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A Revised Economic Forecast for Fiscal 2005-2006
(Subsequent to Release of Preliminary QE for July-September)

November 15, 2005

Annualized Growth of 1.7% in the July-September Quarter

In the July-September quarter of 2005, Japan's real GDP rose by 0.4% on the previous quarter (equivalent to annualized growth of 1.7%). Owing chiefly to a slowing of the strong growth of consumer spending and capital investment recorded in the first half of the year, and to a surge in imports, the growth rate slowed from 1.5% in the January-March quarter (equivalent to annualized growth of 6.3%) and 0.8% in the April-June quarter (equivalent to annualized growth of 3.3%). However, there was also a great deal of evidence that the foundations of the Japanese economy are growing firmer, such as (i) the fact that consumer spending and capital investment both continued to rise in spite of institutional predictions that they would begin to fall, (ii) double-digit export growth for a second straight quarter, (iii) the beginnings of a rise in housing investment, (iv) overall growth rose to +3.0% on the same quarter in 2004, and (v) the fact that nominal growth also remained positive in spite of the contrary wind of high crude oil prices.

The movements of the major elements of demand were as follows.

(1) Consumer Spending (Real: +0.3% on Previous Quarter, +1.4% Annualized)

The substantial growth seen in the first half of the year slowed. Among other factors, this is due to the fact that the pent-up demand (especially for automobiles) that emerged as fears over employment and incomes receded is tailing off, and the fact that demand for autumn goods has been slow owing to the hot weather and typhoons in the late summer. However, employee incomes have continued to rise, share prices have recovered and spending increased in a number of areas, including slimline TV sets and personal computers, whose prices continue to fall, visits to the Aichi World Expo and other leisure-related activities, and commission on securities transactions, the anticipated fall in spending was averted, and the figures show that consumer spending actually rose quarter-on-quarter for a third quarter in succession.

(2) Housing Investment (Real: +1.5% on Previous Quarter, +6.3% Annualized)

Housing investment rose quarter-on-quarter for the first time in three quarters. Although the downward trend of in the construction of detached housing has continued, the flow of investment money into real estate market has grown and construction of large and small apartment blocks in city areas has picked up, greatly boosting overall investment figures.

(3) Capital Investment (Real: +0.7% on Previous Quarter, +3.0% Annualized)

Although capital investment figures rose quarter-on-quarter for a sixth quarter in succession, the rate of increase has slowed since the first half of the year, which saw double-digit annualized growth. This is due, largely, to the peaking of the volume of redevelopment projects in city centers and a slowdown in construction investment as the construction of factories in the manufacturing sector (especially the electrical machinery industry) entered a lean period. However, given that investment in machinery, which accounts for around 70% of all capital investment, continues to rise (machinery orders and private sector demand excluding shipping and electrical power are expected to record quarter-on-quarter growth for a fifth quarter in succession in October-December 2005) and that the local regeneration drive has spread to the suburbs, it seems likely that the major growth slowdown recorded over the July-September quarter is a temporary phenomenon. Moreover, given that an increasing number of companies are drawing up business plans calling for greater emphasis on added value in domestic production and the strengthening of development capability, the construction of factories in the manufacturing sector is unlikely to start falling.

(4) Public Investment (Real: +1.0% on Previous Quarter, +4.1% Annualized)

Although public investment continues to fall, it appears that reconstruction projects following natural disasters in the Hokuriku Region, large-scale projects initiated by the former Japan Public Highway Corporation (projects relating to the New Tomei Expressway, the installation of ETC toll collection equipment, the construction of tunnels for the Shuto Expressway), the remodeling of hospitals, prisons and government offices, and other public investment projects have all begun to make headway at once, and that the pace of decline in overall investment has slowed. The July-September figures show positive growth on the previous quarter.

