Last year saw a gradual upswing in the Japanese economy. The stock market revived and many Japanese corporations earned record profits. The average stock price at the Tokyo Stock Exchange has risen by about 40 percent in the past year. Toward the end of 2005, it topped 16,000 for the first time in more than five years.

The Bank of Japan’s “tankan” quarterly business survey released in mid-December showed companies turning more optimistic amid increasing exports and firm domestic consumption. Industrial production was growing, with the November output index rising to 103.5, the highest since 1998 under the current statistical method. Thus the government projects modest economic growth of 1.9 percent in fiscal 2006 — 1.5 percent from domestic demand and 0.4 percent from exports.

The government even expects the consumer price index to register a year-on-year rise of 0.5 percent and the GDP deflator, which reflects general price movements, to rise by 0.1 percent — further signs that the economy may be ridding itself of the deflationary pressure that began in 1998.

Despite these rather optimistic forecasts, however, caution is still needed. Unease over financial institutions has abated as the level of bad debts held by banks returned to normal at the end of March. Major enterprises have cut much of their excess labor, debts and equipment and are expected to achieve another record profit year ending in March 2006. But internal factors are not the only contributors to the economic recovery. Exports to China and the United States contributed a lot.

Although the U.S. economy is on a steady path, a decline in the value of the dollar due to that country’s swelling current account deficit could crimp exports from Japan. China is now a major market for Japanese exports along with the U.S., with its economy growing at an annual rate of nearly 9 percent. But excessive supplies of steel and other industrial materials emerging in the country could push down the prices of these materials on the world market, thus affecting production output by Japanese companies.

Another external factor is high oil prices, which are expected to hover in the range of $55 to $60 a barrel. A crisis in the Middle East could lead to additional spikes in oil prices and disturb the world economy. It is becoming all the more important for Japan to develop an economic structure that depends on less oil.

There was good news for many Japanese households as winter bonuses for 2005 offered by 288 major enterprises registered a record high for the third straight year. The improved performance of corporations is likely to allow the first pay raise in years for many industries. Because of the prevailing near-zero interest rates, money owned by individuals is finding its way into the securities market.

Coupled with the inflow of large amounts of money from foreign investors, the robustness of the stock market is likely to renew concerns about a stock bubble forming. On the other hand, market moves in the opposite direction could affect sentiments favoring individual consumption, which accounts for about 60 percent of gross domestic product.

Given the year-on-year rise in November in the core consumer price index pointing to a possible end of deflation, the BOJ hopes to lift its ultra-easy monetary policy in the spring. Under the policy introduced in March 2001, the banking system has been flooded with excess liquidity while short-term interest rates are kept at almost zero percent. The government is reluctant to end the ultra-easy money policy because a rise in interest rates will push up debt-service costs. If the ultra-easy money policy continues, excess liquidity could go toward speculative buying of real property, thus causing an asset bubble. The government and the BOJ need to act wisely to prevent the recurrence of an economic bubble.

If the government goes ahead with a plan to halve the current fixed-rate reductions on income and resident taxes, and raise premium payments for the national pension system, the public’s tax burden will increase by about 3 trillion yen. Depending on the movement of the economy, the government should flexibly handle this plan, including considering postponing it.

From a long-range viewpoint, Japan needs to continue making efforts to strengthen its competitive edge in the global market. Manufacturing is the main engine for the Japanese economy. Since Japan is a geographically small country lacking natural resources, research and development of new technologies and the acquisition of industrial skills should be of paramount importance to the government and enterprises.

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