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Revised Economic Forecast for Fiscal 2007-2008
(Subsequent to Release of 2nd Preliminary QE for January-March)

August 14, 2007

Real annualized growth of +0.5% in the April-June quarter

The 1st preliminary quarterly estimates (QE) put real GDP growth for April-June 2007 at +0.5%(Annualized) quarter-on-quarter. Although this represents positive growth for a tenth consecutive quarter, the rate of growth has slowed from the +5.4% recorded in the fourth quarter of 2006 and +3.2% recorded in the first quarter of 2007.

The two main reasons for this slowdown in the pace of growth are (i) a fall in exports to the United States and (ii) a slowing of household demand against a background of sluggish wage growth (with a pause in the growth of consumer spending and a fall in housing investment).

However, the Japanese economy still shows underlying strength in some areas. The diversification of export destinations through, among other things, the development of markets in resource-producing countries is absorbing the impact of the peaking of exports to the United States (exports are maintaining an upward trend overall), the growth of capital investment has accelerated since January-March 2007 (real annualized growth has gone from +1.4% to +4.9%) and, as a result, real GDP as a whole has maintained growth on the same quarter in the previous year of over +2% (2.3%).

The upward trend of the import deflator accelerated owing to the high price of natural resources and to the weakness of the yen (exerting downward pressure on the GDP deflator). Nevertheless, owing to a rise in the export deflator, largely due to the weakness of the yen, and to moves in the construction material and fuel sectors to pass on the rising cost of raw materials to customers, among other factors, the GDP deflator rose on the previous quarter for the first time in three quarter, to an annualized rate of +0.5% (or +1.5% if domestic demand is taken in isolation, its largest increase since the second quarter of 1997).
As a result, nominal GDP recorded positive growth for a third consecutive quarter, rising +1.1%(Annualized) quarter-on-quarter.

Although the 1st preliminary QE give an increasing sense that GDP growth is slowing quarter-on-quarter, they also confirm that the economic recovery mechanism is still in operation and that the deflationary mood in the domestic markets has lightened. The impact of the 1st preliminary QE on the question of whether or not the BOJ should raise interest rates in August is therefore likely to be neutral.
However, the turmoil in the international money and capital markets due to the problems surrounding sub-prime mortgage lenders in the United States is unlikely to die down quickly and will present a high hurdle that is likely to delay the interest rate increase until September or later.

The recovery is set to continue but the pace of growth is unlikely to show any clear signs of acceleration

Looking ahead, the strength of exports to newly developing economies and resource-producing countries, the low level of inventory ratios in industries other than the IT devices sector and the plentiful money stocks available to the corporate sector suggest that the economy is likely to hold firm

Under these conditions, the addition of positive factors including the recovery of the US economy, led by the corporate sector, an acceleration in the growth of capital investment by the non-manufacturing, the growing impact of the rise in lump sum retirement benefit payments to the dankai generation of baby boomers, and the end of inventory adjustments in the IT devices sector should see an upturn in the quarterly pace of growth as spring 2008 approaches.

However, three negative factors suggest that the pace of growth is unlikely to increase so far as to show any clear signs of acceleration. Although the full-year real economic growth rate is likely to reach +2.2% in fiscal 2007, remaining above 2% for a fifth consecutive year, the increase on fiscal 2006 is likely to be a small one.
(i) The pace of recovery of the US economy is likely to be slow, largely because of the continued adjustments in the housing market and the resulting diminution of the asset effect.*1
(ii) The recovery in the business performance of small and medium enterprises is set to be delayed by the rise in the cost of raw materials and by price competition.
(iii) The stagnation of wages and the growing pressures on household finances will continue to curb spending activity in the household sector (particularly among the working generations).

The economic recovery scenario of the second half of fiscal 2007 is likely to remain in place for a time, continuing through the first half of fiscal 2008, but in the second half of the fiscal year, from about the time of the Beijing Olympics, there may be a slowdown in overseas demand, especially demand for investment from China, and moves to hold back on domestic capital investment as the growth of capital investment efficiency slows. The growth rate for the full fiscal year is likely to be +2.0%, a little slower than that for fiscal 2007.*2

Although the cutting of mobile phone call charges, among other factors, will continue to exert downward pressure for some time, the improvement in the macro balance of supply and demand, the establishment of the upward trend in the price of services and the gradual rise in the price of crude oil 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 slowly, begin to rise.

*1: Furthermore, if the problems surrounding sub-prime mortgage lenders in the United States are prolonged and the risk tolerance of domestic and overseas money and capital markets does not recover, it is possible that the downward pressure on Japan's real economy will increase via a diminution of the asset effect in the household sector.
*2: Given the current political situation, the assumption that the consumption tax rate will be raised by 2 points in April 2009 has been omitted from this forecast.

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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