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Revised Economic Forecast for Fiscal 2006-2007
- The Formation of a Capital Efficiency-Based Growth Pattern and Issues to be Resolved if Japan is to Achieve Sustained Economic Growth -

July 7, 2006


Since early 2002, the Japanese economy has been enjoying a sustained recovery, which is gaining an increasingly firm footing. However, although the current recovery is on the point of outlasting the "Izanagi boom", a number of causes for concern have emerged, including the destabilization of the world financial markets, the pressure on corporate profits due to the high price of crude oil and other natural resources and the reverse wealth effect of the softening/decline of share prices.

The current economic recovery phase, which started from the "low" recorded in January 2002 and has gained momentum since the second half of 2004, differs from the two preceding recovery phases since the collapse of the bubble economy in that it has involved a substantial fall in the labor share, a sustained recovery of consumption and a sustained improvement in profitability. One reason for these differences is the formation of a new growth pattern that could be termed "capital efficiency-based".

The pattern of allocation of added value is shifting towards the prioritization of retained profit and dividends and the restriction of allocations to personnel costs. Underlying this shift is a change in the behavior of companies, which are striving to increase their profit ratios by curbing their personnel costs and reducing both their liabilities and their assets, with a view to boosting "capital efficiency".

This change in corporate behavior, placing greater emphasis on capital efficiency, has opened up a new route for the recovery of consumption. Thanks to this more capital efficiency-oriented corporate behavior, the wealth effect generated by the rise in share prices and the rise in dividend income is supporting the recovery of consumption.

Looking to the future, the recovery trend is basically set to continue under the influence of the virtuous circle of export and capital investment growth leading to growth of production and profits, which leads to employment and wages growth, which in turn brings growth of consumer spending, and further growth of production and profits.

However, the following factors are likely to curb the pace of recovery in the short term:

  • With the US economy expected to decelerate gently until the spring of 2007, it is likely that the high pace of export growth, which has been in double digits on an annual basis, will gradually decline.
  • The drive to stabilize the labor share at a lower level means that, even if the recovery in the number of persons in employment gathers momentum, the adjustment made to wages will keep the growth of employee remuneration to a gentle pace on a macro basis.
  • Against the background of a worldwide decline in the supply of risk money, the continued stagnation of share prices means that the stimulus to consumption provided by rising share prices is likely to tail off, chiefly during the second half of 2006.
  • Interest rates and natural resource prices bottoming out and beginning to rise will bring pressure to bear on corporate profits.

Ultimately, although this recovery is set to outlast the "Izanagi boom" and the growth rate for fiscal 2006 as a whole is likely to exceed 2%, the pace of growth is likely to slow to some degree as the economy downshifts from the rapid recovery mode that it entered after escaping from the "plateau" and settles into sustained growth mode.

From the beginning of fiscal 2007, two factors (i) the recovery of the US economy and (ii) the boost to corporate profits provided by the mass retirement of dankai generation baby boomers (through increased consumer spending on the strength of a rise in the payment of lump sum retirement benefits and through a fall in personnel costs) will have an increasingly positive effect on the economy.

Under these conditions, economic growth is likely to accelerate into 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.

Consumer prices are likely to settle into a positive trend as the balance of supply and demand improves. However, a number of factors, including intense market competition fanned by the growth of imports, the low recovery potential of wages and a slowdown in the rate of increase of natural resource prices, mean that there is little scope for an acceleration of the rate of increase.

Thus although the economic recovery is likely to continue throughout fiscal 2006-07, a number of risk factors remain.Notwithstanding fears over the negative impact of disorder in the financial markets triggered by the modulation of the US economy, as long as the scenario of global economic expansion coupled with price and interest rate stability hinging on the complementary relationship between the US and Chinese economies remains basically unchanged, the Japanese economy is unlikely to suffer a slump. However, looking forward to the second half of fiscal 2007 and beyond, it should be noted that, given the low interest rates worldwide and the continued growth of the global economy, there is a risk of a "capital investment bubble", with inefficient investment leading to an accumulation of excess of capital stock.

Besides imposing discipline on the corporate sector and encouraging capital efficiency-oriented behavior, Japan should normalize policy interest rates and restore soundness to government finances by rationalizing expenditure, with a view to the early recovery of its ability to respond to external shocks with policy measures. To accomplish these tasks within the limited time available, it is essential that the government should follow a policy procedure arranged on the following lines:

Step 1: Publication of a roadmap for bold reductions in expenditure (fiscal 2006-07)
Step 2: Normalization of policy interest rates (target: by end of fiscal 2008)
Step 3: 2-point increase in rate of consumption tax (from fiscal 2009 onwards)

For more information on the content of this report, please contact:
Yamada, Ogata、Ishikawa the Japan Research Institute, Limited.

Tel: 003-3288-4245・5120・4263
E-mail:yamada.hisashi@jri.co.jp ogata.naoko@jri.co.jp ishikawa.makoto@jri.co.jp

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