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A Revised Economic Forecast for Fiscal 2004-2005:

August 18, 2004

GDP Growth Slows in April-June Quarter Mainly Due to Lack of Growth of Capital Investment

Real GDP for the April-June quarter was up 0.4% on the previous quarter (annualized rate +1.7%). However, while the growth was positive for a fifth consecutive quarter, it was unexpectedly low, largely because capital investment saw little or no growth although exports and consumer spending achieved a solid recovery.

(1) Household Sector

Against the backdrop of the beginnings of a gentle recovery in employment and income conditions, and steady improvement in consumer confidence, consumer spending has continued to rise thanks to continued firm demand for digital consumer electronics and increased spending on eating out, leisure travel, financial services and other services, among other factors. However, given that the figures for consumption expenditure in the Family Income and Expenditure Survey have been boosted significantly by changes in the survey sample, among other factors, it is possible that the figures are higher than the real level of consumer spending. Although investment in detached houses weakened, a rise in construction starts on condominiums in the Tokyo area resulted in a slight overall increase in housing investment.

(2) Exports

Owing to the continued recovery of the global economy, export figures showed two-digit annualized growth for a fourth consecutive quarter. Exports to Asia of goods to satisfy internal demand, such as general machinery, as well as exports of production goods such as electronic devices and audio equipment components saw growth. Exports to the United States and Europe also rose in reflection of the economic recovery.

(3) Capital Investment

Figures saw little or no growth on the previous quarter, but given that the quarterly deflation of capital investment on a GDP basis has been extremely rapid and that machinery orders, the Bank of Japan's Short-Term Economic Survey (Tankan) and other statistics indicate a recovery led by manufacturing industry, among other factors, the forecast that capital investment will continue to recover remains unchanged. The GDP deflator continued its rapid decline, falling by 2.6% on the same quarter in 2003, but a breakdown reveals significant changes in its constituent factors. Against the backdrop of a rise in construction costs, etc., the downward trend of the capital investment and public investment deflators has slowed, while the import deflator has risen sharply, largely owing to the rise in the price of crude oil (exerting downward pressure on the GDP deflator).

Outlook - the Japanese Economy Set to Decelerate into Fiscal 2005

Looking ahead to fiscal 2004, the following three factors suggest that the economic recovery is set to continue:

(i) The continued recovery of the European, US and Asian economies means that exports will continue to underpin the economy. Exports to China, in particular, are likely to grow across a wide range of sectors, including materials, components and capital goods, as that country consolidates its position as "factory to the world" and internal demand, with the exception of capital investment in specific industries, remains firm.

(ii) Capital investment will continue to grow rapidly, especially in the manufacturing sector. Capital investment plans in the Bank of Japan's Tankan survey and machinery orders both indicate a high rate of growth, but as actual investment in the first half of 2004 was unexpectedly slow (on a nominal basis), it is likely that, in the short term, capital investment will remain prone to swing upwards in reaction.

(iii) Thanks to the slowing of the deterioration in employment and income conditions and to the underpinning provided by the older generations, which have a higher propensity to consume, consumer spending is expected to hold firm. The stimulus to propensity to consume resulting from the efforts of the corporate sector to develop new products in areas such as cellular phones and digital consumer electronics is also likely to continue for some time.

As current conditions make it difficult to pass costs on to the price of final goods, the rise in the price of materials such as crude oil is likely to exert a downward pressure on business profitability but the extra income resulting from the expected sales growth may be enough to absorb the negative impact and avert a decline in profits. Incidentally, if the price of crude oil remains around 40-45 barrel a dollar, the increase in costs in fiscal 2004 will be in the region of \1 trillion. This would be canceled out by sales growth of approximately 0.5%.

We have revised our forecasts of economic growth for fiscal 2004 to 3.9% on a real basis (a downward revision of 0.2% points) and 1.3% on a nominal basis (a downward revision of 0.8% points). The downward adjustment on a real basis is largely based on the fall in capital investment and public investment due to the rise in the price of construction materials, and to the acceleration of the decline in nominal public investment. The sizeable downward adjustment of the nominal GDP forecast is due to the growth of import figures owing to the rise in the price of crude oil.

Looking ahead to fiscal 2005, we feel that, as a reaction to companies bringing forward their investment plans, capital investment relating to digital consumer electronics (which has been one of the leading factors in the present economic recovery) is likely to peak out earlier than previously expected, and have adjusted our forecast growth rate downwards, bringing it into the 1-2% range. However, given that the growth of exports is set to continue thanks to the continued growth of the Chinese economy and that the basis for economic recovery is broadening thanks to the progress made on restructuring programs in the corporate sector, among other factors, the economy should be able to avoid a serious slump.

For more information on the content of this report, please contact
Hideki Matsumura, the Japan Research Institute, Limited.

Tel: 03-3288-4245 / 03-3288-4245

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