Japanese Economy in 2006 and Beyond: Despite Slow Growth, Record Postwar Expansion Achieved

General Indicators: Japan's Longest Economic Expansion in the Postwar Period The Japanese economy achieved high growth rates in 2006, particularly in the corporate sector in the first h

Contents

Overview i

1 General Indicators: Longest Economic Expansion in Postwar Japan 1

A Corporate Activity Robust, Although Growth Slows in 2006 Second Half 1

B Characteristics of Current Economic Growth 4

C Issues and Outlook for Japanese Economy 5

2 Trade and Direct Investment: Ties with Emerging Markets Deepen 13

A Exports and Imports Reach High Levels 13

B Trade Trends by Geographic Area (Jan.–Nov.) 13

C Trade by Product 16

D International Trade Balance 20

E Expectations for 2007 20

F Foreign Direct Investment 21

3 Production: Mining and Manufacturing Output Remain High 27

A Expansion Continues Despite Uneven Pace 27

B Rising Inventories in Electronic Components and Devices 31

C Mild Growth to Continue in 2007 32

4 Corporate Sector: Capital Expenditure Plans Still Solid 33

A Corporate Earnings Continue Growing 33

B Capital Expenditure Maintains Steady Growth 35

C Slower but Sustained Growth in 2007 38

5 Employment: Wages Stagnant but Employment Improves 42

A Employment and Wage Trends in 2006 42

B Gearing Up For Mass Retirements by Baby Boomers 45

C Outlook for 2007 47

6 Personal Consumption: Spending Remains at a Standstill 50

A Trends in 2006 50

B Growing Expectations for Spending by Baby Boomers 53

C Outlook for 2007 54

7 Prices: End to Deflation Put on Hold 57

A Consumer Prices Maintain Slight Upward Movement 57

B Corporate Goods Prices Peak 58

C Outlook for 2007: End of Deflation 59

8 Finance: Financial Environment Returns to Normality 62

A BOJ Tightens Money Policy 62

B Demand for Funds Recovers, albeit Slowly 64

C Banking Industry Trends 68

D Stock, Securities and Foreign Exchange 70

E Increased Polarization of Real Estate Market 73

F Key Points to Watch 74

Columns Column 1 11

Column 2 17

Column 3 26

Column 4 40

Column 5 49

Column 6 56

Column 7 61

Column 8 67

Column 9 75

Overview

1 General Indicators: Japan's Longest Economic Expansion in the Postwar Period

The Japanese economy achieved high growth rates in 2006, particularly in the corporate sector in the first half of the year The middle of 2006 brought a slowdown, especially in consumer spending In general, however, corporate performance held steady, labor supply was tight and the economy overall did not slow significantly The economic growth phase that began in January 2002 is virtually certain to

be statistically verified as having marked its 58th consecutive month in November 2006, making it the longest period of growth in postwar Japan Although favorable results have been seen in the corporate sector, there was only mild improvement in wages and consumer spending, so the pace of recovery was slower than in previous phases of growth

The United States economy is forecast to slow down in 2007 Meanwhile, Japanese companies remain reluctant to increase wages, so the Japanese economy is also expected to lose momentum The labor supply will tighten as baby boomers retire en masse It is unlikely that the economic recovery will stall due to slowed consumer spending Stable economic growth is expected, although actual results could be hurt by a potential downturn in the United States economy, crude oil prices rising again, an increase in the fiscal deficit or political events that could negatively affect consumer confidence

2 Trade and Direct Investment: Deeper Ties with Emerging Markets

Exports increased thanks to a weaker yen and favorable conditions in the global economy Imports also expanded as the Japanese economy recovered and crude oil import prices stayed high Despite potential risks, conditions remain favorable in China and the rest of East Asia, which together accounted for 45.7% of total Japanese exports Exports to this region should remain brisk in 2007 Crude oil prices appear to have stabilized since October 2006, so import growth is expected to decline

Foreign direct investment in January to September 2006 confirmed that investment in China continued to slow down, as in 2005 Japanese corporations, aware of the risks of intellectual property rights violations in China, partly shifted operations to the emerging markets of India, Russia and Vietnam Outward M&A included several megadeals as Japanese corporations sought to expand their core businesses Inbound FDI was boosted by major increases in funding, resulting in the largest net outflow since such statistics were first complied in 1996

3 Production: Mining and Manufacturing Production Sustains High Levels

Mining and manufacturing output maintained an overall upward trend in 2006, sustained by a steady recovery in the materials industries Robust increases in both internal and external demand for products such as transport equipment and electronic components and devices led to high growth in shipments overall, although trends varied among industries Stock buildups of certain key products, such as mobile phones and game equipment in the electronic components and devices industry, put sporadic pressure on the mining and manufacturing sector to reduce inventories But the buildups were considered transitory,

so mining and manufacturing is forecast to enjoy moderate growth sustained by brisk internal and external demand in 2007

4 Corporate Sector: Appetite for Capital Investment Remains Healthy

Corporate profits continued growing, buoyed by an economic climate of high production and stabilized oil prices Increased profits were seen across a wide range of industries and firms (in terms of company size), which helped to boost capital investment The scope of capital investment expanded due

to efforts to raise global competitiveness, centering on processing industries, and the elimination of perceived overcapacity among even small and midsized enterprises Capital investment could see a reactionary decline in 2007, but it is still expected to continue growing because of new overseas demand being developed by Japanese companies seeking to reinforce their revenue bases

5 Employment: Wages Stagnant but Employment Improves

Employment improved in 2006 as the labor supply tightened due to the start of mass retirements by baby boomers and corporate performance rose steadily Corporate performance is forecast to remain firm, which would help to fuel a moderate improvement in employment However, with non-regular workers now accounting for 30% of all employees, this could lead to new problems in the labor market, including broader inequalities in incomes

Wages tended to remain static in 2006 Earnings were not passed along to employees due to corporate reluctance to increase wages A tightening labor supply, however, is exerting upward pressure

on wages, which are expected to increase moderately in 2007

6 Personal Consumption: Spending Remains at a Standstill

Personal consumption (consumer spending) was stagnant in 2006, influenced by factors such as a long rainy season and sluggish sales of winter clothing due to unusually warm weather Spending was hampered by sluggish wage increases Although consumers remain uncertain about prospects due to the scheduled elimination of tax breaks and increases in their social security burden, wages are expected to rise as the labor supply continues to tighten This, along with retirement payments to baby boomers retiring en masse, should stimulate a moderate increase in personal consumption in 2007

7 Prices: Move out of Deflation Comes to Standstill

Consumer prices turned moderately upward in 2006 However, statistical revisions to key indices and increasingly severe price competition in digital products negated any clear upward trend in prices, so the government did not officially declare an end to Japan’s chronic deflation But these special factors notwithstanding, the elimination of domestic oversupply and, on the demand side, personal consumption will be pushed upward by moderate wage increases As a result, the demand/supply gap is expected to tighten and prices are likely to experience upward pressure in 2007

8 Finance: Financial Environment Improves

The Bank of Japan lifted its easy money policy for the first time in five years in March 2006, and then ended Japan’s era of ultra-low interest rates by raising its bank lending rate in July Although further increases were expected during the year, they were postponed until January 2007 The impact of the BoJ’s tightened money policy was limited to commercial and home loans Going forward, however, intensified upward pressure on rates should affect households and companies, and beyond them government finances The financial climate moved steadily toward normality, particularly in banking where non-performing loans were largely eliminated The BoJ’s timing for additional rate increases must

be watched, as a distinctly tighter stance is envisioned in the latter half of 2007, when the Japanese and U.S economies are expected to show clear signs of stable growth and rising prices

1 General Indicators: Longest Economic Expansion in Postwar Japan

A Corporate Activity Robust, Although Growth Slows in 2006 Second Half

The Japanese economy enjoyed stable growth led by capital expenditure in 2006 The underlying positive tone of 2005 extended into first half of the year, with high growth primarily in the corporate sector From midyear, however, the economy began to slow, particularly in consumer spending

The GDP rose more than two percent in the first quarter, propelled by consumer spending, capital expenditure and other segments of the private sector In the second quarter, growth slowed to 0.3% over the previous quarter (1.1% annualized) due to weakened demand from the public sector and efforts to cut inventories Although the GDP in the third quarter was up just 0.2% (0.8% annualized), it was the seventh consecutive quarter of positive growth, so the economy continued to avoid any significant decline (figs 1-1 & 1-2) Consumer spending turned pessimistic and declined 0.9% from the second quarter The decline, although due to temporary factors such as inclement weather, also reflected the fact that improved jobs and stronger corporate results had not translated into increased incomes because companies kept a lid on personnel costs Capital expenditure grew 1.5% The third-quarter GDP was also supported by external demand as exports to the U.S and East Asia rose Imports were sluggish

After years of chronic deflation, the consumer price index (excluding fresh foods, 2000 [pre-revision] baseline) rose 0.5% year on year in January, which followed 0.1% growth in each of the two previous months Thereafter, the index grew throughout much of the year, but the GDP deflator and special factors influencing CPI growth remained negative, so the government did not officially announce the end of deflation (Fig 1-3)

