Japan Will Manage 1% Growth Concentrated in the Second Half-FY 1997 Economic Forecast-

Summary

Japan's economy experienced two consecutive years of standstill in fiscal years 1995 and 1996.Although the economy is presently recovering， the consumption tax hike slated for the first half of FY1997 threatens to extend the slump into 1997. However， the economy will avoid a downward spiral and pick up again in the second half of FY1997 because the brunt of adjustments in capital investment have been completed， and the strong yen has halted the decline in external demand.The main issue confronting the economy is its revitalization through adjustments in the industrial structure， financial reorganization， and administrative reform. Macroeconomic policies should move away from implementing additional public investments and focus instead on tax cuts and continued monetary easing.

Overseas - Slow Down in the U.S.， Recovery in Germany， Acceleration in the U.K.， and Signs of Partial Recovery in Asia
1. Due to preventive interest rate hikes and other measures the U.S. economy slowed down from 3.5% growth in 1994 (the potential growth rate was approximately 2%) to 2.0% in 1995. Interest rates were lowered from mid1995 to early 1996， followed by a wait-and-see stance since then. The economy stagnated in the third quarter， with final sales (GDP minus inventory increases) posting near zero growth. This occurred against a backdrop of (1) restrained consumption in the dept-ridden household sector (a balance sheet adjustment)， and (2) peaking out in residential investment due to higher long-term interest rates in the first half. The economy will remain sluggish int the first half of 1997 but improve in the second half due to (1) steady capital investment primarily in information equipment， and (2) completion of the household sector's balance sheet adjustment in mid 1997. We predict the economy will grow 2.2% in 1996 and 1.9% in 1997. Inflation will edge upward as the economy improves in the second half. There is a strong probability of a preventive discount rate hike frfom 5.0% to 5.25% in late 1997.
2. Germany is in an initial recovery phase from its export dependence， while the U.K. is in an acceleration phase led by domestic demand. While economies are weak throughout continental Europe， they continue to pursue fiscal tightening and monetary easing in preparation for EMU membership. Germany slumped from the second half of 1995 due in part to the deflationary impact of the strong mark， but bottomed out in the first quarter of 1996 and entered a recovery phase. The recovery will continue due to (1) a recovery in exports from the correction of the strong mark， and (2) an increase in capital investment as export growth boosts business confidence. The real economic growth rate will rise from 1.4% in 1996 to 2.3% in 1997. Prices will retain a stable undertone. Policy interest rates will stay unchanged in 1997 due to (1) price stability， moderate economic recovery， and high unemployment， and (2) the EMU membership deadline in early 1998.
  The U.K. is ahead in the interest rate cycle. Preventive monetary tightening kept the economy sluggish in 1995， and despite interest rate cuts at year-end， under monetary easing， housing market and income growth， consumer spending accelerated， reached 3.0% annual rate by the third quarter. The acceleration will continue as capital investment also increases. The economy's growth rate will rise from 2.25 in 1996 to 3.3% in 1997. Inflation will exceed the government's target. A base rate hike from 5.75% to 6% was implemented in late October， and if the Labor Party wins the general election likely to take place next spring， it will further hike rates to signal its anti-inflationary stance.
3. East Asia's (NIEs， ASEAN and China) growth rate remains high， but will drop from 8.4% in 1995 to 7.5% in 1996 due to monetary tightening， reduced competitiveness from high exchange rates， and the worsening semiconductor market. In 1997， the region's growth rate will be roughly the same; monetary easing will boost China's recovery， but this will be offset by a slowdown in Korea and other factors.
4. The yen/dollar exchange rate， which set a record of 79.75 yen in April 1995， subsequently underwent continued correction toward a stronger dollar and presently is in the 100 yen range. The exchange rate will rise slightly in FY 1997 and average 105 yen (compared to 109 yen in FY 1996) because although the interest rate spread between domestic and foreign rates will remain large， Japan's rising external surplus， the economy's improvement in the second half of 1997， and the probability of interest rate hikes. The yen will weaken slightly in the first half due to the economy's weak performance.
Japan - Fiscal Policies Cause Standstill in 1H， but Economy Recovers in Second Half
1. The economy came to a standstill from spring to summer 1996， the second time since the recovery begin in Novemver 1993， record high yen in the first of FY 1995. This time the factors were (1) inventory adjustment of producer goods， (2) a lull in durable consumer goods after strong growth in the January-March quarter， (3) the impact of the O-157 E. coli epidemic (estimated to have reduced consumption in the July-September quarter by 0.2 percentage point). However， with capital investment continuing a growth undertone and external demand making a small positive contribution to the growth rate， the economic standstill will be alleviated in the second half of FY 1997 due to (1) ongoing inventory adjustment， (2) revival in automobile sales， and (3) passing of the O-157 impact.
2. While the economy continues to be plagued by weaknesses， growth in capital investment， improved external demand， the recovery will continue in FY 1997 albeit at a slow pace. The positive and negative factors affecting the economy are:
  Positive factors:
  
