1. This statement provides an update of information that has become available since the release of the staff report (SM/02/199, 7/3/02). It reflects further discussions held in Tokyo during July 10–11 with senior government officials and private sector analysts. The statement covers recent economic, financial, and policy developments. This information does not alter the thrust of the staff appraisal.

2. Recent data continue to indicate that the economy is on a modest recovery path, although activity remains reliant on external demand.

• The latest Tankan survey, released in early July, reported a better-than-expected improvement in business conditions in the second quarter of 2002, with the key all-enterprise diffusion index rising sharply from its March levels. The improvement was concentrated in large manufacturing companies—particularly in the electrical machinery sector—which have a significant export exposure; small firms and those in the nonmanufacturing sector reported a more modest improvement. Firms expected that business conditions would improve further in the third quarter.

• The all-industries production index (the closest supply-side proxy of GDP) increased by 1.1 percent (m/m) in May, after declining by 1.3 percent (m/m) in April. Industrial production increased by 4.1 percent (m/m) in May, spurred by strong exports.

• Indicators suggest that business and residential investment may be close to bottoming. Capital goods shipments and private core machinery orders—a reliable leading indicator of business investment—have both risen recently, while new dwelling starts have increased over the past two months. Data on private consumption, however, has been mixed—household living expenditures fell by 2.7 percent (m/m) in May, although registrations of new passenger vehicles rose strongly.

• Exports have continued to grow robustly, with volumes rising by 8.5 percent (m/m) in May. Although import volumes have also recovered from their weak first quarter levels, external demand is again expected to make a positive contribution to growth in the second quarter.

• Despite the strengthening in activity, employment fell by 390,000 in May, and the unemployment rate rose to 5.4 percent.

• Deflation remains entrenched, with the core CPI (which excludes perishable food and energy) declining by 0.9 percent (y/y) in May.

3. The staff’s current growth forecast calls for real GDP to decline by ½ percent in CY2002 (annual average basis), broadly in line with the latest private consensus forecast. While recent indicators suggest that activity in the second quarter may have been somewhat stronger than anticipated, the staff expects that the new methodology for calculating the quarterly national accounts—which will be introduced with the publication of the second quarter data in late-August or early-September—will result in a downward revision to first quarter growth. Given the uncertainty about the extent of this revision, staff intend to wait for the new data before considering any change to the forecast.

4. The main additional risk to the growth outlook since the issuance of the staff report is the continued appreciation of the yen, especially given the narrow concentration of the recovery on exports. The yen has risen by a further 2½ percent against the U.S. dollar since end-June. It has now appreciated by 13½ percent against the U.S. dollar since late-February, and by 6–8 percent in real and nominal effective terms. If sustained, this appreciation represents an important risk to the economy going forward, a point also acknowledged by the authorities in the context of recent statements by Finance Minister Shiokawa (including, for example, after the foreign exchange market intervention to stem the yen’s rise in late June). Indeed, forecasts made by companies in the June Tankan survey assumed an average exchange rate of ￥125.7 per U.S. dollar in FY2002. Driven by the weakness in world equity markets and concerns about the impact of the stronger yen on export prospects, the TOPIX has declined by 3½ percent since end-June, while 10-year bond yields have fallen to around 1¼ percent.

5. Macroeconomic policies remain as described in the staff report. The Bank of Japan (BoJ) Policy Board left the target for current account balances (bank and nonbank reserves held at the central bank) unchanged at ￥10–15 trillion at its July 15–16 meeting. However, with the BoJ withdrawing the liquidity it supplied in excess of the target during March-April, the year-on-year growth of base money has slowed from 36¼ percent in April to 27½ percent in June. No further details have emerged regarding the government’s tax reform proposals, or on the issue of a possible supplementary budget.

6. The Financial Services Agency (FSA) has announced its intention to examine a number of measures to promote mergers and consolidation among regional banks and other small deposit-taking institutions. These include: the use of public funds to strengthen the capital base of merged institutions with strong business improvement plans; a higher level of deposit insurance protection for merged institutions; and assistance in defraying the upfront costs associated with a merger. Separately, an advisory panel to Financial Affairs Minister Yanagisawa has released a report on “The Future Vision for the National Financial System,” although it remains unclear to what extent its recommendations will be incorporated in the FSA’s medium-term financial system plan that will be submitted to the Council on Economic and Fiscal Policy (CEFP) later this year. The staff has not had an opportunity to assess the report—which is only available in Japanese at present. Press reports, however, indicate that the advisory panel called for the selective use of public funds to recapitalize viable banks and a more active role for the Resolution and Collection Corporation (RCC) in dealing with the bad loan problem. It also recommended the scaling back of government financial intermediation, the leveling of the playing field between the postal savings system and private institutions, and tax changes to encourage equity investment to facilitate a more viable and dynamic financial sector over the medium-term.

7. The bill to reform the Postal Services Agency has passed the Lower House, and is expected to be approved by the Upper House by the end of this month. The reforms will create a public corporation from April 2003 to take over the postal services—mail delivery, postal savings, and life insurance. The reforms, however, set no firm date from which the postal agency will begin paying fully equivalent deposit insurance premiums and corporate tax payments, and therefore is likely to do little to level the playing field between the postal savings system and private financial institutions in the near term. Prime Minister Koizumi has established a consultative group to make recommendations on the possible future privatization of the postal services corporation.