Fig 1-1 Contributions to GDP Growth by Calendar Year and Quarter

Real values, derived from a fixed-base estimates formula up to 1994, and a chain-weighted index formula from 1995

“Other” includes private-sector inventory growth (decrease) and private housing

Sources: Economic and Social Research Institute, Cabinet Office and Government of Japan

2.83.4 3.26.8

-0.1

1.10.2

3.0

1.90.20.31.4

-2.0

1.62.73.4

5.23.8

10-1206/1-3 4-6 7-9

Other

Public sector demand

Net exportsPrivate sector capital investments

Private sector final consumption expenditureGDP

Quarter(annual rate, % QoQ)Calendar Year (% YoY)

Fig 1-2 GDP Growth Trends

Levels of contribution to overall GDP by private-sector inventories and net exports Quarterly GDP deflator figures show annual change

Sources: Economic and Social Research Institute, Cabinet Office and Government of Japan

The current economic

expansion, which began in January

2002 and reached 58 months as of

November 2006, almost certainly

will be declared the longest postwar

growth period1 , surpassing the

57-month Izanagi boom in

1965–1970 The economic

sentiment diffusion index (DI,

coincident indicators), which shows

the economy’s current direction, fell

below the 50 midpoint in both

February and March, but then

trended above 50 for the rest of the

year The coincident indicators,

which indicate the value of the

economy, rose to 113.0 in October

and thereby bested the previous

record of 112.2 set in October 1990

Nevertheless, the leading indicator

indicators issues its analysis of business cycles (economic peaks and troughs) retroactively The current cycle’s trough, for example,

which occurred in January 2001, was tentatively proclaimed in June 2003 and officially confirmed in November 2004

Private sector inventories (annual rate)

Quarter (QoQ)

GDP deflator

Calendar year (YoY)

Fiscal year (YoY)

Nominal GDP

Private sector demand Net exports

sector demand Private

sector final Housing investment

Fig 1-3 Consumer and Wholesale Price Trends

-6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0

95/01 96/01 97/01 98/01 99/01 00/01 01/01 02/01 03/01 04/01 05/01 06/01

-30.0 -20.0 -10.0 0.0 10.0 20.0 30.0

40.0

C orporate goods (sem i-finished, right axis)

C orporate goods (finished goods)

C onsum er Price Index (except fresh foods)

G D P deflator

C orporate goods (raw m aterials, right axis)

Impact of sales tax increase not reflected in corporate goods index or CPI

Sources: Statistics Bureau, Ministry of Internal Affairs and Communications; Bank of Japan; Economic and Social Research Institute; Cabinet Office and Government of Japan

DI was below 50 from July to September, and the coincident indicators also fell after peaking in May, so the data2 could be taken as suggesting an impending economic correction

Fig 1-4 D.I Trends

Fig 1-5 C.I Trends

Shaded areas indicate recession D.I plots average quarterly values, but data for October 2005 is monthly value

Source: Cabinet Office

Fig 1-6 Business Cycles in Japanese Economy

Current cycle continued for 60 months as of January 2007

Source: Cabinet Office

0 50 100

Leading Coincident Lagging

50 60 70 80 90 100 110 120 130

73/0474/1076/0477/1079/0480/1082/0483/1085/0486/1088/0489/1091/0492/1094/0495/1097/0498/1000/0401/1003/0404/1006/0

4

Leading Coincident Lagging

Expansion Recession Entire cycle

-2nd cycle 1951/10 1954/01 1954/11 27 months 10 months 37 months 3rd cycle 1954/11 1957/06 1958/06 31 months 12 months 43 months 4th cycle 1958/06 1961/12 1962/10 42 months 10 months 52 months 5th cycle 1962/10 1964/10 1965/10 24 months 12 months 36 months 6th cycle 1965/10 1970/07 1971/12 57 months 17 months 74 months 7th cycle 1971/12 1973/11 1975/03 23 months 16 months 39 months 8th cycle 1975/03 1977/01 1977/10 22 months 9 months 31 months 9th cycle 1977/10 1980/02 1983/02 28 months 36 months 64 months 10th cycle 1983/02 1985/06 1986/11 28 months 17 months 45 months 11th cycle 1986/11 1991/02 1993/10 51 months 32 months 83 months 12th cycle 1993/10 1997/05 1999/01 43 months 20 months 63 months 13th cycle 1999/01 2000/11 2002/01 22 months 14 months 36 months

Trough Peak

B Characteristics of Current Economic Growth

In the current economic growth

phase, as well as in the period from the

collapse of the economic bubble to

around 2001, external demand in the

corporate sector has led the way The

current phase has also benefited from a

virtuous cycle of corporate profits

boosting employment and consumer

sentiment, which in turn spurred

consumer spending But companies

have yet to raise wages, especially

contractually obligated payments, so

consumer spending has remained fragile

and the recovery has been relatively

sluggish compared to previous periods

of economic growth (Fig 1-7) The

private sector has worked to eliminate

the so-called “three excesses,” i.e.,

excess debt, employment and facilities,

so perceptions of oversupply in

employment and facilities have been

mostly eliminated (Fig 1-8), while

banks nationwide have reduced bad

debts by more than 60% from the peak With the three excesses now behind Japan, deflation also has nearly been eliminated

Foreign countries also had a hand in the elimination of the three excesses In the 1990s, following the collapse of the Soviet bloc, China and other former socialist countries leveraged their low-cost labor

to rapidly increase their presence on the supply side, which at first increased the breadth of direct and

Fig 1-7 C.I Trends for Previous and Current Business Cycles

95 100 105 110 115 120 125 130 135

March 1975~January 1977 September 1977~February 1980 February 1983~June 1985 November 1986~March 1991 October 1993~May 1975 January 1999~October 2000 January 2002~

(Business cycle trough = 0 months)

Source: Cabinet Office

Fig 1-8 Sentiment on Three Excesses

- 3

98/ 1-

3 99/ 1- 300/ 1-

3 01

- 3 02/ 1- 303/ 1-

3 04/ 1

- 3 05/ 1-306/ 1- 3

30.0 32.0 34.0 36.0 38.0 40.0 42.0 44.0 46.0 48.0 50.0

Recession

Over-staffing sentiment (excess – shortage)

Excess facilities sentiment (excess – shortage)

Interest-bearing debt to total assets ratio (right axis)

(%) (Points)

Fig 1-9 Growth in Exports, Imports and Industrial

Production Index from 1990

-10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0

Export volume index

Import volume index

Industrial production index

1991 - 1995

1996 - 2000

2001 - November 2006 (%)

Sources: Ministry of Economy, Trade and Industry, and Ministry

indirect supply-side pressure on Japan But as some of these countries developed their consumer markets and other demand-side economies in the 2000s, they then eased supply-side pressures on the Japanese economy by ameliorating their exports to Japan while purchasing increased exports from Japan (Fig 1-9)

Another characteristic of the recovery has been sustained growth despite substantial cuts in government expenditure Public demand (total government expenditure, public fixed-capital formation and increased public inventories) as a share of GDP reached more than 24% between 2001 and 2002, but fell to 21% in the second quarter of 2006 and contributed negatively to economic growth (figs 1-10 & 1-11)

Following the inauguration of the Koizumi administration in April 2001, the government designated the following three years to fiscal 2004 as a period of structural reform Measures included stepped-up efforts to eliminate non-performing assets, resolution of bad debts through the Financial Revitalization Program and economic stimulation through regulatory reform, such as specially deregulated zones and reduced taxation of R&D and capital expenditure The effect was reduced downward pressure on the economy and stronger stimulation of the private sector On the other hand, rapidly retrenched employment and declining government expenditure, as well as changes in industrial structure, led to widening disparities in income, consumer spending and household assets Moreover, reduced public works led to widening regional disparities (see Column 1) The Abe administration, after taking in September 2006, has made the promotion of new opportunities one of its main policies Specifically, it has encouraged steady employment for job-hopping “freeters,” offered assistance to families headed by single mothers to help them become more independent, banned multiple consumer loans, and provided support for entrepreneurs and people restarting their careers

C Issues and Outlook for Japanese Economy

1) Population decline and need for higher productivity in services

The Japanese population decreased by 21,266 to mark its first postwar decline in 2005, according to

Fig 1-10 Public Demand’s Share of GDP

3 04/ 1-

3 05/ 1- 306/ 1

(%)

Sources: Economic and Social Research Institute,

Cabinet Office and Government of Japan

Fig 1-11 Increase/Decrease in Contribution to GDP

by Demand Line Item

0.6

0.1

1.2 0.9

0.5

-0.5 0.0 0.5 1.0 1.5 2.0

1991-1995 1996-2001 2002-2006/3Q

External demand Public demand Private demand (Annual rate, %)

