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Japan's economy still at risk of a downturn

June 11, 2010

The Japanese economy has been recovering at a rapid rate since the low of March 2009; the recovery has been led by manufacturing industry. Recently, however, grounds for uncertainty over the future of the economy have emerged. First, the growth of exports and mining and industrial production shows signs of slowing. Second, the scale of the shift towards domestic demand as the engine of economic recovery has been limited.

The rapid growth achieved to date is not solely the result of the economy's own ability to recover but has been artificially inflated by the combination of the rebound that followed the sharp downturn and the stimulus measures implemented by the government. If the effects of internal and external stimulus measures are discounted, the Japanese economy is still stagnating.

Economic activity is still well below the levels seen prior to the Lehman Shock. The slump in the corporate sector is particularly severe, largely because exports to Europe and the United States have been slow to recover.

Although exports to Europe and the US will continue to grow, the pace of their recovery is likely to remain slow, partly because the household sector in the US has been slow to recover and because the depreciation of the euro has made it more difficult to export to eurozone countries.

Exports to China have seen continued rapid growth until now, but as the effect of that country's 4 trillion yuan stimulus measures tails off, that growth is highly likely to slow. Naturally, the Chinese economy's medium-to-long term potential for growth means that exports to China can be expected to see sustained growth and continue to drive Japan's economy forward.

The stagnation of domestic demand is likely to be prolonged. Although the GDP gap is steadily narrowing, Japan still has a \25 trillion demand shortfall. The downward trend of consumer prices is likely to be prolonged.

The potential for recovery in capital investment will remain low, as the sentiment of over-capacity will be slow to lift. Furthermore, with the disparity between economic growth rates in Japan and overseas growing, companies are likely to hold back on investment in Japan and a policy of shifting investment overseas is likely to become increasingly apparent. A lack of government policy support will exacerbate this tendency, and the stagnation of capital investment may be prolonged.

The recovery in wages and salaries is also likely to be slow. Child allowances and other measures to support households will be coming into effect, but they will not boost disposable incomes significantly and their positive impact on consumer spending will be limited.

With the pulling power of external demand declining, and low potential for recovery in domestic demand, a range of risks of an economic downturn will emerge. First, the rising price of natural resources will result in an income drain towards resource exporting countries. Given the difficulty in passing rising costs on to final prices, the corporate sector is expected to bear the brunt of the fall in income and this will exert downward pressure on corporate earnings.

The negative effects of stimulus measures tailing off will also become apparent. Specifically, (i) the decline in public investment will accelerate, (ii) the effect of measures to help small and medium enterprises with cashflow in preventing corporate bankruptcies will tail off, (iii) the effect of employment adjustment subsidies in preventing unemployment will tail off and (iv) there will be a fall in sales of consumer durables in reaction to the termination of the subsidized vehicle scrappage program and the Ecopoint system, all of which will exert downward pressure on the economy from the second half of fiscal 2010. The risk of a fall in sales of durable consumer goods is particularly severe. In the second half of 2011, the fall in sales of consumer durables alone is likely to cause real GDP to fall by ¥8 trillion.

The Japanese economy has therefore come to the end of a rapid recovery phase and is slowing down to a "cruising" speed, more suited to the pace of recovery of domestic and external demand. With domestic demand still weak during fiscal 2010, the pace of growth is likely to slow proportionately to the decline in the pulling power of exports and consumer durables.

Fiscal 2011 is likely to see a concentration of the negative effects of stimulus measures tailing off. A sharp fall in sales of consumer durables is likely to be the major cause of the real GDP growth rate falling to between zero and 1%.

Given that there is still a risk that the Japanese economy will see a further downturn, it is vital that the government maintain its stimulus-based policy stance. As a short-term measure, it should pursue decisive stimulus measures while working on a growth strategy for the medium-to-long term.

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

E-mail:matsumura.hideki@jri.co.jp

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