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Persistent deflation and massive bad loans in the nation’s banking system have weakened Japan’s economy and no improvement will be seen until structural reforms are implemented, according to an annual government white paper released Tuesday.

“The susceptibility of Japanese business to the ups and downs of the global economy is evidence of the weakness of the Japanese economy,” the fiscal 2002 Annual Report on the Japanese Economy and Public Finance says. “It is essential to rid the economy of its fragile nature and carry out structural reform to build an economic structure that contains high growth potential.”

The tax system for individuals and companies also needs to be reformed in a way that will bring about economic vitality, the report says.

According to the report, the government expects the Bank of Japan to maintain its easy monetary stance to fight deflation, which is expected to continue for some time.

It also says fiscal reforms must continue in order to rein in the nation’s huge public debt.

The white paper, compiled by the Cabinet Office, is designed to provide the Council on Economic and Fiscal Policy, a key government policy-setting body, with an analysis of current economic conditions.

Assuming that structural reforms will be implemented, it says that while they take hold the economy’s potential growth rate will be limited to around 1 percent, unchanged from last year. But the growth rate will rise to around 2 percent in the following decade if reforms are carried out.

It also says that any comeback could falter if the U.S. economy turns sluggish.

It points out that Japanese banks are keeping their resources locked up in unproductive companies and that they must dispose of their massive amount of nonperforming loans.

The report was released a week after the government completed a package of measures to accelerate the cleanup of the banking sector and fight deflation. In the package, the government promises to work to solve the bad-loan problem by the end of fiscal 2004 by halving the dud-loan ratio at major banks.

Particular emphasis was put on analyzing deflation in this year’s report, Economic and Fiscal Policy Minister Heizo Takenaka said after submitting the white paper to the morning’s Cabinet meeting.

“We analyzed deflation from a multifaceted viewpoint with the notion that further importance should be put on it,” he said. “One of the many causes of deflation is the nonperforming loans obstructing banks’ financial intermediary functions. Deflation and the bad-loan problem are feeding each other in a vicious cycle.”

Private economists have long pointed out that companies that get debt waivers and additional loans from banks use their new lease on life to lower prices, putting pressure on the profit margins of still-healthy companies and decreasing their own ability to pay off their new loans.

But the report drew criticism from other economists who focus on the short-term pain a bad-loan cleanup would inflict.

“My impression is that the economic and fiscal white paper lacks a sense of crisis,” said Seiichi Toshida, economics professor at Senshu University.

Although it says reforms are necessary to regain strength, such reforms “increase deflationary pressure and will have a negative impact on the economy,” Toshida said. “There is a leap in logic.”

The white paper, the second of its kind drawn up by the Cabinet Office, analyzed the nation’s tax systems in detail for the first time in response to the government’s reform efforts, a Cabinet Office official said.

Prime Minister Junichiro Koizumi has issued orders to carry out tax cuts of more than 1 trillion yen in fiscal 2003 as part of efforts to bolster the economy. Details of this plan have yet to be finalized, but it is expected to include reductions in corporate research and development taxes.

The BOJ’s easy monetary stance seems to have weakened the yen rather than boost bank loans, the report says, but it adds that the initial goal of bolstering the loans could be achieved once balance sheet adjustments make progress in the financial sector.

It says overall fiscal spending is unlikely to decrease dramatically — despite cuts in public investment — due to an increase in social security expenditures.

The government should work to drastically cut the budget deficit and review the contents of fiscal spending while watching their impact on the economy, the report says.

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