incentive to cut prices of older medicines. Japan has virtually no generics industry to make cheap copies of off-patent drugs. Thus in Japan, only 7 per cent of prescription spending goes on cheap generics compared with 40 per cent in the US, where drug prices plummet once patent protection is lost. "Some categories should be cut more," says Mr Asano of Kirin. "Very innovative drugs and so-called generics should be in different systems."

If the government implements such a scheme, it could damage the business of those local companies that have relied on older products for continued revenue. Conversely, it could help research-driven companies with innovative medicines.

That makes the outcome of the current pricing review critical for the future structure of the industry. Local and foreign companies alike are waiting expectantly for a clear policy to emerge.