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Revised Economic Forecast for Fiscal 2006-2007
(Subsequent to Release of 1st Preliminary QE for April-June)

August 14, 2006

Annualized growth of +0.8% in April-June quarter

The April-June quarter saw real economic growth of +0.2% quarter-on-quarter (equivalent to an annualized rate of +0.8%), positive growth for a sixth quarter in succession, but the pace of growth has slowed relative to the quarter-on-quarter growth of +1.1% recorded in October-December 2005 and +0.7% recorded in the January-March quarter this year.

The four major factors behind this slowdown in the pace of growth are as follows.
(i) The acceleration of the decline in public investment since the beginning of fiscal 2006
Against a background of continued cuts in public works spending, the boost to demand provided by recovery projects following natural disasters is tailing off.
(ii) A slowdown in exports, centering on shipments to the United States and Asia
With the US economy starting to slow, the impact of the downward pressure on demand has started to affect not only shipments of final goods destined for the local market but also shipments of intermediate goods to overseas production bases.
(iii) A sharp fall in housing investment centering on apartments for sale
This is thought to be due to factors on the developers' side, including a desire to reflect the recovery in land prices, especially in city centers, in sales prices.
(iv) A fall in corporate inventory levels (especially in the distribution sector)

By contrast, the growth of capital investment accelerated quarter-on-quarter to +3.8% (equivalent to an annualized rate of +16.2%), faster still than the annualized rate of +13.9% recorded for the January-March quarter. Moreover, consumer spending, which it was feared would suffer from poor weather, among other factors, achieved some growth, rising by 0.5% quarter-on-quarter (equivalent to an annualized rate of +1.9%), thanks to the continued improvement in employment conditions (real employee incomes rose by 0.5% quarter-on-quarter, having recorded +0.0% in the January-March quarter)*1. Overall, the 1st Preliminary Quarterly Estimates reflect the fundamental strength of domestic private sector demand*2.

*1: One important reason that real consumer spending growth for the April-June quarter exceeded most predictions is that the 1st Preliminary QE for April-June have revised the figures for consumer spending in the January-March quarter downwards from +0.5% to +0.2% quarter-on-quarter (equivalent to an annualized rate of +0.8%). The Cabinet Office explains that this adjustment was made in response to a downward revision of the basic statistics used to estimate telephone call charges and Internet connection fees (Telecommunications Format Statistics).
*2: The fall in inventory investment that curbed the economic growth rate may also be partly due to the fact that demand was higher than supply-side expectations in many areas and for many categories of goods.

Thus, the overall trend for the April-June quarter can be interpreted as "a speed adjustment as the economy settles from the fairly strong growth recorded in fiscal 2005 to a more sustainable pace of growth."

During the April-June quarter, the GDP deflator also turned positive quarter-on-quarter for the first time since the April-June quarter of 2003 (+0.1%). Following the rise in natural resource prices, the rise in the import deflator accelerated (exerting downward pressure on the GDP deflator), while the domestic demand deflator turned positive, at +0.2%, for the first time since January-March 2002, due in large part to household demand (consumption and housing demand).

Growth will settle to sustainable pace in FY 2006 and accelerate once more in FY 2007 thanks to US economic recovery, retirement of dankai baby-boomers

Looking to the future, the Japanese economy is likely to see a gentle deceleration into the spring of 2007 against the backdrop of (i) the slowdown in the US economy, (ii) the rise in the prices of crude oil and other natural resources, (iii) the slow recovery of wages, and (iv) the diminution of the asset effect in conjunction with the softening of share price.

Moreover, if overseas economies, including that of the United States, slow down, there is a risk of pressure for inventory adjustments in the IT sector, which has been stepping up production at a rapid pace.

Nevertheless, the Japanese economy is likely to retain a considerable ability to absorb shocks (a different scenario from those observed during the "plateau" phase of 2004 or at the time of the collapse of the high-tech bubble):

(i) The shipments-inventory balance in non-IT sectors is improving (short-term factor)
Even if pressure for adjustments arises in the IT sector, the non-IT sectors will underpin demand and it is likely that a major production adjustment across all sectors of industry can be avoided.
(ii) The corporate sector is resolving pressures for structural adjustment and is likely to enjoy plentiful money stocks (medium-to-long-term factor)
With management concerns in the corporate sector shifting from the "adjustment of excessive levels of employment, capital equipment and debt" to "active business development with a view to survival against global competition" and "securing human resources in anticipation of the retirement of the dankai generation baby-boomer and full-scale population decline", there is little risk that the upward trend of capital investment and employment will falter in the short term.

Thus, in fiscal 2006, it is likely that the economy will continue to renew its record for the duration of a growth phase (outlasting the "Izanagi Boom") while adjusting its speed towards a sustainable growth trajectory. The quarterly pace of growth is likely to remain at an annualized level of around 2% (somewhat higher than the likely latent growth rate, which is expected to be between 1.5% and 2.0%) and the growth rate for the fiscal year as a whole is likely to be around 2.2%.

In fiscal 2007, the recovery of the US economy and 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, it is highly likely that the pace of growth will accelerate into the second half of the fiscal year, and that growth rate for the fiscal year as a whole will reach the middle of the 2-3% range.

Consumer prices (excluding fresh foods, year-on-year change) 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, the low recovery potential of wages and a year-on-year slowdown in the growth of natural resource prices, mean that there is little likelihood of an acceleration of the rate of increase. Consumer price growth is likely to remain around +0.5% year-on-year as compared with the current standard of 2000 prices, or between +0.0% and +0.5% as compared with the new standard of 2005 prices (scheduled for publication on August 25; the index is likely to be revised downwards as a result of changes to categories and weights), for some time.

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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