Japan: Contraction in the cards

Japan: Contraction in the cards

Japan: Contraction in the cards

Asia Pacific Economic Outlook, October 2012

Despite a significant upward revision to Q1 GDP growth, the outlook for the Japanese economy has not improved, and the economy shows signs of contracting in the third quarter of 2012.

Japan’s economy has decelerated sharply since the beginning of the year. While GDP growth came in at an impressive 5.5 percent in the first quarter of the year, it declined to an annualized rate of just 1.4 percent in Q2 2012. Moreover, manufacturing sentiment declined in the three months to September, and it is likely to deteriorate further. Meanwhile, export-oriented industries continue to struggle, owing to weak external demand. Amid persistent economic challenges, Japan’s economy is likely to contract in the coming quarter.

There are several reasons for Japan’s economic challenges. A fragile recovery in the United States, persistent sovereign debt problems in Europe, and economic deceleration in China have dampened Japan’s export sector. In addition, a stronger yen is taking its toll on the competitiveness of Japanese exporters. Moreover, consumer spending, which makes up over half of Japan’s GDP, has moderated and is unlikely to offset the decline in external demand. While reconstruction activity was one of the main drivers of growth during the first quarter, its impact on the economy is expected to recede in the coming quarters. Finally, weak business investment and lackluster job growth do not augur well for the country’s growth prospects. As a result, policy makers are likely to face tough choices, and the Bank of Japan’s (BoJ) monetary policy could play a major role in influencing the country’s economic wellbeing.

Following in the footsteps of the ECB and the U.S. Federal Reserve, the BoJ eased its monetary policy by adding 10 trillion yen to its asset purchase program. The announcement came as a surprise because the expansion of the program will not take effect until 2013. It appears that the BoJ intends to convey a strong signal regarding its commitment to revive the economy amid widespread weakness. However, previous rounds of quantitative easing have not had their anticipated impact. Meanwhile, the BoJ will stick to its current policy stance, purchase 5 trillion yen worth of securities by the end of the year, and maintain its policy rate between 0 and 0.1 percent. Furthermore, the deputy governor of the BoJ reiterated that the central bank is willing to take additional steps to ease monetary policy and adopt a flexible approach in order to assist growth. Japan’s economy is far from attaining its inflation target of 1 percent in 2012, and adding to the asset purchase program could help spur consumption by pushing up inflation expectations. Finally, additional liquidity may result in a currency devaluation, which would favor the country’s export-dependent industries.

Meanwhile, Japan registered a $9.6 billion trade deficit in August because of slower exports to Europe and China. The trade balance remained in the red for the second month in a row. Exports fell for the third consecutive month, declining by 5.8 percent year-over-year, and imports lost 5.4 percent due to a recent slide in oil prices, marking the sharpest decline in nearly three years. While the auto sector output is likely to decline for the third straight month, industrial output is also expected to post a decline in August. BoJ’ s forthcoming tankan survey is likely to indicate a weaker outlook for the manufacturing sector, which is experiencing declining sentiment amid expectations that Japan’s economy could stall over the rest of the year.  In addition, recent friction with China over the ownership of the Senkakus islands is also likely to cast a shadow on trade relations between the two countries. Overall, weak external demand is likely to constrain exports and growth in the near term.

The economy decelerated sharper than expected in the second quarter, and it could slump further.

Japan’s decelerating economy and its deflationary environment pose a significant challenge for the country. While GDP growth surprised on the upside in Q1 2012, the sustainability of the recovery was a concern. The economy decelerated sharper than expected in the second quarter, and it could slump further. Growth forecasts for 2012 range between 1.8 and 2.2 percent, and downside risks persist. While the central bank has adopted an aggressive monetary stance, Japan’s recovery hinges precariously on the external environment.

Japan: Contraction in the cards
Cover Image by Stephanie Dalton
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