Real values, derived from a fixed-base estimates formula up to

1995, and a chain-weighted index formula from 1996

Source: Economic and Social Research Institute, Cabinet Office and Government of Japan

official statistics released on November 30,

2006 The forecast is for the population to fall

below 100 million by 2046 and 90 million by

2055, a faster decline than previously

anticipated (Fig 1-12) This will have an

adverse effect on the economy owing to the

diminishing stock of capital due to declining

labor inputs, while aging will put downward

pressure on the overall economy due to

reduced levels of personal savings An aging

population will also have an impact on social

guarantees such as pensions and medical care,

leading to pressure to revise the entire social

security system To ease such pressures and

achieve sustainable economic growth,

measures will be needed to halt declining

births, and bring women and older citizens

more fully into the labor force Although Japan

experienced a lengthy economic downturn

from the mid-90s to 2001, overall productivity

was not impaired and growth was at levels not

substantially lower than those of other major

developed nations (figs 1-13 & 1-14) But

while manufacturing maintained high

productivity compared to other nations, the

services sector was weak (Fig 1-15) Since the

service sector’s share of the economy is

increasing, improved productivity is vital The

new economic growth strategies announced in

May 2006 contain specific measures to boost

competitiveness and productivity, such as

promoting new business models, deregulation, training, IT and foreign direct investment entering Japan

Fig 1-12 Japanese Population Estimates

60 100 140

19 19 19 19 19 19 19 19 19 19 20 20 201020 20 202520 20 204020 20 2055

Population growth (actual) Old estimate (January 02) New estimate (January 07)

95 96 97 98 99 00 01 02 03 04 05 (%)

Source: Council on Economic and Fiscal Policy

Fig 1-14 Breakdown of Economic Growth in Major

Nations

0.7

0.9 1.0 0.9

3.2 3.2 2.8 1.0

U.K Japan U.S Germany Canada France

Manufacturing Enterprise services Other services Other industries (%)

Source: OECD

2) Fiscal restructuring

Japan’s government finances are the worst among developed nations, so fiscal restructuring is

required (Fig 1-16) In the January 2002 Structural Reform and Medium-Term Economic and Fiscal

Perspectives, the government announced it would turn the deficit into a surplus by the early 2010s by

reducing spending through structural reforms In fact, some anticipate that a surplus might be possible even sooner, due to increased corporate tax revenues in conjunction with the economic upswing In fact, improvements proceeded faster than expected at the start of 2006, with the primary balance for FY2006 estimated at ¥11.2 trillion (2.2% of GDP) and ¥4.4 trillion (0.8% of GDP) for FY2007 under the proposed budget (Fig 1-17) Government debt issued under the draft FY2007 budget would be reduced

to ¥25.4 trillion, down from ¥29.97 trillion in FY2006, with the aim of further reductions for the next three years Assuming steady progress in fiscal restructuring, dependence on government bonds would drop to 30.7%, down from a peak of 41.8% (real) in FY2003

3) Robust economic growth, but weak consumer spending

Ensuring that Japan’s economic expansion continues in 2007 will require prudent action Although companies have steadily improved their finances and profits, they have remained cautious about raising wages, especially contractually obligated payments (figs 1-18 & 1-19) Companies still believe that in light of intense international competition, stronger earnings should be passed along to employees only as bonuses or one-time payments3 Consumer spending through 2006 did not exhibit a clear growth trend due to the lag in wages, and it is unlikely that improved employment will boost consumer spending in

2007 However, it is also difficult to conceive this might lead to a correction in the economy Manufacturers and other leading corporations have nearly completed their financial restructuring by putting lean financial structures into place In employment, baby boomers born between 1947 and 1949 will begin to retire in 2007, so the real issue will be how to ensure sufficient staffing In fact, perceptions

of a tighter labor supply in light of increasing demand are expected to grow Despite low expectations of wage increases, substantially lower wages are very unlikely

Fig 1-16 Government Debt as % of GDP in Major

08 (e)

Actual Outlook as of January 06

％

(Annual rate)

Sources: Ministry of Finance and Council on Economic and Fiscal Policy

The corporate sector, after supporting the

economy in 2006, should again enjoy strong

profits in the first half, especially among

exporters, given that the yen weakened

unexpectedly to ¥119 to the U.S dollar as of the

2006 yearend4 While a temporary lull in capital

expenditure is expected, if only as a backlash to

aggressive expenditure through 2006, the

possibility of a large downturn is limited because

producers don’t yet feel they have excess

capacity Corporate profitability will remain

strong

In external demand, the U.S economy

should slow until around mid-2007 and Asian

NIEs also appear headed for a slight downturn

Exports to these countries and regions will be

affected, but the breadth of decelerated exports

will remain limited due to high growth in China

and the ASEAN region (Fig 1-20)

Since domestic oversupply has nearly been

resolved, demand is expected to remain generally firm, except for somewhat fragile consumer spending, and will exert upward pressure on consumer prices Crude oil prices (West Texas Intermediate) continued to fall nearly across the board after hitting an all-time high of $77 in July 2006 Falling petrol prices will affect consumer prices Aside from such market factors, however, prices are forecast to remain stable and deflation will be virtually eliminated in 2007

¥113.40 to the dollar in the latter half of 2006

Fig 1-19 Real Growth in Capital Expenditure and

Wages

-20.0 -10.0 0.0 10.0 20.0

95/ 1- 396/ 1- 397/ 1- 398/ 1- 399/ 1- 300/ 1- 301/ 1- 302/ 1- 303/ 1- 304/ 1- 305/ 1- 306/ 1- 3

-4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0

Capital expenditure Wages (right axis) (% YoY)

Sources: Economic and Social Research Institute, Cabinet Office and Government of Japan

Fig 1-18 Labor Share Trends

3 00/ 1-

3 01/ 1-

3 02/ 1-

3 03/ 1-

3 04/ 1-

3 05/ 1-

3 06/ 1- 3 (%)

Labor share = wages/GDP

Sources: Economic and Social Research Institute,

Cabinet Office and Government of Japan

Fig 1-20 IMF Country/Region Forecasts

1.6

3.9

2.9

0.9 1.1

5.3

3.2

4.4 5.6

2.4 1.9

8.3 9.1

10.0 10.0 10.2 10.1 10.0

-1.0 1.0 3.0 5.0 7.0 9.0 11.0

(forecast)

2007 (forecast)

Euro zone Asia NIEs ASEAN 4 China (% YoY)

Forecasts for 2006 and 2007 Source: IMF

To sum up, capital expenditure, consumer spending and external demand are all expected to grow at slowed rates in the first half of 2007, but the economy should grow stably, underpinned by solid corporate earnings External demand and the corporate sector will steadily pick up speed from midyear, when signs of a recovery will begin to appear in the U.S economy But the pace of the recovery in consumer spending will be sluggish, so economic growth will lack strength overall There is a slight possibility of the economy faltering due to stalled consumer spending resulting from a tightened labor supply Nevertheless, stable growth is forecast, although it will lack the strength of economic activity from 2005 to mid-2006 Of 19 private think tanks, nine have predicted a slowdown in fiscal 2007, although the forecasts vary widely from 1.2% to 2.5% All but one predict the deflator will revert to positive, anticipating an end to the trend of nominal growth exceeding real growth (figs 1-21 & 1-22)

4) Main risk factors are overseas economies and impaired sentiment

A potential risk in 2007 is the possibility of the U.S economy growing slowly Many anticipate it difficult to hope for the U.S to achieve more than its potential growth rate of around 3% (annualized) basis in the first half, particularly if consumer spending were curbed by falling home prices and rising costs of mortgages If the U.S economy were to come under even stronger downward pressure, the effect would be felt in Japan after a lag of around half a year Under this scenario, the Japanese economy would be more turbulent in the second half of 2007

Energy prices rose until midyear 2006, but by the end of the year crude prices (WTI) had fallen more than 20% from their peak, diminishing anxieties But in the future, if high prices were coupled with a weaker yen (which began declining in December 2006), corporate profits would be hurt and fears

of rising consumer prices would increase Even in this case, however, damage to the overall economy would be limited so long as energy prices did not match previous highs5

Domestic factors that may affect consumer sentiment include increased burdens on households and fears

estimates that an effect equal to the 1973 oil shock are inconceivable unless the price of crude were to exceed $125 per barrel

Fig 1-21 Private and Government Growth-Rate

Forecasts

(%)

FY 2006FY 2007FY 2006FY 2007

Nomura Securities Financial & Economic Research Cente 1.8 2.2 1.4 2.5

Sources: Above companies and Cabinet Office

Fig 1-22 Real/Nominal Growth Rates (Fiscal Years)

1.5

2.2 2.0 2.4 2.6

95 96 97 98 99 00 01 02 03 04 05 06

(f)

07 (f)

Deflator (% YoY)

Source: Cabinet Office

of future tax increases due to the abolition of uniform tax breaks and increases in national pension premiums, along with local elections in April and upper house elections in July Many believe that the long-term political stability of the Koizumi administration contributed significantly to stabile consumer sentiment, so political developments under the Abe administration bear watching

