The economy recovered during the first half of 2002, underpinned by a low level of inventories and a sharp increase in exports. However, these factors have already weakened and, with domestic demand likely to be constrained by flat household incomes, real GDP growth is projected to ease to around 1 per cent during the rest of the year and to continue at that rate in 2003 and 2004. Financial sector strains, the need to issue a large volume of public debt without pushing up interest rates, and the possibility that deflationary forces could strengthen represent major downside risks to the projection.

The resolution of non-performing loans should be accelerated in line with the government’s new goal, accompanied by further structural reforms and if necessary by the direct injection of public funds. Monetary policy should take the lead in dealing with deflation by increasing liquidity further through the purchase of a wider range of financial assets. While the fiscal stance should for the moment remain neutral, it will also need to be sensitive to the speed and scale of the resolution of bad debts. Fiscal policy must now be placed in a medium-term consolidation framework going beyond the government's present plan and incorporating relatively short-term targets for real expenditures.