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A Revised Economic Forecast for Fiscal 2005-2006
(Subsequent to Release of 1st Preliminary QE for October-December)

Februaly 21, 2006

October-December Quarter Sees 5.5% Annualized Growth

In the October-December quarter of 2005, Japan's real GDP rose by 1.4% on the previous quarter (equivalent to an annualized rate of +5.5%), indicating that the economy has accelerated since the July-September quarter. GDP was up 4.2% on the level recorded for the October-December quarter of 2004. Although the rise includes the reaction to the dip that occurred in that quarter*1, it is the largest increase since 1995, the earliest year for which comparable statistics are available.

Meanwhile, nominal GDP achieved a degree of growth in spite of the continued decline of the GDP deflator, due among other factors to the rise in the price of crude oil, rising by 0.9% on the July-September quarter (equivalent to an annualized rate of +3.5%).

*1: Real GDP for the October-December quarter of 2004 was up 0.4% on the level recorded for the same quarter in 2003. In the October-December quarter of 2004, real GDP rose by 0.4%. The dip in consumer spending due to the mild winter and natural disasters kept growth low in comparison to the +2.4% registered in the July-September quarter of the same year and to the +1.4% registered in the following January-March quarter.

One reason for this high growth in the October-December quarter, amidst a range of structural pressures for adjustment, is the action of a virtuous circle in which strong exports and capital investment boost corporate profits, bringing a recovery of employee incomes and a continued upward trend in share prices, which leads to a rise in demand from the household sector, which in turn boosts corporate profits still further. This virtuous circle has helped to offset the negative impact of the rise in the price of crude oil. Another factor that helped to boost the growth rate is the fact that imports, which have seen sharp short-term fluctuation in recent months, remained virtually stable during the October-December quarter.

Movements of the Major Elements of Demand and the GDP Deflator
(1) Consumer Spending (real: +0.8% on previous quarter, +3.2% annualized)

Consumer spending remained firm. Against the backdrop of a continued recovery in employee incomes, the rapid rise in domestic share prices appears to have stimulated household propensity to spend. As of December, the severest cold wave since the Second World War has boosted consumption and thereby the economy, by stimulating sales of cold weather clothing and heating equipment.
However, there is still some variation in sales trends by product. In the higher-priced goods sector, for instance, flat-screen TV sets and branded goods performed well, but sales of passenger cars remained sluggish, continuing the trend recorded in the July-September quarter.

(2) Housing Investment (real: +1.9% on previous quarter, +7.9% annualized)

Housing investment rose, quarter-on-quarter, for a second quarter. Overall figures were boosted by a rise in the construction of housing for rent, against the backdrop of an influx of investment money into the real estate market. However, the downward trend in the construction of detached houses continues and the figures for construction starts in December suggest that the upward trend in construction of housing for rent and for sale is also slowing. Given the impact of the scandal over the falsification of earthquake resistance data, it is likely that the market trend will remain on the cautious side in the January-March quarter and thereafter.

(3) Capital Investment (real: +1.7% on previous quarter, +7.2% annualized)

Capital investment remained firm, rising quarter-on-quarter for a seventh consecutive quarter. Although the boost provided by major redevelopment projects in city centers is tailing off, investment is beginning to rise in a number of areas, including (i) the development of more sophisticated products and entry into growth markets in the manufacturing sector, (iii) the building of fiberoptic networks in the telecommunications industry, and (iv) an expansion of investment in IT by financial institutions.

(4) Public Investment (real: –1.7% on previous quarter, –6.6% annualized)

The downward trend of public investment had slowed in the first half of fiscal 2005 owing to the implementation of restoration projects following natural disasters, among other factors, but accelerated once more in the second half.

(5) Net Exports (real: contribution to growth on previous quarter: +0.6 points, annualized contribution: +2.3 points)

Exports saw two-digit annualized growth for a third quarter in succession (growth of 3.1% on the previous quarter, equivalent to an annualized rate of +13.0%). Although shipments of capital goods to Asia (excluding China) dipped slightly, shipments to China and to the oil-producing countries and other exporters of natural resources continue to rise, and exports of automobiles to the United States, which weakened in the July-September quarter, have seen a sharp recovery.
Meanwhile, imports fell on the previous quarter for the first time since the April-June quarter of 2003 (–1.3% on the previous quarter, equivalent to an annualized fall of –5.1%). Basically, although the general growth of imports has continued as domestic demand has recovered and the international division of labor has come into fu the earliest year for which comparable statistics are available.ll operation, the October-December quarter saw a reaction to the sharp rise in imports of airplanes and personal computers in the July-September quarter, which has sharply depressed overall figures (real imports for the July-September quarter were up 3.2% on the previous quarter, equivalent to an annualized rise of 13.5%). This represents an acceleration of import growth as compared with the annualized rates of +4.5% in the first half (January-June) and +7.4% in the second half (July-December) of 2005.
Under these conditions, the contribution of net exports to the economic growth rate saw its largest rise since 1994, the earliest year for which comparable statistics are available.