Column 1: Intensifying Debate on Inequalities

Many countries have experienced growing economic inequalities due to advancing globalization, the spread of information technologies and intensifying competition In Japan, the debate over inequalities began when the country entered recession 1998 and has continued to intensify despite the advent of economic recovery in 2002

In February 2006, then-Prime Minister Koizumi answered questions in parliament concerning

income and asset inequalities In July, the Cabinet Office issued its Annual Report on the Japanese

Economy and Public Finance 2006, which addressed and analyzed the issue Public opinion polls have

revealed that perceptions of inequalities have been spreading The OECD Economic Survey of Japan

2006 pointed out that the Gini coefficient6 has risen above the OECD average, making relative poverty

in Japan one of the highest among the OECD countries7 Economists engaged in the debate include

Professor Toshiaki Tachibanaki of Kyoto University, who published Nihon no keizai kakusa (Economic Inequality in Japan) in 1998 and Kakusa shakai nani ga mondai nano ka (Social Disparity and the Nature of the Problem) in 2006, and Professor Fumio Ohtake of Osaka University, who published Nihon

no fubyodo kakusa shakai no genso to mirai (Inequality in Japan: An Illusion of an Unequal Society

and the Future) in 2005 The Japanese public has grown increasingly concerned about the issue There is also the issue of inequalities between Tokyo area and other regions of Japan Yubari, a town on the northern island of Hokkaido that suffered a financial collapse, exemplifies the struggles of Japan’s depressed regional economies

The mass media in other countries have aired reports about the debate in Japan Such reports show that Japan had a well-established reputation as a middle-class country with minor income inequalities compared to the high-income countries of Europe and North America

Has income inequality been growing in Japan? Moreover, is the magnitude of the problem comparatively large in international terms?

Public opinion polls consistently indicate that the Japanese have developed heightened perceptions of economic disparities and inequalities8 This is true among households headed by non-regular wage-earners, whose presence has grown amid corporate restructuring and downsizing The growing population of “freeters” and NEETs9 is due in part to severe employment conditions faced by young-adult Japanese Economists are paying attention to the growing inequality of their incomes, a key point in the debate

The Gini coefficient, which is based on published statistical data, confirms that income inequality slowly increased from the 1980s According to the Japanese government, the major cause was the growing number of households comprising elderly people From 1999, however, there was a distinct upward trend in the Gini coefficient among the younger population No doubt, the future will bring calls for further measures to diversify employment patterns and address related problems of young adults There is also the issue of international comparisons, wherein the Gini coefficient for Japan is about the average for other OECD countries (see figure) In fact, income inequality is smaller in Japan than in the United Kingdom and the United States Comparisons introduce the problem of whether to work from relative or absolute poverty levels In OECD statistics, figures vary greatly depending on how they are prepared, which makes simple comparisons impossible

total inequality (Appended Table 3-4, Annual Report on the Japanese Economy and Public Finance 2006)

of disposable income in the National Survey of Family Income and Expenditure 2004 and found that Japan ranked twelfth among the 24

OECD countries with which comparisons were possible

or Training) are people of the same age group who are counted as unemployed

In terms of inequalities between executive and non-executive wages, U.S executives earn compensation and benefits that are extremely high compared to those in Japan Some reports have called for corrections in this inequality10 Even here, however, it is difficult to conclude that income inequality

in Japan is greater than that in Europe or North America In any event, inequalities tend to be linked with growing social unrest and crime worldwide, so the need for solutions is universal

Fig 1 International Comparison of Gini Coefficients for 27 OECD Countries

any Hun

gary

Cana Ireland Aus traliaJapan

Unite

d Ki

ng dom SpainNew

Zealan

d Gree

ce Italy

Portugal

Source: OECD

2 Trade and Direct Investment: Ties with Emerging Markets Deepen

A Exports and Imports Reach High Levels

Japanese exports during

January to November 2006 rose

7.8% over the same period in

2005 to $587.7 billion (Fig

2-1) The yen’s depreciation

and a buoyant world economy

helped exports achieve

double-digit growth since 2003

The trade balance over the

same period was $60.1 billion,

down $11.8 billion from 2005

Import value rose as the

Japanese economy recovered

and crude oil prices soared

By volume, exports

increased 11.2%, 8.7% and

8.4% in the first three quarters,

respectively Yet export growth

for all of 2005 was just 0.8%

Export volume was solid for all

regions except the ASEAN4

nations Import volume grew

4.5%, exceeding the 2.9% rate

of 2005

B Trade Trends by

Geographic Area

(Jan.–Nov.)

The largest contributions to

export growth were China (2.0

points), the U.S (1.8 points)

and South Korea (0.5 point)

Exchange Rate (yen/$)

2006 2005

Trade with World

2006 (Jan-Nov)

2006 (Jan-Nov) Q1 Q2 Q3 Exports 134.9 132.9 34.4 35.5 37.3

Export volume increase 2.4 14.8 19.0 18.4 11.7 Import volume increase 11.2 7.9 8.8 6.4 6.5 Asia NIEs are South Korea, Taiwan, Hong Kong and Singapore ASEAN 4 are Indonesia, Thailand, China

was maintained in each

of the first three

billion (Fig 2-3) The

main factor was

points of the increase

in Japan’s total exports,

with 1.5 points coming

from automobiles In

addition to increased demand for smaller vehicles due to soaring gasoline prices, Japanese exports benefited from a lag in the U.S production of popular Japanese compact cars, hybrids and diesel vehicles The depreciation of the yen also drove up export value as models from Japan enjoyed strong demand (Fig 2-5) After growing 7.3% to 1.93 million vehicles in 2005, exports skyrocketed 29.9% to 2.28 million vehicles during January to November 2006

Fig 2-3 Changes in Exports to China by Product

-20 -10 0 10 20 30 40 50 60 70

01

/1-3 4-6 7-9 10-1202/1-

3 4-6 7-9 10-1203/1-3 4-

6 7-9

10-12

04/1-3

4-6 7-9

10-12

05/1-3

4-6 7-9 10-1206/1-

3 4-6 7-9

Others

Metal products Chemical products Precision equipment Electrical equipment General machinery

Transport equipment Total export volume Total export value

(% QoQ)

Source: Ministry of Finance

Fig 2-4 Contributions to Changes in Exports to the U.S., by Commodity

-25 -20 -15 -10 -5 0 5 10 15

01/

1-3 4-6 7-9 10-1202/1-

10-12 03/1-

3 4-6 7-9

10-12 04

3 4-6 7-9 10-1205/1-

10-12 06/1-

(% QoQ)

Others

Precision equipment Electrical equipment

A stagnant U.S housing

market dampened Japanese

exports of construction and

mining equipment After a

3) Exports to Brazil, India and Russia Grow

Trade (January to November) with the emerging economies of Brazil, India and Russia rose 35.8%

to $13.2 billion, fueled by high prices for primary commodities and increased exports of machinery Although these three countries accounted for just 2.2% of Japan’s total trade, they each saw their trade with Japan grow by double digits

Exports to Brazil rose 12.3% to $2.8 billion, Russia 58.9% to $6.4 billion and India 24.9% to $4.0 billion Fast-growing exports to Brazil included transport equipment, up 20.3% to $700 million, of which automotive parts rose 8.4% to $400 million India-bound exports were led by machinery, up 31.0% to $1.3 billion, of which metalworking machinery grew 50.6% to $200 million Automobile exports to Russia climbed 62.1% to $3.2 billion, much of which comprised used vehicles Automobiles, which accounted for 74.7% of exports to Russia, were expected to hit an all-time high for the seventh consecutive year

4) Middle Eastern Countries Drive Import Growth

Looking at import

growth by trading partner

(Fig 2-6), the largest

contributors were Saudi

Arabia (2.7 points),

China (2.5 points) and

the United Arab Emirates

(UAE, 2.1 points)

The increased value

of imports from the

Middle East was largely

due to high prices for

crude oil Imports from

Saudi Arabia (up 32.6%

to $34.2 billion) and the

(vehicles, %)2005

(full year)

2006(Jan.-Nov.)

(YoYchange) 13.9 24.6Sources: Japan Automobile Manufacturers Association and Ministry of Finance

Fig 2-5 Auto Exports to and Sales in U.S.

