The main culprit for this startling downgrade in the country's prospects is the yen's appreciation. It hit a peak of 79.85 against the dollar in April, hitting exports and sending Japanese manufacturers flocking to expand production in cheaper Asian countries.
The IMF estimates that foreign currency losses on overseas investments of $400bn between 1980 and the present - most since 1993 - triggered a vicious cycle of the repatriation of funds and further yen appreciation, which led to further losses on foreign assets. The huge misalignment in the exchange rate that this produced has been successfully reversed since the last G7 meeting in April.
Michael Mussa, IMF economic counsellor, said yesterday: ''If anything, the dollar is a little bit on the weak side but we would not be saying now that there is a serious misalignment of the type that existed earlier." The analysis is likely to increase the determination of G7 finance ministers, meeting on Saturday, to keep the yen close to its present level.
Mr Mussa also gave credit to the Japanese for relaxing both monetary and fiscal policy. The newly published IMF forecast does not take account of the 20 September supplementary Budget package, worth $150bn. He said the predicted recovery from 0.5 per cent growth in 1995 to a 2.2 per cent expansion in GDP next year could be an under-estimate. Even so, it will be weaker than normal for Japan, where growth would be 4 to 8 per cent at the same stage of the cycle in less troubled times.
There are two particular challenges identified by the IMF. One is the need to take further action to close or merge insolvent financial institutions, although the Fund has welcomed the public failure of two credit unions this year - the first since 1926 - as a healthy sign of realism. The other is the need to continue to deregulate the economy. Resources in the economy are not used as efficiently as they might be because of over- regulation.