  1. Recovery in private demand: In the corporate sector， the revival of capital investment is growing is growing in scope， and profits are trending upward; in the household sector， the employment and income environment continues to improve moderately.
  
  2. Improvement in external demand: On a fiscal year basis， external demand stopped declining and made its first positive contribution to economic growth in five years.
  
  Negative factors:
  
  1. Fiscal tightening: The consumption tax hike， abolition of the special income tax cut， and reduced public works investment will dampen consumption， housing and some area of capital investment after the last-minute surge in demand ends.
  
  2. Persistent structural problems: adjustments in the industrial structure， corporate restructuring， disposal of massive bad debts， ets.
3. The real growth rate for FY 1997 will slow down to 1.0% (2.4% in FY 1996) due to (1) reduced consumption from the consumption tax hike and abolotion of the special income tax cut， (2) reduced public works investment， and (3) reactionary fall in residential investment. Positive factors are moderate while negative factors fiscal policies are concentrated in the first half， the first half will be the third standstill in the present recovery， and the second half will revert to a moderate recovery.
  Our forecast is based on the following assumptions: (1) a 1 trillion yen supplemental public works budget (GDP basis， almost all to be implemented in FY 1997)， and zero real growth in the initial FY 1997 budget; (2) a consumption tax hike the present 3% to 5% in April; (3) abolition of the special income tax cut (2 trillion yen)， (4) an official discount rate hike from the present 0.5% to 1% in January-March 1998， and (5) yen/dollar; exchange rate of 105. yen In addition， we assume that the tax increases will have the following effects: (1) The consumption tax hike will spur a last-minute demand surge， adding 0.3% to GDP growth in FY 1996 and causing an equivalent reactionary fall in FY 1997. There will be a deflationary effect of -0.5% from the consumption tax hike and -0.2% from the abolition of the special income tax cut. (2) The tax increases will have a -1.3% impact on economic growth in FY 1997.
4. While prices will basically remain calm， the consumption tax hike will push consumer price inflation above 1% for the first time in four years， and wholesale price inflation for the first time in seven years. Since correction of the strong yen has slowed down import growth below that of exports， the current surplus will stop falling at 7.9 trillion yen in FY 1996 (1.6% of GDP)， and rise to 8.8 trillion yen in FY 1997 (1.7% of GDP).
5. Monetary policy will remain lax due to the recovery's wealness， fiscal spending cuts， the bad loan problem， and stable prices. We predict that the official discount rate will be raised from the present 0.5% to 1% in late FY 1997， when the economy will have pulled out of stagnation， and the pace of fiscal contraction will decline for FY 1998. Market interest rates will also trend upward.

Table 1 Real GDP Growth Rate
(% change yoy; FY for Japan; 1995 is estimated for East Asia)

Table 2 Consumer Price Inflation Rate
(% change yoy; FY for Japan)

Table 3 Currant Account Balance
(half-year figures are saar; parentheses denote ratio to nominal GDP in %; FY for Japan)

Table 4 Interest Rates
(%; P=peak， B=bottom)

Japan Will Manage 1% Growth Concentrated in the Second Half-FY 1997 Economic Forecast-

the Economic Research Dept.