Fig 2-6 Changes in Imports Entering Japan, by Geographic Area

-25 -20 -15 -10 -5 0 5 10 15 20 25

Total import value

Source: Ministry of Finance

C Trade by Product

1) Automobile Exports Expand

Automobiles were the major contributor to Japan’s increased exports, which grew 16.3% to $95.8 billion (Fig 2-7) Exports were also boosted by electrical machinery (up 4.0% to $125.7 billion), including electronic parts (up 3.1% to $37.7 billion) and parts for consumer electronics (up 14.7% to

$12.2 billion)

Automobile exports, robust throughout the year, were estimated to have accounted for more than 50% of total production by major automakers for the first time since 1987 (see column) The U.S took about 40% of Japanese vehicle exports Exports to Russia soared 76.7% to $48.0 billion, mainly due to increased used car sales

Electrical machinery exports to China jumped 19.8% to $22.5 billion, while those to Mexico shot up 34.6% to $3.2 billion Downward pressure was exerted by precision instruments, including a 6.7% fall to

$20.2 billion for scientific and optical instruments, particularly those to Asian NIEs, which slumped 12.5% to $8.1 billion

Source: Ministry of Finance

Fig 2-7 Japanese Exports by Product (Jan.-Nov 2006)

Column 2: Auto Export Ratio Estimated to Have Exceeded 50% for First Time in 19 Years

Association The ratio of

exports to total domestic

production was estimated at

51.4%, the first time to exceed

the 50% mark since 1987

The increase was due to: 1)

rising demand for

energy-efficient Japanese

vehicles due to rising crude-oil

prices in the U.S., 2) lagging

overseas production of popular

Japanese vehicles and 3) a

weaker yen In 2006, the price

of crude oil rose 27.5% to $64.60 per barrel, a more than 2.5-fold increase since 2001 As gasoline prices rose, the demand for more fuel-efficient cars increased Double-digit growth in unit exports was reported by all domestic automakers except Nissan and Fuji Heavy Industries (Fig 2) Exports to the U.S were particularly strong

Offshore production in January to June rose 5.6% to 5.41 million vehicles Although production increased in various regions of the world, it did not keep pace with global demand

The yen declined 5.9% to ¥116.2 per dollar in 2006 (January to November) It also depreciated against the euro, while exports to the EU25 rose 3.0% to 830,000 vehicles

Fig 1 Annual Vehicle Production and Export Ratios

0 2,000 4,000 6,000 8,000 10,000 12,000 14,000

19841985198619 19 19 19 19 19 1993199419951996199719 19 20 20 20 20 20042005

2006 (Jan.-N

ov.)

(1,000 vehicles)

0 10 20 30 40 50 60 70 80 90 (%)

No of vehicles produced

No of vehicles exported Export ratio (right axis)

Source: Japan Automobile Manufacturers Association

(vehicles, %)YoY change

Companies shown in descending order of exports

Source: Japan Automobile Manufacturers Association

Fig 2 Vehicle Production and Exports in 2006 (Jan.-Nov.)

Vehicles made Vehicles

Import value was boosted by

mineral fuels such as petroleum

(up 43.1% to $56.8 billion)

Machinery and equipment, such

as semiconductors and electronic

components, grew 18.9% to $23.2

billion (Fig 2-8)

Crude oil prices rose above

the $60 threshold to average

$64.6 per barrel in

January–November In the third

quarter, prices broke through the

$70 barrier to average $70.7 per

barrel The rising trend

throughout the year fueled a rapid

increase in the value of petroleum

imports (Fig 2-9) In November,

however, imports fell below the

previous year's figures for the

first time in 32 months

China contributed strongly to

increased imports of semiconductors and

electronic components as locally based

Japanese firms expanded production

Imports of machines and equipment rose

9.3%, 7.2% and 8.5% in the first three

quarters, respectively

3) IT Trade: Production Shift Continues

IT exports increased 2.9% to $125.7

billion, while imports rose 5.5% to $78.9

billion IT parts were key to these exports

increasing for the first time in two years

Robust imports of both parts and finished

products enabled total IT imports to

exceed exports, reducing the trade balance by $500 million to $46.9 billion (figs 2-10 & 2-11) The

(US$ millions, %, points) Amount YoY change Share Contribution

　　Clothes and similar products 21,838 4.9 4.1 0.2

Source: Ministry of Finance

Fig 2-8 Japanese Imports by Product (Jan.-Nov 2006)

Fig 2-9 Crude Oil Imports

0 50 100 150 200 250 300 350 400

06

(1-11)0 10 20 30 40 50 60 70 80 90

100

Quantity (million kiloliters)

US$ billions (right axis) US$ per barrel (right axis)

Source: Ministry of Finance

(US$ millions, %) YoY YoY YoY YoY YoY YoY

Product definitions follow JETRO's White Paper on International Trade and Investment

Fig 2-10 Japanese IT Exports (Jan.-Nov 2006)

growth in IT trade was due to increased sales of LCD TVs in connection with the Olympics in February and World Cup soccer in June

IT exports to China jumped 17.9% to $20.6 billion, followed by Mexico (up 43.3% to $29.0 billion) Exports to China were up significantly for both finished products (up 20.4% to $42.9 billion) and parts (up 17.2% to $16.3 billion) Semiconductors and electronic components accounted for the largest share

of the increase (up 20.6% to $71.3 billion), due to parts exports as Japanese production was transferred

to China Japan exported key parts to North America for the assembly of IT finished products in Mexico, but the large increase in exports to Mexico reflected increased production of LCD TVs by local Japanese firms

Negative contributions to IT exports included the U.S (down 1.4% to $24.1 billion) and Asian NIEs (down 1.2% to $36.6 billion) Since IT finished products were exported to the U.S via Mexico and to Asian NIEs via China, direct exports to these final destinations declined The total value of Japanese exports to Asian NIEs declined, since a large share of these exports were IT products (Fig 2-2)

Leading IT exports were semiconductors and electronic components (up 3.7% to $37.7 billion) and other electronic components (up 12.4% to $32.9 billion) (Fig 2-12) IT parts exports rose 6.2% to $85.0 billion, the fourth consecutive annual increase Expanding production offshore enabled exports to East Asia to account for 65.3% of total IT exports, including China and Asian NIEs (up 0.1% to $28.3 billion) and the ASEAN4 (up 2.8% to $10.9 billion) Imports of IT finished products from East Asia rose from

$11.4 billion in 1996 to $23.9

billion in 2006 (January to

November), a 2.1-fold increase

Labor continued to be strategically

allocated through the export of parts

from Japan and the import of

finished products from East Asia

The driving forces behind IT

imports were China (up 5.2% to

$28.0 billion) and the Asian NIEs

(up 10.4% to $19.7 billion) Imports

from China included both IT parts

(up 6.2% to $12.5 billion) and IT

finished products (up 4.4% to $15.5

Product definitions follow JETRO's White Paper on International Trade and Investment

Fig 2-11 Japanese IT Imports (Jan.-Nov 2006)

Fig 2-12 IT Exports by Commodity

-30 -20 -10 0 10 20 30 40

Data from JETRO's White Paper on International Trade and Investment

Source: Ministry of Finance

D International Trade Balance

Japan's trade surplus rose

increase from 2005 (Fig 2-13)

The balance of payments in

services was a deficit of $15.7

billion (January to October)

Travel’s deficit shrunk to

The surplus in income

increased significantly due to

dividend and interest income

resulting from more vigorous

corporate and individual

investment overseas The income surplus is estimated to have exceeded the trade surplus for the second consecutive year: the income surplus in January to October rose $15.5 billion to $103.4 billion, while the trade surplus fell $17.4 billion to $62.2 billion Securities investment income, accounting for 76.7% of the income surplus, rose $11.3 billion to $79.3 billion, while direct investment income climbed $6.2 billion to $23.1 billion According to the Bank of Japan, the surplus in securities investment income was due largely to North America, where it rose $2.9 billion in January to June to $21.3 billion The U.S accounted for the vast majority (up $2.8 billion to $20.6 billion) The surplus in direct investment was primarily attributed to Asia (up $1.2 billion to $5.9 billion) and North America (up $2.4 billion to $4.8 billion)

E Expectations for 2007

Japanese exports are expected to be affected by the economic slowdowns forecast for the U.S and the Asian NIEs around the middle of 2007 But the size of the overall slowdown in exports is expected to

be limited as continued high growth is forecast for China and the ASEAN countries Although East Asia

is predicted to grow slightly slower than in 2006, the pace is still expected to be 7% or higher In December 2006, the Institute of Developing Economies forecast 7.4% growth

Potential risk factors include increased crude oil prices (despite signs of stabilization in late 2006), a stronger yen if the U.S were to cut interest rates or the Bank of Japan were to raise them, and the future course of the U.S economy The U.S economy’s estimated real growth rate of 3.3% in 2006, the result

of a stagnant housing market, is expected to slow to 2.4% in 2007 (OECD, November 2006) If this were

to occur, exports from Japan could slow Even under this scenario, Japanese exports are expected to remain steady in 2007 due to the robust economies of East Asia, which accounted for 45.7% of Japanese exports in 2006 The rate of growth in imports, however, is expected to slow starting in October due to more stable crude oil prices

Change shows comparison with same period of previous year Dollar conversion rates are monthly market averages (based on regulations in Ministerial Ordinance for Reporting Foreign Exchange Trading), but conversion rates for imports/exports are based official customs rate *Jan.-Sept 2006 Sources: Ministry of Finance and Bank of Japan

Fig 2-13 Shift in International Trade Balance

(vale change) (value change)

(value change)

(% YoY) (% YoY)

(value change)

2005

(US$ billions, %)

