Economy set to decelerate in the short term but accelerate once more in the second half of FY 2007

The 2nd preliminary quarterly estimates (QE) for the January-March quarter of 2007, published by the Cabinet Office on June 11, put annualized real growth on the previous quarter at +3.3%, an upward revision from the figure of +2.4% suggested at the time of the 1st preliminary QE. A particularly important contribution to the overall upward revision was made by the upward revision to figures for capital investment, which now reflect the content of the Quarterly Report on Financial Statements Statistics of Corporations by Industry. Their real annualized contribution to growth on the previous quarter has been revised upwards to +1.0 points, as compared with the –3.7 points suggested at the time of the 1st preliminary QE, and their contribution to the real GDP growth rate has been revised upwards by an annualized 0.8 points.
As a result, the real growth rate for fiscal 2006 has been revised upwards to +2.1% (from the figure of +1.9% at the time of the 1st preliminary QE) and the carry-over effect on growth in fiscal 2007 has been revised upwards to 1.4% (from the figure of +1.2% at the time of the 1st preliminary QE)

However, the movements of orders for machinery and figures on construction starts suggest that the pace of capital investment has fallen in recent months, especially in the manufacturing sector. Although figures for January-March have been revised upwards as compared with the previous quarter, the Institute feels this has made it more likely that the April-June quarter will see capital investment start to fall again.

The Institute's revised forecast for the economic growth rate, reflecting the 2nd preliminary QE, is as follows. The forecast of the basic trend of the economy is unchanged since the release of the 1st preliminary QE on May 18, but, owing to the upward revision of the carry-over effect and the relative weakness of leading indicators of capital investment in recent months, the forecasts of real growth rates for both fiscal 2007 and fiscal 2008 have each been adjusted very slightly (the real growth rate for fiscal 2007 adjusted upwards by 0.1 points; that for fiscal 2008 downwards by 0.1 points).

Although the overall trend of the Japanese economy is still one of recovery, some areas remain weak; consumer spending continues to recover and exports are still growing, but capital investment has slowed, especially in the manufacturing sector.

Looking to the future, the economy is likely to slow a little in the short term owing to the deceleration of the US economy and continued uncertainty over of its future direction (exerting downward pressure on exports and leading to the postponement of capital investment), the high inventory ratio in some sectors of industry and 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).

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 to include newly developing countries, resource-producing countries, etc.

(ii) Inventory ratios remain at a low level throughout mining and manufacturing industry. Inventory ratios are at their lowest ever levels, especially in the metals sector and in IT final goods. While excessive optimism would be inadvisable, the IT devices sector, in which a mood of adjustment has prevailed since the end of 2006, is showing hopeful signs, with capacity utilization ratios bottoming out worldwide. Under these circumstances, there is little risk of a prolonged or severe adjustment of production across mining and manufacturing 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, there is still scope for growth in capital investment and employment, notwithstanding the short-term trend of earnings. The movements of leading 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 are likely to curb the growth of consumer spending 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 remain in the 2-3% range for a fifth consecutive year, reaching +2.4%.

Looking ahead to fiscal 2008, the 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 for fiscal 2008 is likely to be on a par with that for fiscal 2007, it is highly likely to see 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 to zero 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
E-mail：ishikawa.makoto@jri.co.jp

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