Business sentiment DI hints at current slow performance but brighter prospects

The Business Sentiment Diffusion Index (DI) in the Bank of Japan's Short-Term Economic Survey ("Tankan") for June is expected to show that the economy is still treading water.
Given the residual impact of the deceleration of the US economy (slower export growth and capital investment) and the fact that raw material prices are inching upwards, the DI for all sizes of company and all industries is highly likely to fall for a second quarter for the first time since the "economic plateau phase" of winter 2004-spring 2005.

Among small and medium enterprises in particular, efforts to improve profitability by curbing fixed costs (personnel expenses, land costs and interest costs) are reaching the limits of their effectiveness and it is likely that business sentiment will be relatively low, especially in sectors that have not been able to escape from price competition and among companies that are not able to achieve economies of scale in procurement.

However, the level of the DI itself (all sizes of company/all industries) will still be in the positive range (+7; during the "plateau phase" it was just in the negative) and it does not appear that the risk of an outright economic slump has increased.
If anything, the fact that production has bottomed out in the electronics sector, the firm demand for services and the strength of exports to newly developing economies and natural resource-producing countries make it likely that business sentiment has recovered in some sectors (the DI among large companies is expected to remain at the same level or rise slightly).

Against this backdrop, the factors mentioned above together with the increasing likelihood that the adjustment in the US economy is coming to an end and expectations that the "dankai effect" will begin to emerge in earnest, suggest that the "Forecast" DI for the period to September this year will indicate a slightly more optimistic outlook overall.

Capital investment plans: investment growth set to continue in FY 2007 although slower than in FY 2005 and 2006

In recent months, capital investment has slowed, especially in the manufacturing sector, owing, among other factors, to the emergence of the risk of a dip in the US economy in early spring 2007 (leading to the postponement of investment plans) and to the rapid expansion of investment until now, which has boosted progress in the modernization of production equipment (reducing the urgency of replacement investment).
Owing in part to the fact that companies are making more active use of mergers & acquisitions and other methods of expanding their businesses, as well as to these recent developments, the growth of capital investment is likely to be somewhat slower over fiscal 2007 as a whole than in fiscal 2005 and fiscal 2006.
The year-on-year growth of capital investment plans for fiscal 2007 recorded in the June Tankan, on an all sizes of company/all industries basis, is likely to be +2.8% (including investment in land but excluding investment in software), below the figures recorded in June in the past two years (fiscal 2005: +5.4%; fiscal 2006: +6.2%).

However, the fact that the risk of a dip in the US economy has receded as the middle of 2007 has approached, the fact that a wave of replacement investment can be expected in the non-manufacturing sector, the medium-term rise in the anticipated growth rate, and moves in the corporate sector to implement highly independent investment relating to "moving into new business areas", "enhancing added value" and "research & development" all suggest that the rising trend of domestic capital investment itself will continue.
As uncertainty over the future direction of the US economy continues to recede, the September Tankan and subsequent surveys are likely to follow a similar pattern of revision as that seen in fiscal 2004, and capital investment is ultimately set to achieve growth of around +5%.

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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