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Revised Economic Forecast for Fiscal 2006-2007
(Subsequent to Release of 2nd Preliminary QE for October-December)

March 13, 2007

Real growth forecasts of 2.1% for FY 2006, 2.4% for FY 2007

The 2nd preliminary quarterly estimates (QE) for the October-December quarter of 2006, published by the Cabinet Office on March 12, put real growth on the previous quarter at +5.5%, an upward revision from the figure of +4.8% suggested at the time of the 1st preliminary QE.
A breakdown of figures by demand category reveals that the positive contributions to the upward revision were led by (i) capital investment (a real annualized contribution to growth on the previous quarter of +2.1 points, up from the +1.5 points suggested at the time of the 1st preliminary QE, reflecting the content of the Quarterly Report on Financial Statements Statistics of Corporations by Industry for October-December) and (ii) public investment (a real annualized contribution to growth on the previous quarter of +0.7 points, up from the +0.5 points suggested at the time of the 1st preliminary QE, reflecting the content of the Integrated Statistics on Construction Work for December). By contrast, export figures saw a small downward adjustment (making a real annualized contribution to growth on the previous quarter of +0.4 points, down from the +0.7 points suggested a real annualized contribution to growth on the previous quarter, reflecting the content of the Balance of Payments Monthly for December).

Moreover, as a result of the re-application of seasonal adjustments, the 2nd preliminary QE also make a slight upward adjustment to the real growth rate for the July-September quarter, centering on capital investment (to +0.5% annualized growth on the previous quarter as against the figure of +0.3% suggested at the time of the 1st preliminary QE).
Consequently, even if the January-March quarter of 2007 sees negative annualized growth of –0.6% or so, the Japanese economy is likely to attain real growth of 2% for fiscal 2006. (At the time of the 1st preliminary QE, it was suggested that an annualized rate of around +1.0% was required for the first quarter.)

However, the 2nd preliminary QE have not forced any major revision of the assessment of GDP in October-December made at the time of the 1st preliminary QE, namely that (i) growth of consumer spending sufficient to make up the ground lost in the sharp fall recorded in July-September 2006, (ii) steady growth of capital investment and (iii) a temporary slowing of the rate of decline in public investment, have offset the negative impact of the slowdown in exports and that the economy as a whole remains firm.

The Institute's forecast of growth rates following the release of the 2nd preliminary QE is as follows. The forecast of the basic trend of the economy remains unchanged, but, owing to the upward revision of the "launch pad", the forecasts of real growth rates for both fiscal 2006 and fiscal 2007 have each been adjusted upwards by 0.1 points, as compared with the February forecasts.
However, since (i) it is likely that the impact of the reduction in mobile phone call charges on the consumer price index will appear earlier than previously forecast and (ii) the pace of decline in the price of IT products has become fairly sharp, the movements of the GDP deflator after the January-March quarter of 2007 have seen a small downward adjustment. Consequently, the forecast nominal growth rate for fiscal 2006 has been revised upwards, like that of the real growth rate, while the forecast nominal growth rate for fiscal 2007 has been revised downwards by 0.1 points.

From January 2007 onwards, the economy is likely to see a gentle deceleration, due largely to the export slowdown and production speed adjustments in the IT devices sector.
The real growth rate for the January-March quarter (annualized quarter-on-quarter rate) is likely to fall to around the same level as the latent growth rate (the middle of the 1-2% range).

However, for the following reasons, the Japanese economy still retains a considerable ability to absorb shocks, and it is unlikely that the recovery trend itself will be disrupted:
(i) Inventory ratios in non-IT sectors are at a low level.
Inventory ratios in the metals and machinery sectors, in particular, are at their lowest ever levels. For this reason, there is little risk of a prolonged or severe adjustment of production across industry as a whole.
(ii) The corporate sector is resolving pressures for structural adjustment and is enjoying plentiful money stocks.
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 the need to secure human resources in preparation against the retirement of the dankai generation of baby boomers and the onset of full-scale population decline, the corporate sector is maintaining its positive stance on capital investment and employment.

Against this backdrop, caught between negative factors such as the corporate sector's efforts to curb the labor share and the increased burden on the household sector on one hand and positive factors such as improving employment conditions and the recovery in share prices and rise in dividend income on the other, consumer spending is likely to continue to fluctuate for some time.
However, the presence of a number of other factors, including the increasing scope for wage increases due to the pause in the upward trend of crude oil prices, and the impact of the mass retirement of the dankai generation of baby boomers (through a rise in lump sum retirement benefit payments and increased scope for wage hikes for those still of working age), make it highly likely that the above positive factors will gradually become dominant. (In the long term, the trend of consumer spending is likely to be upward.)

Ultimately, even if the economy decelerates in the short term, its basic trend is likely to remain steady. Real growth for the full fiscal year (2006) is likely to be +2.1%. This will be the fourth consecutive year that Japan has achieved 2% growth or better.
Moreover, if the US economy does achieve a "soft landing", it is highly likely that the pace of growth will pick up once more in the second half of calendar 2007. The real growth rate for fiscal 2007 is likely to be up on the level recorded for fiscal 2006, at +2.4%.

Consumer prices (excluding fresh foods, year-on-year change) are likely to settle into a positive trend as the macro balance of supply and demand improves. However, a number of factors, including the persistent preference of consumers for lower prices and a year-on-year slowdown in the growth of petroleum product prices, mean that the pace of consumer price growth is likely to remain slow. In the short term, consumer prices may even see slight negative growth in some months.
Under these conditions, although the GDP deflator should continue to improve (year-on-year), it is unlikely to return to the positive range before the second half of 2007.

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

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

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