The report, prepared by the Economic Planning Agency, said the economy remained stagnant and that its condition was becoming more severe.

"The economy has lost speed, affected by the Asia crisis and a loss of trust in the financial system from various bank failures since autumn. It now remains stagnant and is becoming severe," it said.

The report said hopes of a gradual recovery from the effects of an increase in the national sales tax and the termination of special tax cuts faded in late 1997, as sluggish domestic demand, and the cautious lending stance of banks, dampened capital investment and triggered production adjustments that affected employment.

Seiji Shimpo, director-general of the EPA's research bureau, said failures of large financial firms had raised fears of unemployment, while exports, which hadbeen a strong support for the economy, had fallen off due to economic troubles in Asia. The report cast doubt on the effectiveness of expansionary fiscal policy and added that Japan's easy monetary policy had failed to put the economy on a sustainable recovery track, although both helped to support the economy.

Shimpo said, "We're in a confidence crisis. Our system is in a state of fatigue and is not working properly. The biggest problem is the financial system."

In the short term, the government's economic stimulus steps and plans to stabilise the financial system should lift the economy from the end of 1997 and the start of the new fiscal year next April, the report said.

The economic stimulus plan should also help prevent Japan from falling into a deflationary spiral, it said.

"But for these measures to lead to a continued recovery-based on private demand, we need deregulation, a fair and transparent tax system and financial reforms which would offer incentives for the public and for companies,"the report said. Economic structural reforms, such as deregulation in areas of growth like telecommunications, are needed to boost production and develop new technologies, it said.

Japan should also consider changes in income tax and corporate tax that would offer incentives, promote science and technology and nurture venture businesses, it said.

Japanese banks, burdened by problem loans built up during the `bubble' economic era of the late 1980s, must dispose of their bad loans quickly and restructure their businesses while interest rates were low, so ample funds could be channelled to smaller firms and venture businesses, it said.

Shimpo said: "We took too much time to realise that there will be no real recovery until we dispose of problem loans and reform the financial system."

The report said the government must also ensure the success of "Big Bang" financial reforms to create an efficient, transparent and fair system that would offer firms more options in fund management.

It also stressed theimportance of long-term social reforms, such as reduction of state debt so the government could maintain pension payments and welfare services.

The report denied Japan was in a liquidity trap, in which interest rates do not fall despite increases in money supply, saying overnight call rates had fallen from around December to the end of March period in line with ample fund injections from the Bank of Japan.

"A liquidity trap becomes an issue when rates do not fall despite increases in money supply and thus become unable to affect investments. But...theoretically speaking, there is still some room for further rate falls," it said.

On Asia, the annual report said the yen's recent weakness against the dollar should not worsen the region's economic troubles.

The yen was still strong against other Asian currencies, and imports from Asia to Japan were not easily affected by foreign exchange rate fluctuations, it said.

It added that Japanese products do not necessarily compete with those of neighbouringcountries in the global market.