F Foreign Direct Investment

1) FDI in Western Europe Expands through M&A

Foreign direct investment in January–September 2006 (balance of international payments, net, flow) was $29.8 billion, a year-on-year decline of 4.7% (Fig 2-14) The decline, a sharp reversal from the 42.7% gain one year earlier, was due to a spike in FDI value in 2005 due to changes in methods of listing reinvestment earnings beginning in January that year11, as well as increased withdrawals from foreign investments

Investment in Asia grew 6.9% to

$11.5 billion, accounting for the largest

share, 38.4%, of Japanese global FDI

Although investment declined in countries

such as Singapore and the Philippines, the

number of investment projects in India

and Malaysia more than doubled In India,

which enjoyed robust growth as a newly

emerging economy, direct investment by

automobile parts suppliers continued to

grow in line with expanded investment by

vehicle manufacturers In August 2006,

for example, NGK Spark Plug Co

launched a new company in India to turn

out spark plugs

Western Europe, the second largest

destination for Japanese FDI, soared

81.5% to $11 billion in

January–September Growth for all of

2005 was 5.8% In Germany, where FDI

skyrocketed 567.4% over

January–September 2005, investment rose

in a wide range of industries, including

transportation machinery, chemicals and

drugs Investment in the U.K was marked

by major M&A deals

In North America, Japanese FDI declined 41.6% to 4.3 billion, due mainly to withdrawal from large communications-related investments Investment in the U.S totaled $3.6 billion for the nine months, a 47.7% plunge

Among other countries, South Africa attracted $500 million, a huge rise of 796.5%, primarily due to increased investment by auto parts suppliers and other automotive-related industries In April, Mitsui &

Co and Luxembourg steel producer Arcelor Mittal established AMSA Steel Service Center Pty Ltd as a joint venture to process automotive steel products

Viewed by industrial sector12, Japanese manufacturing investment was up 49.0% to $18.6 billion in the first half Investment in the glass and stone industry ballooned 1,252.3% to $2.2 billion, driven by major M&A deals (Fig 2-15) In the petroleum sector, where Marubeni and other trading companies aggressively acquired resource-mining rights, investment jumped 364.6% to $2.2 billion Transportation

Figures for incoming investment (appearing later) are treated the same way

Jan-Mar Apr-Jun Jul-Sep Jan-Sep Share YoY

Sources: Ministry of Finance and Bank of Japan

Yen-denominated published values are converted at Bank of Japan interbank rates averaged by quarter Minus signs indicate net withdrawals from investments overseas “0” indicates less than the unit of measurement EU include 10 new members from Q2 2004 “All countries” includes countries not grouped by region, so totals do not necessarily match Third quarter 2006 figures are preliminary Within Jan-Sep figures, Jul-Sep figures are preliminary.

Fig 2-14 Japanese Foreign Direct Investment by Geographic Area

2005

2006

(US$ millions, %)

2006

machinery, which accounted for a large share of manufacturing investment, dipped 5.5% to $4.3 billion

In February, Toyota Motor revamped the production line at New United Motor Manufacturing Inc (NUMMI), its joint venture with General Motors With automakers and parts suppliers investing in emerging markets, transportation machinery accounted for over 20% of manufacturing investment Non-manufacturing investment fell 76.6% to $1.3 billion, adversely affected by withdrawals from communications investments in the

United States Wholesaling and retailing,

a major category of investment, jumped

843.1% to $2.8 billion due to

investment in the U.K and Canada

Foreign M&A increased 54.2% to

$18.4 billion, the highest value since the

M&A boom of 2001 The number of

deals declined by 13.7% to 202 projects,

showing that per-deal value increased

Mega-deals worth over $1 billion

totaled four, twice the number in 2005

(Fig 2-16)

The largest M&A deal was the $5.4

billion acquisition by Toshiba, The

Shaw Group and other partners of

Westinghouse Electric, a major player in

nuclear power-generation equipment

and fuel-related industries Toshiba

reportedly undertook this bold M&A to

stabilize power supply and help prevent

global warming The deal was the

largest in the manufacturing sector since

2000, and the largest undertaking since

NTT DoCoMo invested $9.8 billion in

AT&T Wireless Services in 2001

The second largest deal was the acquisition of the U.K.’s Pilkington Group by Nippon Sheet Glass

Co for $3.0 billion The move was intended to maximize synergy between the two companies and enable them to grow as a unified global company Another notable deal was completed by the wholly owned Marubeni subsidiary Marubeni Offshore Production (U.S.), which acquired Pioneer Natural Resources USA, a company with promising rights and interests, to improve its position in the global competition for resources

Mar Apr-Jun Jan-Jun Share

Jan-YoY change

Yen-denominated published values are converted at Bank of Japan interbank rates averaged by quarter Minus signs indicate net withdrawals from investments overseas “0” indicates less than the unit of measurement.

Fig 2-15 Japanese Foreign Direct Investment by Industry

2006 2005

Mar Pioneer Natural Resources USA Inc U.S Oil and gas Marubeni Offshore Production (U.S.) Inc Oil and gas 1,300.00 100.0

Oct 2006 OYL Industries Berhad Malaysia Electrical machinery Daikin Industries, Ltd Electrical machinery 963.71 45.2

Definition of M&A from Thomson Financial

Source: Thomson Financial

Fig 2-16 Major Foreign M&A

millions)

Resulting equity (%)

2) Rising Interest in Newly Emerging Countries

The China boom, which lasted from 2001 through 2005, appears to have moved into a lull Investment in January–September rose only 2.9% to $4.8 billion13 Recruit Co in April acquired stock valued at approximately $100 million in 51job, aiming at a business partnership to realize high-quality human-resource services Yokohama Rubber Co in April established a company to produce and sell truck and bus steel tires in Suzhou, Jiangsu Province Nissan Motor Co in February opened an engine plant in Guangzhou, Guangdong Province and is now expanding operations

According to statistics from China, worldwide investment inflow in January–September fell 1.5% Worldwide investment slipped 0.5% for all of 2005, and another 0.5% in the first half of 2006, signaling flagging investment from Japan and the rest of the world as well Chinese government sources point to four reasons:

1) Investment costs have increased because the country is pursuing more orderly development14, resulting in higher standards for environmental protection, social security, land use and other areas;

2) Growth of domestic private capital has decreased dependence on foreign capital;

3) Other countries are pursuing foreign capital more aggressively by enhancing their appeal to foreign investors; and

4) China attracted $50 billion to $60 billion in direct investment in recent years, limiting room for further increases15

While companies worldwide

continue to view China as a promising

market, concerns about its legal

system, inadequate protection of

intellectual property and other matters

have caused many investors to avoid

the risk of over-concentrating

investment in China According to a

study by the Japan Bank for

International Cooperation, Japanese

companies continue to rate China as a

highly promising market, but risk

factors have eroded the degree of

interest (Fig 2-17) In contrast, close

to 50% of the companies surveyed

view India as a promising market for

its growth potential, low-cost labor and other advantages Brazil and Russia are also considered to have high potential Major Japanese companies, particularly in the automotive industry, are planning vigorous programs to promote demand in Brazil, India and Russia (Fig 2-18) Thailand, also considered promising, has seen a slight decline in interest recently, perhaps due to pessimism concerning its political problems since spring 200616

In view of the advancing decline of Japan’s population, Japanese companies—particularly manufacturers—are expected to continue advancing into other countries in anticipation of a shrinking

of the 16th National Congress of the Communist Party of China in October 2003

by 5.5%,” Tsusho Kouhou, August 23, 2006 (written in Japanese)

Fig 2-17 Survey of Japanese Firms' FDI Interests, by Location

0 10 20 30 40 50 60 70 80 90 100

a Vietn

am Thai

R of Kor

ea

Indones

ia Taiw an

(%)

FY2004 FY2006

FY2006 survey indicates top 10 locations only Total of 484 manufacturers responded to FY2006 survey (multiple replies) Source: Japan Bank for International Cooperation

domestic market

3) Major Investments Produce FDI Outflow

Foreign direct investment in Japan for

January–September 2006 (balance of

international payments basis, net, flow)

amounted to an outflow of $8.4 billion (Fig

2-19) Investment on an international

payments basis is figured by subtracting the

gross flow of capital to Japan from the gross

flow of capital from Japan (return on

investment) Inflow increased, but a large

rise in outflow resulted in the largest net

outflow since 1996 Major outflows

included General Motors’ sale of stock in

Suzuki Motor, Fuji Heavy Industries and

other companies, and Softbank Mobile’s

acquisition of the Japanese mobile telephone

business of Vodafone

Large outflows were recorded by

companies in Western Europe ($4.4 billion),

North America ($3.1 billion) and Asia ($1.8

billion) Although outflows were prominent,

investment inflow from the U.K rose a huge

5,877.5% to $1.6 billion due to increased

activity by investment funds

By sector (Fig 2-20), the GM sell-offs

pushed outflow in the manufacturing sector

to $1.8 billion Telecom giant Vodafone’s

withdrawal from Japan contributed to an

outflow of $9.5 billion in the non-manufacturing sector

The value of M&A deals targeting Japan declined 2.4% to $3.2 billion, while the number of cases declined 20.8% to 84 The largest deal, $800 million, was the capital increase in Kokudo by Cerberus Capital Management of the U.S to restructure Seibu Railway Mitsuboshi Belting Kaseihin strengthened its belt business by selling Mitsuboshi Belting Kaseihin, its wholly owned subsidiary for automotive interior/exterior parts, to the International Automotive Components Group Japan, which is operated by U.S investor Wilbur Ross The acquisition was aimed at integrating IAC’s business on a global scale The financial sector saw several notable cases of foreign companies hosting private placements of new shares (Fig 2-21)

