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A Revised Economic Forecast for Fiscal 2006-2007
(Subsequent to Release of 1st Preliminary QE for January-March)

May 23, 2006

January-March quarter sees 1.9% annualized growth

In the January-March quarter of 2006, the growth of Japan's real GDP slowed from 1.1% quarter-on-quarter in October-December 2005 (equivalent to an annualized rate of 4.3%) to 0.5% (equivalent to an annualized rate of 1.9%). However, the recovery of import growth played a major part in the slowing of GDP growth, and, if anything, the contribution of domestic private sector demand to GDP growth saw a slight increase, largely due to the recovery of capital investment (from annualized quarter-on-quarter growth of 2.3 points to 2.4 points). With structural adjustments in the corporate sector coming to an end, it appears that the economy is becoming more robust.

Movements of the major elements of demand and the GDP deflator

(1) Consumer spending (real: +0.4% on previous quarter, +1.6% annualized)

Although employee incomes were virtually unchanged on the previous quarter (real change on previous quarter: 0.1%), and the impact of the halving of the fixed rate income tax reduction began to show, consumer spending saw some growth. With share prices still rising, although unstable, it is likely that one major factor was the continued vigor of the market for " high-value goods".

(2) Capital investment (real: +1.4% on previous quarter, +5.8% annualized)

Following the first quarter-on-quarter fall in seven quarters (real change on previous quarter: –0.2%), recorded in October-December 2005, capital investment began to recover. Order and construction start statistics and the Bank of Japan's "Short-Term Economic Survey" (Tankan) reveal that this was due to, among other factors, a concentration of investment in the renewal of facilities in the electric power industry,and the recovery of construction investment (led by the construction of commercial facilities), which had weakened at the end of 2005.

(3) Net exports (real: contribution to growth on previous quarter: +0.1 points, annualized contribution: +0.2 points)

Exports recorded double-digit annualized growth for a fourth consecutive quarter (2.7% quarter-on-quarter, equivalent to an annualized rate of +11.3%).Although the growth of shipments to the United States slowed a little, the rapid growth of shipments to the oil-producing countries and other exporters of natural resources, centering on automobiles, continued to provide the momentum for overall export growth. Shipments of capital goods to Asia (excluding China), which weakened at the end of 2005, also recovered.However, imports, which had fallen quarter-on-quarter in the last quarter of 2005, recovered their upward momentum (3.0% quarter-on-quarter, equivalent to an annualized rate of +12.6%, due to a surge in sales of personal computers and food products), andthe contribution of net exports to the economic growth rate fell sharply from the level recorded in October-December 2005 (an annualized quarter-on-quarter contribution of +2.4 points).

(4) GDP deflator (change on previous quarter: –0.4%; change on same quarter in previous year: –1.3%)

The GDP deflator fell, quarter-on-quarter, for an eleventh consecutive quarter. A breakdown reveals that although domestic private sector demand deflator appears to have bottomed out overall (having declined by only 0.1% quarter-on-quarter), the import deflator continued to rise in conjunction with the rise in the price of natural resources (gaining 0.7% quarter-on-quarter), the export deflator fell for the first time in four quarters (dropping by 1.2% quarter-on-quarter), and the public demand deflator fell, led by a slump in government consumption (by 0.3%). As a result, nominal GDP saw virtually no change quarter-on-quarter in January-March, rising by just over 0.0% (equivalent to an annualized rate of +0.2%).

Growth likely to settle to a sustainable pace in fiscal 2006; Fiscal 2007 to see emerging benefits of retirement of dankai baby boomers

Looking to the future, the economic recovery is set to continue thanks to the action of the virtuous circle in which strong exports and capital investment boost corporate profits, bringing a recovery of employment and wages, leading to a rise in consumption, which in turn boosts corporate profits still further.

With various pressures for structural adjustment abating, the corporate sector is likely to focus on active business development in order to survive global competition and securing fresh human resources in preparation against the retirement of the dankai generation of baby boomers and the full-scale onset of population decline, while working to boost its medium-term potential growth rate.

However, the following factors suggest that economic growth is unlikely to see another acceleration in the short term:

  • Given that the US economy is expected to see a gentle deceleration from the spring of 2007, it is highly likely that the rapid growth of exports (currently recording double-digit annualized rates) will gradually slow.
  • In the high-tech industries, the improvement in the balance of shipments and inventory and the pace of production growth have begun to slow, and it is possible that the ability of these industries to drive the economy forward will gradually decline.
  • Given that attempts are being made to stabilize the labor share at a low level, even if the rising trend in the number of persons in employment strengthens, the adjustment made to wages will keep the growth of employee remuneration on a macro basis to a gentle pace.
  • The rise of natural resource prices and long-term interest rates will bring pressure to bear on corporate profits1.

Note 1: The appreciation of the yen is expected to exert downward pressure on the profits of the machinery sector, which currently has a substantial export surplus. In other industries (materials, processing excluding machinery, and non-manufacturing industries), however, it will also help to offset the rise in the cost burden that has accompanied the rise in the import prices of natural resources. For this reason, the pressure on profits of these industries, on a macro basis, is likely to be limited (specific calculations will be covered in another report).

In summary, fiscal 2006 is likely to see the economy shift away from the rapid recovery mode it entered after escaping from the "plateau" and search for a "cruising speed" that will allow sustained growth. In more specific terms, growth is likely to settle to an average annualized rate of around 2%.

In fiscal 2007, besides the positive effects of a recovery of the US economy, it is likely that the mass retirement of dankai generation baby boomers will have a growing positive effect on the economy, via two routes — the boost to consumption that will be provided by a rise in the payment of lump sum retirement benefits, and the boost to corporate profits that will come from a fall in personnel costs. Under these conditions, economic growth is likely to accelerate in the second half of the fiscal year, and it is possible that the growth rate for the fiscal year as a whole will reach the middle of the 2-3% range.

Inquiries relating to the content of this report, etc. should be addressed to Ishikawa , Economics Department, the Japan Research Institute, Limited.

Tel: 03-3288-4263
E-mail:ishikawa.makoto@jri.co.jp

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