bank of japan ’ s july report of recent economic and financial developments1 bank of japan communication, 21 / 7 / 98. the bank ’ s view2 final demand remains weak and production has declined significantly. employment and income conditions continue to deteriorate, and corporate sentiment is weakening further. as a whole, japan ’ s economic conditions have deteriorated. with respect to final demand, public - sector investment seems to have bottomed out. net exports, which decreased temporarily in the first quarter of 1998, have resumed to increase mainly due to a sharp decline in imports. business fixed investment, however, has decreased significantly, and housing investment remains weak. private consumption has shown little sign of recovery, although the deterioration has stopped. against the background of weak final demand, the level of inventories remains high, and the decline in industrial production is accelerating. as a result, corporate profits have further decreased, and employment and income conditions have deteriorated conspicuously as seen in the fall in wages below the previous year ’ s level. although the above indicates negative interactions of production, income, and expenditure, a further deterioration in the economy is expected to cease as the effects of the comprehensive economic stimulus package, including additional public works and the special income tax reduction, become full scale. however, given the current considerably low level of economic activities, the positive influence of the package on private demand will likely be limited, and the economy ’ s immediate transition to a self - sustained recovery is hardly expected. in these circumstances, measures to rebuild the stability of the financial system have been devised, and the reform of the taxation system is expected to be discussed actively. the materialization of these policies along with the effects on corporate and household sentiment should be carefully monitored. with regard to prices, wholesale prices continue to fall, and consumer prices ( excluding the effects of institutional changes ) have declined slightly below the previous year ’ s level. with respect to the factors affecting the outlook, the downward pressure on domestic prices induced by the decline in import prices is weakening. in addition, the expansion in the output gap in the economy is expected to slow in line with the implementation of the comprehensive economic stimulus package. nevertheless, reflecting the present large output gap, the downward pressure from domestic factors is unlikely to weaken considerably, and hence, prices are likely to be weak for some time. as for financial markets, stock prices and yields on long - term government bonds have rebounded since mid - june 1998. this may be attributed to a slight recovery in market

, however, that compared with many cases of heavily indebted emerging economies that have faced financial problems in the past, china ’ s debt is largely domestic. a considerable portion of that has arisen from state - owned or controlled financial institutions lending to state - owned or state - controlled enterprises, which to some extent allows the problem to be handled within the official “ family ”. 15 moreover, the debt has largely been funded by the household sector, which has sustained a very high rate of saving. although this does not preclude the possibility of substantial disruption in the financial system, it does provide some leeway for authorities attempting to ensure that the financial system remains liquid. the extent of that leeway will potentially depend on the effectiveness of capital controls. but that is a topic for another time. there is a tension between the government maintaining the smooth functioning of financial markets through implicit guarantees of financial institutions, and the problems of moral hazard and inefficient resource allocation that can result. bis central bankers ’ speeches conclusions china ’ s economy has grown at an impressive rate over the past 20 – 25 years or so. however, growth has moderated over recent years and is projected to ease further as the longer - term drivers of that growth recede. moreover, the pattern of development has given rise to significant imbalances. high and rising levels of corporate debt in the face of excess capacity and declining profitability suggests a greater risk of corporate defaults, which could ultimately lead to disruption in the financial system. there have been many positive signals from the leadership about improving the sustainability of growth, including recent calls to implement so - called ‘ supply - side ’ reforms, with a view to facilitating deleveraging in the corporate sector and reducing excess capacity in key industries. nonetheless, the direction of policy so far has tended towards more, rather than less, accommodative monetary and fiscal settings. to the extent that this represents a re - prioritisation of short - term objectives over longer - term sustainability, it may increase the likelihood of a future disruptive adjustment. even so, the authorities will no doubt respond if the economy experiences shocks that might otherwise lead to a so called ‘ hard landing ’ for the economy as a whole. in other words, they are aware of the challenges and have scope to respond if the economy turns out to be much weaker than expected. for australia, the primary risk posed by the uncertain outlook in china is to commodity prices and the exports of goods (