Country Investing company Industry Value Startup Products Reasons Koito Manufacturing Co., Ltd Automobiles 1.7 billion yen Jan 2007 Front/beacon lights Increased orders NGK Spark Plug Co., Ltd Ceramics 600 million yen Dec 2007 Spark plugs Growing industry Toyota Motor Corporation Automobiles 15 billion yen Dec 2007 Automobiles Growing market Nissan Motor Co., Ltd Automobiles 22.66 billion yen 2009 Automobiles Growing market Honda Motor Co., Ltd Automobiles US$100 million - Automobiles Growing market Mitsui & Co., Ltd Oil and gas US$250 million - Gas Supply diversification

Fig 2-18 Japanese Investments in India, Russia and Brazil (Examples)

Honda's aim is to strengthen capacity Mitsui & Co.'s aim is to acquire companies in the gas indusry.

Source: Company press releases

Sources: Ministry of Finance and Bank of Japan

Fig 2-19 FDI Entering Japan, by Location

2005

Yen-denominated published values are converted at Bank of Japan interbank rates averaged

by quarter Minus signs indicate net withdrawals from investments overseas “0” indicates less than the unit of measurement EU include 10 new members from Q2 2004 “All countries” includes countries not grouped by region, so totals do not necessarily match Third quarter

2006 figures are preliminary Within Jan-Sep figures, Jul-Sep figures are preliminary.

No mega-deals took place in 2006

However, the lifting of Japan’s ban on

triangular mergers scheduled in May 2007 will

open the door to major cross-border M&A (see

column)

2006 Jan -

Mar.

Apr Jun.

Jan Jun.

-Growth rate

-2,191 -1,983 167 -1,816 n.a.

Chemicals and drugs -1,168 201 -159 42 -73.0

Iron and nonferrous metals -34 0 1 0 n.a General machinery 164 67 -120 -53 n.a Electrical machinery -1,195 -351 197 -154 n.a Transportation machinery 32 -2,036 90 -1,947 n.a Precision machinery -59 316 255 570 272.1

5,414 6,177 -15,714 -9,537 n.a Agriculture and forestry -1 0 0 0 n.a Fisheries and marine products 0 0 -7 -7 n.a.

Transportation 2,108 13 10 23 -98.8 Communications 912 266 -10,022 -9,755 n.a Wholesaling and retailing 1,157 246 -390 -144 n.a Financial and insurance 645 4,587 -5,433 -846 n.a.

Sep 2006Mitsuboshi Belting Kaseihin Co.,Ltd. Auto parts International AutomotiveComponents Group Japan, LLC U.S Financial 305.00 100.0

The Thomson Financial definition of M&A is used.

Source: Thomson Financial

Fig Mechanism for Triangular Mergers by Foreign Firms

Overseas Japan

Exchange of shares

Allotment of shares

Foreign firm (Firm "A," parent corporation)

Japanese corporation (subsidiary)

Firm "B"

shareholder

Japanese firm (Firm "B")

Japanese corporation (subsidiary)

Foreign firm (Firm "A," parent corporation)

Column 3: Triangular Mergers Expected to Spur M&A Japan

amalgamated corporation shareholders or other parties Parties to the merger must already be in a parent-subsidiary relationship, the businesses must be interrelated, and neither party’s business can be more than five times larger than the other’s (sales, employees, capitalization, etc.)

The Corporate Law enacted in May 2006 introduced increased flexibility for compensation in mergers A key effect will be the start of triangular mergers, in which shareholders of a company absorbed in a merger or split-up are issued shares of the parent corporation of the surviving firm, or succeeding firm Also enabled are cash-out mergers, in which shareholders are compensated with cash These new measures were to go into effect in May 2007, following a one-year grace period to permit Japanese corporations to adopt takeover defenses A new Ministry of Justice ordinance is expected to govern requirements for annual shareholders’ meeting resolutions and other such actions of triangular mergers

Broader compensation options will help to facilitate M&A, particularly triangular mergers, presumably leading to increased foreign investment in Japan However, some in Japan have called for improved laws and ordinances out of concerns for possible loss of corporate value, technology outflow, etc., as well as shareholder protection The Nippon Keidanren has urged measures to govern triangular mergers involving cash or non-listed securities, and has proposed stricter requirements for annual shareholder’s meeting resolutions (requiring extraordinary resolutions, for instance) and stronger provisions for disclosure and accountability to shareholders when such mergers take place (“Further Revision of M&A Legislation is Needed,” December 2006)

The American Chamber of Commerce in Japan (ACCJ) and European Business Council (EBC), however, pointed out that triangular mergers cannot be used for hostile takeovers They opposed Keidanren’s proposal on the grounds that it conflicts with the Japanese government’s policy to promote foreign investment in Japan Meanwhile, media reports at the end of the year indicated that the ruling

party was shifting its position by not imposing stricter requirements for shareholder resolutions (Nihon

Keizai Shimbun, December 9, 2006)

Triangular mergers have important tax implications The tax revision package proposed by the ruling party for fiscal 2007 contains provisions governing triangular mergers17: 1 No capital gains tax on amalgamated corporations (“B” in figure), 2 amalgamated corporation shareholders can defer capital gains taxes, and 3 merging corporation (“A”) shares issued to amalgamated corporation shareholders are exempt from dividends tax As a result, previous bottlenecks for triangular mergers are set to be resolved

3 Production: Mining and Manufacturing Output Remain High

A Expansion Continues Despite Uneven Pace

1) New Record for Output

Manufacturing output, after expanding

rapidly on a seasonally adjusted basis in the

latter half of 2005, stagnated in the first half

of 2006 After repeated ups and downs

throughout the year, however, output ended

extremely high for the year, setting a new

record (Fig 3-1) The Ministry of Economy,

Trade and Industry (METI), realizing that a

solidly expansive phase had taken root,

upgraded its assessment of the economy in

June from “moderate upward trend” to

“upward trend.” This was the first such

upgrade since October 2005, affirming that

economic expansion had become a definite

trend in 2006

2) Producer Goods Underpin Growth

Basic materials, supported by rising global demand, contributed greatly to output growth Parts and raw materials (about half of all industrial output) rose strongly (figs 3-2, 3-3 & 3-4) Processing industries were sluggish apart from electronic components and devices, according to the Index of Manufacturing Production Forecast In other sectors, especially producer goods, recovery was solid (Fig 3-5)

Fig 3-2 Contributions to Changes in Industrial Indices

All data original series; 2000 = 100

Source: Ministry of Economy, Trade and Industry

Fig 3-1 Manufacturing Production, Shipments and Inventories

All data seasonally adjusted; 2000 = 100 Source: Ministry of Economy, Trade and Industry

80 90 100 110 120

Fig 3-5 Index of Manufacturing Production Forecasts

Original series; 2000 = 100 Source: Ministry of Economy, Trade and Industry 3) Shipments and Inventories Vary by Industry

Manufacturing shipments rose strongly in both the domestic and export sectors (Fig 3-6) Except for precision machinery and metal products, virtually all industries grew Growth was driven by

Fig 3-3 Producer Goods Inventory Cycle

-15 -10 -5 0 5 10 15

Source: Ministry of Economy, Trade and Industry

Fig 3-4 Contributions to Manufacturing Output

-20 -15 -10 -5 0 5 10 15

Manufacturing

Original series; 2000 = 100 Source: Ministry of Economy, Trade and Industry

85 90 95 100 105 110 115 120 125 130 135 140

Manufacturing Processing Processing (electronics, devices, etc.) Materials

Ferrous metals Nonferrous metals Metal products

Forecast

electronic components and devices, as well as transport machinery due to rising automotive exports to the United States As Japanese automakers increased their U.S production capabilities, high oil prices dampened U.S demand for large vehicles and created replacement demand for more fuel-efficient Japanese cars, including exports from Japan (Fig 3-7)

Mining and manufacturing inventories

increased steadily overall in the latter half of

2006 As pressure for cutbacks in electronic

components and devices grew in this

trend-setting sector, fears surfaced that

manufacturing as a whole would enter a

correction phase However, inventories declined

in both the general machinery and the iron and

steel sectors, where cutbacks had been underway

since in 2005, so manufacturing inventories

recovered overall (Fig 3-8)

