Extra budget now focus for Japan

By CNN's Alex Frew McMillan

TOKYO, Japan (CNN) -- Prime Minister Junichiro Koizumi ordered his cabinet on Friday to prepare a supplementary budget to help the world's second-biggest economy.

But he stuck by his promise to limit government spending to 30 trillion yen a year in fiscal 2001 and 2002.

Koizumi has made cutting public spending a cornerstone of his reforms. He also promises to push Japan's banks to deal with their bad loans problem and to revamp Japan's state corporations.

But Japan's poor showing in the second quarter, which saw its gross domestic product shrink 0.8 percent, throws those reforms into question. Experts say now may not be the time to push them.

The extra budget will come later and likely be smaller than normal. Japan watchers wonder whether that's the right way to resuscitate the world's second-largest economy.

"Koizumi is wedded to the idea that fiscal reform is a form of reform … and that he's going to deliver reforms, come hell or high water. And it may well come to that," said James Malcolm, senior economist with J.P. Morgan.

A "balancing act"

Koizumi's vaunted reforms are likely to lead to higher unemployment and bankruptcies. Japan is already battling record unemployment, now at 5.0 percent, as well as a steepening of its already decade-long economic decline.

Against that background, many economists say Japan needs help now, in the form of government spending. Though Koizumi's plans are ultimately good ideas, Japan watchers say the leader has to tread carefully to avoid deepening Japan's slump.

"It's a balancing act really," said Jason Rogers, head of credit research at Barclays Capital. "There are a lot of deflationary pressures out there that are making things a lot worse."

On a grand scale, it's easy to keep pushing reform, Rogers said. But Koizumi is finding it very hard to get to specifics. Friday's GDP figures don't help, confirming that Japan is very weak.

"It makes it very difficult to be optimistic about Japan's prospects over the next few months," Rogers said.

Debate into November

Koizumi's cabinet is expected to push for 2.2 trillion yen (about $18.6 billion) in extra spending, in the supplementary budget. The exact size will be shaped in debate expected to run into November.

Finance Minister Masajuro Shiokawa promised after the GDP figures that it would break from tradition.

"We hope the public will understand that the government will not compile a traditional form of supplementary budget," Shiokawa said. "The extra budget will not focus on public-works spending."

Instead, it is likely to target job creation and ways to spur new businesses. Koizumi is expected to outline the plan on Sept. 14.

After that, there's plenty of room for political wrangling. Koizumi's Economics Minister, Heizo Takenaka, has frequently contradicted his prime minister by saying the 30 trillion yen bond cap may need to be raised.

He did so again Friday.

"If Japan faces a spiral of economic contraction, the issue of the 30 trillion yen cap will be discussed in a separate dimension," he said.

Japan has already mapped out plans to sell 28.3 trillion yen in government bonds this year. That leaves little room to maneuver.

Takenaka also said Japan likely needs to revise its growth forecast. Economists say it has no hope of hitting the 1.7 pecent official estimate for this year.

With U.S. demand showing no signs of recovery, and most areas of the Japanese economy looking weak, the government has little option but to fall back on spending to help out.

"There's very few other areas where you get support in Japan at the moment," Malcolm said. Interest rates are basically at zero.

The confusion over where reforms are heading muddies the water for investors. They drove down Japanese stocks on Friday after the growth figures and the officials' comments on the budget.

The Nikkei was trading down 1.6 percent at 10,482.37. It could break the 10,000 barrier soon, experts say.

"I think what the market wants are decisive, clear-cut moves," Rogers said. "So far, [Japan] is falling short."