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Revised Economic Forecast for Fiscal 2007-2008
(Subsequent to Release of 1st Preliminary QE for January-March)

May 18, 2007

Real annualized growth of +2.4% in the January-March quarter

The 1st preliminary quarterly estimates put real GDP growth for the January-March quarter of 2007 at +0.6% quarter-on-quarter (equivalent to an annualized rate of +2.4%), slower than in the October-December quarter but still above the latent growth rate, thought to be in the region of 1.5% in excess of most forecasts and representing growth for a ninth consecutive quarter. Growth on the same quarter in the previous year also returned to the 2-3% range (+2.0%), confirming the fundamental recovery trend.

A breakdown by elements of demand reveals that the rapid growth over the last quarter was achieved largely on the strength of (i) the continued recovery of consumer spending, led by spending on digital consumer electronics and services, particularly travel and food services, and (ii) the development of markets in newly developing economies and natural resource-producing countries and a rise in shipments to Europe owing to the strength of the euro, which together have offset the slowdown in shipments to the United States, leading to double-digit annualized growth in exports of goods and services for the first time in 5 quarters.
Capital investment, by contrast, recorded a quarter-on-quarter fall for the first time in 5 quarters. The fall was partly a reaction to the sharp rise recorded in the October-December quarter of 2006, but it also appears that companies have been postponing investment in the short term owing to the worldwide fall in share prices that occurred in late February and growing uncertainty over the future direction of the US economy.

Meanwhile, owing to a softening of the personal consumption deflator and a re-acceleration of the upward trend of the import deflator, the GDP deflator became somewhat sluggish and once more slipped quarter-on-quarter (-0.3%).
However, the rate of decline on the same quarter in the previous year is still slowing (~0.2%), and as a result, nominal GDP maintained a rate of growth on the same quarter in the previous year in the 1.5–2.0% range (+1.8%).

Economy likely to see little growth in the short term but accelerate once more in the second half of FY 2007

Looking ahead, the economy is likely to remain somewhat heavy in its movements in the short term owing to (i) the slowdown in the US economy and residual uncertainty over its future direction (exerting downward pressure on exports and leading to the short-term postponement of capital investment plans), (ii) the high levels of inventory in some industries, such as IT devices and (iii) a change in the timing of taxes on the household sector in conjunction with transfer of sources of tax revenue from central to local government (a rise in the amount of local inhabitants' tax due in June).
Moreover, it is still likely to be some time before the problem of the slowdown in the recovery of business performance among small and medium enterprises, which is hindering the acceleration of the economy as a whole, can be resolved.

However, for the following reasons, the Japanese economy still retains a considerable ability to absorb shocks, and unless the US economy suffers an outright slump, is likely to hold steady:

(i) Export destinations are diversifying.
Export destinations are diversifying to include newly developing economies and natural resource-producing countries, etc.

(ii) Inventory ratios remain at a low level throughout industry.
Inventory ratios are at their lowest ever levels, especially in the metals sector and in IT final goods. For this reason, there is little risk of a prolonged or severe adjustment of production across industry as a whole.

(iii) The corporate sector is enjoying plentiful money stocks.
Owing partly to the fact that medium-term anticipated growth rates in the corporate sector have recovered to the 2-3% range, scope remains for growth in capital investment and employment. The movements of forward-looking indicators suggest that capital investment is likely to remain relatively weak in the short term, but is highly likely to begin rising again from the summer onwards, as uncertainty over the future course of the US economy is dissipated.

Against this backdrop, the fact that there is little hope of improvement in the recovery potential of wages and the impact of the change in the timing of taxes described above mean that consumer spending is unlikely to rise far in the short term. However, the improvement in the employment situation, the rise in lump sum retirement benefit payments to the dankai generation of baby boomers, the rise in interest and dividend earnings, and the bottoming out and beginnings of a recovery in land prices all suggest that the medium-to-long term trend of consumption will be upward. From the autumn of 2007, consumer spending is set to gradually firm up.

Under these conditions, the real economic growth rate (annualized quarter-on-quarter growth) is likely to slow to just under +2% in the first half of fiscal 2007, before re-accelerating in the second half of the year. Over the full fiscal year, the growth rate is expected to recover to the 2-3% range, reaching +2.3%.

Looking ahead to fiscal 2008, economic recovery scenario of the second half of fiscal 2007 is likely to remain in place for a time, but in the second half of fiscal 2008, from about the time of the Beijing Olympics, it is likely that there will be a slowdown in overseas demand, especially demand for investment from China, and a softening of domestic capital investment as the growth of capital investment efficiency slows. As a result, the "real growth" of the economy is also likely to see a gradual slowdown.
However, if the consumption tax rate is increased in April 2009, it is likely that the economy will be boosted by a surge in demand ahead of the rate hike. Consequently, although the growth rate will be relatively high in fiscal 2008, it is likely to record a fall, in reaction, during fiscal 2009.

Although the slowdown in the growth of petroleum product prices and the cutting of mobile phone call charges, among other factors, will continue to exert downward pressure for some time, the fact that the improvement in the macro balance of supply and demand is expected to continue, the establishment of the upward trend in the price of services and the likelihood that the price of crude oil will rise little by little, among other factors, make it likely that the decline in consumer prices (excluding fresh foods, year-on-year change) will slow at some point, and that prices will thereafter, albeit gradually, begin to rise.

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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