1. This statement contains information that has become available since the Staff Report was circulated to the Executive Board on June 30, 2008. This information does not alter the staffs broad assessment of policy issues and recommendations contained in the staff report. That said, the recent renewed volatility in global markets slants the balance of risks to the growth outlook more firmly to the downside, while the continued strength of commodity prices underscores upside risks to inflation.

2. Financial markets have weakened in Japan in July, in line with global trends.

• CDS spreads for Japanese financials have risen across the board, especially for nonbank lenders (such as consumer finance companies) that rely on wholesale funding, and Japanese equities have suffered losses. However, money markets have remained stable, with the 3-month LIBOR-OIS spread steady at about 40 basis points. Despite the recent uptick in inflation, JGB yields have declined slightly, while the yen has fluctuated in line with volatility in global risk appetite.

• In light of the recent market developments, concerns have been raised about the exposure of Japanese institutions to U.S. agency bonds, particularly those issued by Fannie Mae and Freddie Mac. According to the U.S. Treasury data, total holdings of U.S. agency bonds by Japan’s private and public entities (including official reserves) amounted to $231 billion as of end-2007. Of this amount, the three largest banks, major insurers and securities firms reportedly account for about $80 billion; for individual banks, exposures range from 5 to about 40 percent of Tier 1 capital.

3. As expected, recent indicators point to a slowdown of economic activity after a surprisingly strong GDP outturn in the first quarter. Sentiment indices (including from the Bank of Japan’s June Tankan survey) continue to deteriorate as the negative impact of higher commodity prices and somewhat weaker external demand are felt. On balance, high frequency data seem broadly consistent with our projection of a soft landing to 1½ percent growth in calendar years 2008 and 2009. Headline inflation reached a 10-year high of 1.3 percent (y-o-y) in May on higher food and fuel prices, but underlying inflation (excluding food and energy) remains close to zero. Owing to continued commodity price pressures, our inflation forecast for 2008 (1.1 percent) is subject to upside risk and, in light of the incoming data, may be raised in the context of the ongoing World Economic Outlook exercise. The possibility of permanently higher commodity prices than assumed in the staff report would also imply some downside revision to our forecast of Japan’s current account surplus and some narrowing of the estimated degree of yen’s undervaluation relative to longer-term fundamentals.

4. At its monthly monetary policy meeting on July 14-15, the Bank of Japan (BoJ) decided to keep its target rate unchanged at ½ percent, citing a slowdown in the domestic economy, rising energy and material costs, and downside risks from the global economy. The median growth forecast of Policy Board members was downgraded from 1.5 percent to 1.2 percent in FY2008 (fiscal year begins April)—slightly below staffs projection of 1.4 percent—and from 1.7 percent to 1.5 percent in FY2009. Board members now forecast markedly higher inflation, with the median FY2008 forecast increasing from 1.1 percent to 1.8 percent and possible upside risks from changing inflation expectations of households and price-setting behavior of firms. In order to further enhance its communication strategy, the BoJ has decided to start releasing the assessment of economic and price developments from “two perspectives” after each monetary policy meeting and also plans to publish the Risk Balance Charts for the outlook more frequently.

5. The government released its FY2008 Basic Policies on June 27. The policy program reaffirms the government’s commitment to achieving primary balance (excluding social security) by FY2011 and to comprehensive tax reform including raising the consumption tax and abolishing road tax earmarking. As expected, the document calls for measures to further open the Japanese economy (by increasing trade with EPA partners, liberalizing aviation, and revising FDI rules); improve labor market participation; and enhance productivity in services and SMEs. The program also aims to reduce regional disparities and cut CO2 emissions. Meanwhile, an expert panel at the Council on Economic and Fiscal Policy has released its recommendations for medium-term structural reforms. The main priorities set out by the panel include greater labor market flexibility and competition in the corporate sector; reform of the social security system; and better integration of Japanese regions into global markets. The staff considers that structural reforms in the areas highlighted by Basic Policies and the expert report would be very desirable. The challenge, however, is to translate these broad reform intentions into specific actions.