Japan's Economy Shrinks In The Second Quarter

The Japanese government's revelation Monday that the economy shrank rather than grew in the April-June quarter highlights the fragility of the recovery of the world's second-biggest economy.

It also will make it hard for the Bank of Japan to justify an interest rate increase in months ahead. The Cabinet Office said Monday it had revised April-June real gross domestic product figures to show a 0.3% decline on quarter, compared with preliminary numbers that showed the economy eked out 0.1% growth. On an annualized basis, that means the economy shrank 1.2% in the second quarter, compared with the preliminary reading that it grew by 0.5%. It was the first contraction in the economy since the July-September quarter of 2006, and also the fastest slide since the January-March period of 2003, when GDP shrank by 0.4% on quarter. The downward revision was the result mainly of a worsened reading of business investment: the new data show it dropped 1.2% on quarter, compared with initial figures that showed it increased 1.2%. A sharp drop in spending in the leasing industry was behind the revision. The revised GDP figures are bad news for Japan's central bank, which has been wanting to lift interest rates to 'normalize' them, that is, bring them more in line with international levels. Only a few months ago, the BOJ looked almost certain to lift the overnight call rate to 0.75% from 0.5% sometime in the summer. Now, weak Japanese economic data, combined with worrying economic signs out of the U.S. and global market woes, indicate that the central bank will have to stay on hold for at least a few months. Market interest rates imply that there is no chance at all the BOJ will lift rates at its policy board meeting this month, and suggest only about a one-third chance that it will tighten policy this year. "The BOJ's basis for taking a forward-looking approach on raising rates early was its assumption that the economy will keep growing," said Kenichi Kawasaki, Lehman Brothers' chief Japan economist. "But the assumption may be about to crumble."

Business Sentiment May Weaken

One worrying sign is that Japan's private demand, which in previous quarters appeared to be rising, is slowing, hurt by sluggish growth in business investment, which has long underpinned growth. Indeed, the revised GDP data showed that domestic demand subtracted 0.3 percentage point from growth, compared with a 0.1 point contribution to growth in the preliminary report. Consumer spending, the biggest part of private demand and 55% of overall GDP, still managed to rise 0.3% on quarter, but that was a slightly slower pace than the preliminary reading of a 0.4% climb. And while analysts say that the sharp drop in capital spending may be due to one-off factors such as skewed samples for smaller firms' investment, they said that capital spending might slow down in coming months. A possible U.S. economic slowdown and global financial market jitters "may dampen business sentiment, which in turn could make Japanese companies reluctant to beef up capital investment further," said Yoshikiyo Shimamine, chief economist at Dai-Ichi Life Research Institute. Business investment may pick up in the high-tech industry because of companies' success at reducing their inventories, but "the possibility can't be ruled out that the economy will face downward pressure across the board," he said. Weakening exports also suggested that a possible decline in exports to the U.S. will likely stand in the way of a recovery in capital spending. Exports were revised down slightly to show a 0.8% rise on quarter compared with a preliminary 0.9% increase. External demand neither added nor subtracted from growth. In spite of the weak economic numbers, Tokyo policy makers moved to reassure markets that Japan's economic fundamentals were firm. "Consumption is continuing to recover, while corporate earnings remain robust. Although the revised GDP data showed a contraction, there is no change in my view that the overall economy will continue to expand," Finance Minister Fukushiro Nukaga told a news conference. Analysts, however, weren't so sure about that, and said the Japanese economy's outlook may depend on how the U.S. economy does and how much longer the market chaos continues.