Shipments versus inventories (shipments

minus inventories, year on year) began to

worsen for electronic components and devices in

May, then electrical machinery and information

and communication equipment from mid-year

(Fig 3-9) Conversely, conditions improved for

general machinery in April, then iron and steel in

July, both for the first time in a year Solid

growth in both domestic and foreign demand

reduced inventories of iron and steel and

nonferrous metals in the second half of 2006

Overall, corrections varied widely from industry

All data seasonally adjusted; 2000 = 100

Source: Ministry of Economy, Trade and Industry

Fig 3-7 Automotive Production and Sales in United States

0 2 4 6 8

Passenger Cars

Light Trucks Domestic Imported

Production (million units) Vehicle Sales (million dollars)

2005 2006

Includes light trucks Source: Ward’s Automotive Group

Fig 3-8 Manufacturing Inventory Cycle

-15-10-50510

Original series; 2000 = 100 Source: Ministry of Economy, Trade and Industry

Fig 3-9 Shipment-Inventory Balance

Improving

Worsening

Original series; 2000 = 100 Source: Ministry of Economy, Trade and Industry

Fig 3-10 Product Inventory Diffusion Index

-20

0204060

/7-(points)

ChemicalsIron and steelNonferrous metalsBasic materialsManufacturing

Excess

Insufficient

Diffusion index of “Excessive or somewhat excessive” minus “Insufficient or somewhat insufficient” Source: Bank of Japan

B Rising Inventories in Electronic Components and Devices

The electronic components and

devices sector, following inventory

corrections in the 2005 third quarter,

saw production, shipments and

inventories all rise to historic highs in

2006 (Fig 3-11) Production of liquid

crystal modules and panels declined,

but cell phone memory devices

enjoyed dramatically increased

production and strong growth in both

domestic shipments and exports (Fig

3-12) In the first half of fiscal 2006

(April–September), shipments of

capacitors and other electronic

components to China jumped 23%,

while shipments to North America,

Europe and other parts of Asia also

continued to expand, according to the

Japan Electronics and Information

Technology Industries Association

Inventories grew at an escalating

pace to reach all-time highs in the second half of 2006, topping previous record-setting levels of 2001 The third quarter saw a return to inventory corrections (Fig 3-13), but in October inventories of new cell phones rose due to the introduction of number portability Game machine manufacturers introduced new home models for the year-end sales push, and computer shoppers delayed new purchases in anticipation

of Microsoft's scheduled introduction of the new Vista operating system in January 2007 All of these factors contributed to increases in electronic component inventories

Fig 3-11 Electronic Components/Devices Production, Shipments

and Inventory

50 70 90 110 130 150 170

98/01 0799/01 0700/01 0701/01 0

7 02/01 0703/01 0704/01 0705/01 0706/01 07

Recession Production Shipments Inventories

All data seasonally adjusted; 2000 = 100 Source: Ministry of Economy, Trade and Industry

Fig 3-12 Electronic Components and Devices

All data seasonally adjusted; 2000 = 100

Source: Ministry of Economy, Trade and Industry

Fig 3-13 Electronic Components and Devices

Inventory Cycle

-60-40-200204060

Shipments (% YoY)

Term-end inventories (% YoY)

4Q 2000

4Q 2006

Increases Reductions

C Mild Growth to Continue in 2007

1) Mining and Manufacturing Seen Gradually Improving

While rising inventories are cause for concern, production, shipment and inventory indices suggest that mining and manufacturing inventories as a whole are not likely to experience a correction in 2007 Given that inventories at the end of 2006 were substantially below surpluses seen in previous periods of correction, inventory management appears to have improved In addition, healthy trends in shipments dispelled any perceived need to cut back production to offset a sudden expansion of inventories Projections indicate continued firm demand from the U.S.A., China and the rest of East Asia, as well as Japan, which should lead to gradual growth in 2007

2) Temporary Corrections Expected in Electronic Components and Devices

Rising inventories of electronic

components and devices in 2006 were

cause for concern due to the possibly

adverse impact on overall production

However, strong sales of components

for game machines released near the

year-end, as well as strong exports,

diminished the specter of further

increases At a press conference on

November 16, 2006, BOJ Governor

Toshihiko Fukui stated that global

corrections in IT notwithstanding, rising

inventories of electronic components

and devices were probably due to

transitory domestic factors in the cell

phone and game machine industries

Long-term trends in shipment/inventory

balances do not suggest that stocks of

non-IT products would rise the way they

did during the IT bubble in 2001, so

sustained improvement is forecast for

general machinery, ferrous metals and chemicals

In addition, while the book-to-bill ratio (new orders vs shipments of U.S.-based semiconductor manufacturers), which measures the scale of global IT demand, was below 1.0 for four months starting

in August, the trend reversed in December with a rise to 1.05 (Fig 3-14) It had been feared that orders might fall below shipment levels because of slackened demand in the first half of 2006, and this fear dampened semiconductor makers’ interest in capital expenditure over the same period However, the reversal of the book-to-bill ratio erased such concerns, and provided another reason to regard sluggish IT demand as a temporary phenomenon

Fig 3-14 U.S Semiconductor Manufacturer Book-to-Bill Ratio

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60

97/01 0798/01 0799/01 0700/01 0701/01 0702/01 0703/01 0

7 04/01 0705/01 0706/01 07

Performance improving

Outlook worsening

(Shipment to inventory ratio)

Three-month moving average Source: SEMI

4 Corporate Sector: Capital Expenditure Plans Still Solid

A Corporate Earnings Continue Growing

1) Earnings

The Ministry of Finance’s Financial

Statements Statistics of Corporations

report indicated that pretax net income for

all companies in all industries rose in the

third quarter of 2006, the seventeenth

consecutive quarter of earnings growth

(figs 4-1 & 4-2) The only longer period

of sustained growth was nineteen quarters

from the late 1960s to early 1970s, during

Japan’s period of rapid economic growth

The increase gained strength with

double-digit growth in the second and

third quarters Large corporations in the

manufacturing sector continued to power

the expansion, but smaller firms, whose

earnings had dipped at the start of the year,

recovered midway Both manufacturing

and non-manufacturing companies of all

sizes contributed to the increase

Performance varied by industry

Double-digit growth was achieved in both

quarters by manufacturers of electric

machinery, general machinery,

information and telecommunications

equipment, and transport equipment

Earnings growth slowed considerably in

the second quarter, however, for chemicals,

petroleum and coal products, and iron and

steel, due to soaring prices for raw

materials and fuel But performance in

these industries improved in the third

quarter as crude oil prices settled down

and higher prices were passed along

Manufacturers as a whole recorded

double-digit increases in both quarters

Among non-manufacturers, the

construction and electric power industries

rose strongly, including by double digits in

the third quarter, the first time for this in

five quarters

Earnings were up on the strength of

higher sales across a wide scope of industries Profit on sales grew solidly in the manufacturing and non-manufacturing sectors (Fig 4-3)

The manufacturing sector was the driving force behind a fall in the profit/loss breakeven point and

Fig 4-1 Corporate Earnings

0481216

Data are for all companies Earnings = revenues labor costs depreciation expense + non-operating income Revenues = operating income + fixed costs

-Source: Ministry of Finance

significantly improved profitability (Fig

4-4) By corporate size, the breakeven

point for midsized and small firms

reached its furthest drop in the fourth

quarter of 2005, but then rose as firms

experienced difficulty absorbing the high

costs of raw materials (Fig 4-5)

Solid demand enabled the processing

and basic materials industries to improve

terms of trade in the second half (Fig 4-6)

Significant progress in passing along price

increases is forecast for the first quarter of

2007 quarter, which would support

increased production and profitability

While such figures have both negative and

positive implications, taken as a whole

they suggest steady growth in earnings

With earnings doing so well, business

sentiment remained positive since the first

quarter of 2005 (Fig 4-7) Even in the non-manufacturing sector, sentiment finally clawed its way out of negative territory in the fourth quarter of 2005—the first time in over thirteen years—and remained positive throughout 2006, underscoring the broad trend of stronger earnings

Fig 4-4 Profit/Loss Breakeven Point Ratio, by

Fig 4-3 Operating Profit on Sales

1.0 2.0 3.0 4.0 5.0 6.0

87/1-3 4-6 7-910-1292/1-3 4-6 7-910-1297/1-3 4-6 7-910-1202/1-3 4-6 7-910-12

(%)

All industries Manufacturing Non-manufacturing

Seasonally adjusted data Source: Ministry of Finance

Fig 4-5 Profit/Loss Breakeven Point Ratio, by

Company Size

70 75 80 85 90 95

4-6 7-9 10-12 92/1-3 4-6 7-9 10-12 97/1-3 4-6 7-9 10-12 02/1-3 4-6 7-9 10-12

(%)

Large Midsize Small

Four-quarter backward moving average for all industries P&L breakeven point ratio = (fixed costs/(1 - variable costs/sales))/sales x 100 = P&L breakeven point/sales Fixed costs = labor costs + depreciation Variable costs = cost of sales + SGA cost - fixed costs forecast

Source: Ministry of Finance