(5) Net Exports (Real Contribution to Growth on Previous Quarter: -0.0 points, Annualized Contribution: -0.2 points)

Exports recorded 2-digit annualized growth for a second quarter, (+2.7% growth on the previous quarter, equivalent to an annualized rate of +11.4%). Although the growth of shipments to the United States, which account for more than 20% of total exports, slowed, especially in the area of automobiles, shipments to China, which weakened in the April-June quarter, saw a rapid recovery in a wide range of categories. The continued growth of shipments to countries that supply Japan with natural resources and are benefiting from the strong commodities market, has also contributed to the overall recovery of exports. Imports also saw their fastest growth since the October-December quarter of 1995 (+3.9% growth on the previous quarter, equivalent to an annualized rate of +16.7%). Imports of airplanes made an important contribution, but basically, the general growth trend has continued as domestic demand has recovered and the international division of labor has come more fully into operation. Besides airplanes, the growth of imports has been particularly significant in the field of personal computers. Although both exports and imports saw rapid growth, the growth of imports exceeded that of exports in relative terms, and the contribution of net exports to the economic growth rate saw a slight fall.

Japanese Economy Set to Hold Firm but Growth is Unlikely to Accelerate

Looking to the future, the Japanese economy is set to hold firm in the short term, on the strength of domestic private demand.

As the corporate sector has resolved long- and short-term problems such as the "three excesses" (excess labor, excess capital equipment, excessive debt) and inventory adjustments in the IT sector, business profitability continues to rise* notwithstanding the high price of crude oil and money stocks are still plentiful, the growth of capital investment is likely to accelerate once more.

Owing to improving employment conditions, the continued recovery in asset values, including share prices, and the expected substantial increase in the sizes of winter bonuses this year**, consumer spending is highly likely to recover in the long term.

*To date, the impact of the rise in the price of crude oil has been offset to a considerable degree by (i) a rise in Japanese exports fueled by the rapid economic growth of newly developing countries which is one of the reasons for the rise in the price of oil, (ii) the benefits of strong economic performance among the oil-producing countries (export growth, an influx of oil money onto the stock markets, etc.) and (iii) the effects of rationalization (workforce reduction in particular). **According to a Keidanren survey, winter bonuses are likely to be 5.08% larger than in 2004 (interim figures for major corporations, as of October 26), owing to the "residual heat" effect of substantial profit growth recorded in fiscal 2004.

However, it is unlikely that the pace of the recovery will accelerate into the second half of fiscal 2006.

Consumer spending is unlikely to see a significant decline, but given the fragile nature of a bonus-led recovery in wages and the scheduled increases in the burden on household sector***, the recovery will inevitably be a little shaky.

Although it is thought that profit growth in the corporate sector is sustainable, as the boost to income provided by the reduction of fixed costs such as personnel expenses tails off, there are fears that the pressure on profits of the continued high price of crude oil will gradually become apparent in the form of delays in making the shift towards products with higher added value and an intensification of competition with foreign firms, especially in industries that still find it difficult to raise sales prices.

Although it is highly likely that the growth of exports will continue, especially in the area of shipments to newly industrializing countries and natural resource-producing countries, as the US economy decelerates over the second half of 2006, the rate of growth is likely to slow. Moreover, with the international division of labor beginning to come more fully into operation, it is likely that import growth will accelerate in tandem with the growth of exports to newly industrializing countries, so that "net exports" will make only a small contribution to economic growth.

***The downward pressure on consumer spending of halving the fixed-rate reductions in income and local inhabitants' tax in January 2006 and abolishing it altogether in January 2007 is estimated at -0.1% in fiscal 2005 and -0.5% in fiscal 2006.

As a result, real economic growth in fiscal 2005 is likely to be +2.7%, the strongest recorded since fiscal 1996. Growth is likely to slow somewhat in the second half of fiscal 2006, yet is set to reach +2% over the full fiscal year.

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

Tel: 03-3288-4524
E-mail:matsumura.hideki@jri.co.jp

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