(6) GDP Deflator (change on same quarter in previous year: –1.6 points)

The downward trend of the GDP deflator, year-on-year, accelerated by 0.25 points as compared with the July-September quarter. The three main reasons are (i) the continuing high level of the price of crude oil (pushing the year-on-year rate of increase of the import deflator to 13.3%, double digits for the first time since the January-March quarter of 1997) and (ii) the sharp fall in the price of fresh food (bringing a fall in the consumption deflator, due in part to a reaction to the sharp rise in the price of vegetables in 2004) and (iii) a rise in the weight of spending on digital consumer electronics, the price of which continues to fall (bringing a fall in the consumption deflator).

Long-Term Recovery Trend Set to Continue Although Mood is Likely to Remain Cautious

Looking ahead, the US economy is highly likely to see a slight deceleration, and, against a backdrop of structural change in the flow of money in the corporate sector, it is unlikely that the Japanese economy will continue to achieve the high rate of growth seen in the October-December quarter.

Amidst growing awareness of the need to "maintain financial soundness" and "enhance shareholders' return measures", companies are considering measures such as mergers and acquisitions and overseas investment, as well as domestic capital investment, and are increasingly basing their choice on their assessment of which is likely to make the greatest contribution to the "enhancement of capital efficiency". Consequently, it is likely that capital investment will rise more slowly than in past growth phases.

Although this year's shunto wage negotiations have focused on raising basic salaries, the growing power of shareholders and the need to maintain and enhance competitiveness mean that management is likely to remain cautious overall as regards an increase in the labor share. On a macro basis, the pace of employment and wages growth is likely to be slower than in the past.

Given that the US economy is expected to see a slight deceleration from the spring of 2006, it is likely that export growth, which has reached double digits on an annualized basis in recent months, will gradually slow.

However, the virtuous circle of export and capital investment growth → profit growth → employment and wages growth and rising share prices → growth of consumption → profit growth is gradually gathering strength. If anything, the fact that companies are maintaining a cautious management stance, and the waning of the deflationary mood that began to be evident at the end of 2005, are likely to contribute to a prolongation of the economic recovery. Moreover, the increasing correlation with and sensitivity to domestic share prices of household consumption suggests that, if share prices regain their stability by reflecting the fundamentals, household consumption will continue to grow faster than the rate of improvement in employment and wages and can even be expected to offset the negative impact of the halving of the fixed rate income tax reduction at the beginning of the year.

Consequently, in the short term, real GDP growth is likely to remain on a par with the latent growth rate, in the middle of the 1-2% range, or slightly higher, and to exceed 3% for fiscal 2005 as a whole. In fiscal 2006, it is also likely to achieve a rate of between 2% and 3%.

The three main factors that could disrupt the above standard scenario are (i) the trend of the US economy, (ii) the price of crude oil and (iii) domestic share prices. In the immediate future, the trend of domestic share prices, which has shown a slight softening, merits particular attention, as it could contribute either to an upturn or to a downturn in the economic trend.

Sources: Cabinet Office; forecast by JRI.
Notes: The forecast is based on the following assumptions:
(i) The US economy sees a slight deceleration from the spring of 2006 due to a slowdown in the growth of housing prices, etc. (real GDP growth for calendar 2005: +3.5%; 2006: 3.3%)
(ii) The import price of crude oil (delivered CIF basis, per barrel) averages $54 in fiscal 2005 and $58 in fiscal 2006. (Fiscal 2004 actual figures: $38.7)
(iii) The Bank of Japan discontinues its policy of quantitative monetary easing in April 2006. (iv) The fixed rate income tax reduction is fully discontinued in January 2007.

Incidentally, the previous forecast (issued in December 2005, subsequent to the release of the 2nd preliminary quarterly estimates for July-September) was for real GDP growth of +2.8% and nominal GDP growth of +1.6% in fiscal 2005 and real growth of +2.1% and nominal growth of +1.9% in fiscal 2006. The two major reasons for the upward revision are (i) an adjustment of the base line of consumer spending reflecting a strengthening of the asset effect and (ii) the recent adjustment of the level of net exports.

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

Tel: 03-3288-4263

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