Japan economy shrinks at fastest rate since Second World War

The Japanese economy shrank by 4 per cent in the first three months of the year – the fastest rate of decline since the Second World War, and an annualised fall in GDP of almost 16 per cent.

However, historic as the numbers are, the markets had been expecting a still-worse reading, and in Tokyo equities and the yen shrugged off the news. Having seen the humbling of such national champions as Toyota, Hitachi and Sony in recent weeks, the fear had been that the Japanese recession would turn into a much more severe slump. Japanese consumers seem especially fearful about job security, according to economists, as consumption fell 3.5 per cent in the quarter, adding to the misery being experienced by exporters, who saw their sales plummet by 26 per cent in the period.

Ben Eldred of Daiwa Securities commented: "Sustained recovery remains some way off and will be heavily reliant on a pick-up in external demand. In the meantime, Japan looks set for a return to persistent deflation."

However, the IMF, completing routine talks with the Japanese authorities, expressed some optimism for the world's second largest economy. The fund said that Japanese fiscal policy should "remain flexible" in the light of the risks of deflation and asked the Bank of Japan to ease monetary conditions still further if needs be: Japan's stimulus spending is sizable at almost 5 per cent of GDP – well above the G20 average – and additional stimulus could be provided "should the recession persist longer than expected", the IMF said. The Japanese Prime Minister, Taro Aso, suggested to parliament that that was precisely what his government intended to do: "Weakness in the corporate sector is gradually spreading to households... This is a very serious situation, so we need to respond appropriately."

Most analysts now expect the Japanese economy to return to growth as soon as the end of this quarter, leaving the economy to shrink by about 6 per cent over the course of 2009. The IMF repeated its forecast of a 6.25 per cent contraction.

Such an outturn is still grave, however, and reflects the way that the collapse in global demand and trade, especially for consumer goods such as cars, has affected major manufacturing and exporting nations such as Japan and Germany, which last week reported a similar decline in GDP. Japan has been badly affected by these trends, and has also had to deal with a resurgent yen, a currency now looking overvalued on fundamentals, according to most economists. By contrast the UK and US only retreated by 1.9 and 1.6 per cent respectively in the early part of this year.

Longer term, the fund again noted the structural weaknesses in the Japanese economy, such as its critically ageing workforce, which is exacerbating her difficult public finances. Fewer Japanese of working age and relatively generous welfare and pension provisions are adding to the debt the nation racked up over the past 20 years as successive governments tried – and failed – to stimulate the domestic economy through public spending and tax cuts.

Japan's national debt approaches 200 per cent of GDP, by far the highest among the G7 nations. The IMF yesterday recommended "expenditure measures and comprehensive tax reforms, including a commitment to raise the consumption tax after the recovery takes hold".