The world’s second-biggest economy may be teetering on the brink of what the Japanese call kansei fukyo, a “recession brought about by government policy error”, that has crushed activity in the construction sector and threatens to drive hundreds of small firms into bankruptcy.

The warning, issued by a senior Morgan Stanley economist, came as the Japanese Government slashed its growth forecasts for the current fiscal year because of the effects of its own laws.

Japan had previously expected 2.1 per cent GDP growth for the year ending in March 2008.

However, the Cabinet Office said yesterday that the expansion would be only 1.3 per cent.

Takehiro Sato, of Morgan Stanley, added that there was now even a scenario in which Japan might return to zero interest rates — the unorthodox policy to which the Bank of Japan clung for six years and from which the country exited only 18 months ago.

Projections that the economy would be bolstered by exports and capital investment and grow at 2.0 per cent in fiscal 2008 were greeted with extreme skepticism by investors.

The Nikkei 225 Index of leading Japanese blue chips took a 177-point nosedive to close only 30 points above the key 15,000 level.

The grim contraction of Japan’s growth outlook follows the implementation this year of a draconian building standards law — a set of poorly explained rules that have caused a significant plunge in housing starts and a bottleneck for new building projects.

The law was made in response to a 2005 scandal in which quake-proofing data was fabricated by a high-profile architect.

The Government’s legislation, which has already triggered a wave of bankruptcies among small construction firms, is viewed by many as a massive overreaction to the scandal.

Housing investment is expected to plummet 12.7 per cent in the current year.

Despite bullish government predictions of a rebound, however, Lehman Brothers economists said that much of the damage to the construction sector might well be semi-permanent.

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