Dec. 12 (Bloomberg) -- Japan's economy is headed for a ``mild recession'' that could be worsened should a bigger-than- expected U.S. slowdown halt the nation's export-led expansion, Morgan Stanley said.

``It's time to buckle up,'' Takehiro Sato, chief Japan economist at the investment bank, said in a report yesterday. Sato cut next year's growth estimate for Japan in half, saying ``errant'' government policy has hurt consumers and the building industry at home, and credit problems stemming from the subprime- mortgage crisis will stifle demand from abroad.

The world's second-largest economy is becoming more dependent on overseas markets just as world growth looks set to slow. Policies meant to protect homeowners from building fraud and borrowers from predatory lenders have hurt an economy that's already struggling with falling wages and record gas prices.

``The foreign-demand growth scenario for Japan's economy appears to be approaching a tipping point,'' Sato said. ``Coming on top of high energy prices, the fallout from the subprime crisis and errant policies will likely cause economic activity to stagnate.''

Sato slashed his 2008 growth estimate to 0.9 percent from 1.9 percent a month ago. He considers growth of less than 1 percent ``for an extended period,'' to constitute a ``mild recession.''

A U.S. recession, combined with higher oil prices and yen gains could cause Japan's growth to ``slide to zero,'' he said, giving that scenario a one-in-three chance.

Reports last week suggest Japan's expansion is already cooling.

Energy Costs

The economy grew more slowly than the government initially estimated in the third quarter and profits fell for the first time in five years because higher energy costs wiped out margins at small and mid-sized companies, where 70 percent of Japan's workers are employed.

Rising raw material costs already make it ``tough for firms to pay higher wages,'' Sato said. Consumer confidence plunged to the lowest level in almost four years in November, the government said yesterday.

The Bank of Japan's quarterly Tankan business survey on Dec. 14 will probably show a drop in sentiment of large manufacturers for the first time since March, according to economists surveyed by Bloomberg News.

Exports, led by shipments to Europe and China, accounted for almost all of the country's annualized 1.5 percent growth in the three months ended Sept. 30.

Government Regulation

Housing starts plunged 35 percent in October and fell to 40- year lows in the previous two month, after the Land Ministry tightened rules for building permits, causing a log-jam in applications. The change was made after architect Hidetsugu Aneha in 2005 admitted to skimping on steel in dozens of hotels and condominiums.

Other well-intended regulations capping the interest rates that consumer-finance companies can charge and requiring banks to be more thorough in explaining the risks of mutual fund investment have also taken a toll on growth, Sato said.

``Just to be clear, we don't think the objectives of these policies is misguided, but hasty moves by bureaucrats to implement such laws, without regard for the economy, have had a considerable impact,'' he said.

Slower growth will prompt the Bank of Japan to postpone raising the benchmark interest rate from 0.5 percent until the third quarter of 2009 and increases the risk of a cut, Sato said.

``A rate cut is a bigger risk than a hike,'' he said. The bank will keep its key rate, the lowest among major economies, on hold until the second quarter of 2008, according to 21 of 30 economists surveyed by a government think tank.

To contact the reporter on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net

Last Updated: December 11, 2007 18:48 EST