1. This statement provides an update of information that has become available since the release of the staff report (SM/00/164, 7/13/00). It covers recent monthly data, the Sogo bankruptcy, monetary policy developments, financial market developments, and fiscal policy plans. This information does not alter the thrust of the staff appraisal.

2. Recent data are consistent with the staff’s view that the recovery remains fragile and subject to downside risks. While monthly household expenditure data are generally consistent with a slight rise in private consumption in the second quarter, a firm uptrend has yet to be established. The unemployment rate remains high—with an uptick to 4.7 percent in June—and survey results suggest that summer 2000 bonuses (which are typically paid in June and July) were 1–2 percent lower than in 1999, although data for June show a small year–on–year increase. The June Tankan survey showed continued improvements in business confidence, but it also confirmed corporate perceptions of significant excess capacity and ongoing deflation, and recent indicators—including declines in capital goods production and shipments in the second quarter—underscore the potential for a slowdown in business investment. Private domestic demand may also be affected by the sharp drop in equity prices since the Sogo bankruptcy in mid–July (see below). On the supply side, industrial production grew by about 1½ percent in the second quarter, while the all–industry index (the closest supply–side proxy of GDP) was roughly unchanged in both April and May. On balance, these data are consistent with the staff’s current forecast for real GDP growth in calendar 2000 of 1.4 percent, which is in line with the consensus. The consumer price index posted a year–on-year decline of 0.7 percent in June (in line with previous months) while the core CPI, which excludes perishable food and energy, fell by 0.4 percent year–on–year.

3. Sogo, a large department store chain, filed for court–led rehabilitation under the new Civil Rehabilitation Law on July 12. Group debt amounts to ¥1 .87 trillion, the largest ever for a nonfinancial firm filing for bankruptcy. This action follows the withdrawal of political support for a restructuring plan that included ¥97 billion ($900 million) in debt forgiveness by the government. Sogo’s debt forgiveness plan required government approval because, under the terms of a loss–sharing agreement between the government and the now foreign–owned Shinsei Bank (formerly LTCB), the latter decided to sell its claims on Sogo to the Deposit Insurance Corporation. Initially, the government had supported the rescue plan, as had all 70 creditors that had been asked for debt forgiveness by Sogo. However, the public outcry against what was perceived as the bailing out of a mismanaged retailer (that had made poor real estate investments) eventually prompted Sogo to withdraw its request for debt forgiveness and to file instead for court–led rehabilitation. Sogo’s bankruptcy will probably force creditors, including the government, to recognize significant losses up front, although major banks are believed to be largely covered by existing provisions. The end–result should be a stronger, more credible restructuring plan.

4. At its last meeting on July 17, the Monetary Policy Board of the Bank of Japan (BOJ) decided to maintain the zero interest rate policy (ZIRP). In an unusual step, however, it issued a statement saying that, while the majority of the Policy Board thought that the economy was coming to the stage where deflationary pressures were dispelled (which was the condition for lifting the ZIRP), some members felt it was desirable to await further evidence on the firmness of the recovery, as well as to see how the Sogo bankruptcy would affect market developments and business sentiment. The next meeting of the Policy Board is on August 11.

5. Since mid–July, the Nikkei stock market index has declined by over 7 percent to about 16,000, led by wholesale, retail, and bank stocks Following the Sogo episode, the decline seems to reflect in part concerns about a pickup in corporate failures among other heavily–indebted companies, and the resulting impact on banks. The yen has weakened to about ¥109/$, a depreciation of about 2 percent since mid–July, and somewhat less in nominal effective terms. The three–month interbank rate and the yield on the benchmark 10–year government bond are both roughly unchanged, at 0.3 percent and 1.7 percent, respectively.

6. Recent monthly indicators confirm that local government financial constraints continue to undercut fiscal stimulus. Monthly data indicate that about 40 percent of the public works spending in last November’s supplementary budget had been executed by the end of the first quarter, suggesting that the drop in public investment in the national accounts in the first quarter was due more to lack of implementation at the local level than delays in executing the stimulus package itself The authorities recently announced the release of a ¥500 billion (0.1 percent of GDP) contingency reserve from the FY2000 budget—mainly to boost public works—which is expected to have its largest effect in the third quarter of this year. In the spending guidelines for the FY2001 initial budget announced this week, the expenditure ceilings have been maintained at about the same level as in the initial FY2000 budget, although no contingency reserve for public works has been included. The outlook for public investment will also depend on the size of any possible supplementary budget—a decision on which is not expected before September.

7. The Tax Commission, an advisory panel to the Prime Minister, recently published its report on medium–term tax reform issues. Noting that Japan’s income tax burden was smaller than that in other major industrial countries, the Commission cautioned against any further reduction in personal or corporate income tax rates, and noted that the high minimum threshold of taxable personal income in Japan should be reviewed. While not recommending an increase at this time, the Commission argued that, in view of the demographic changes underway, the consumption tax would likely become a more important source of revenue over the long term, given the need to provide a more stable revenue base and ensure a more equitable distribution of the tax burden across generations. To stabilize the tax revenue of local governments, the Commission stressed the importance of a broader base for the corporate income tax, such as a combination of profits, the wage bill, interest payments, and rent.

8. Recently available results for the regional banks for the financial year ended March 2000 confirm that a number of them had capital adequacy ratios well below 8 percent of risk weighted assets.¹ Specifically, 23 of the 55 second–tier regional banks had capital ratios below 8 percent, while 15 of these had capital ratios below 7 percent, and 4 had capital ratios below 6 percent. A number of first–tier regionals (8 out of 64) also had capital ratios below 8 percent, with five banks having capital ratios below 6 percent.