Recession Risks Are Contagious As Japan’s GDP Stumbles—Again

Japan’s economy shrank…Typing these words is maddeningly familiar for long-time Tokyo journalists. After 20 years of deflation, zero interest rates and countless recessions and false dawns, news Asia’s No. 2 contracted in the first quarter comes with an inevitable well-here-we-go-again vibe.

Yet this time, things really are different for Prime Minister Fumio Kishida and his Liberal Democratic Party. Using these, the five most dangerous words in economics, is always dicey. There’s nothing familiar, though, about where Japan finds itself barely five months into a bewilderingly uncertain year.

That wholesale inflation jumped 10% from a year ago in April, the biggest surge in 41 years, is shock enough. Coming amidst a 1% annualized contraction in gross domestic product in the January-March period makes the magnitude and suddenness of this price boom all the more sobering.

The real wake-up call here is how little Kishida and Bank of Japan Governor Haruhiko Kuroda can do about it.

Fiscal policy options are greatly limited by a debt-to-GDP ratio well above 250%, making Tokyo quite the outlier among Group of Seven nations. In fact, the zeros are almost getting too numerous to type out here. In the fiscal year that ended in March, the balance of long-term Japanese government debt topped 1,000 trillion yen, or $7.7 trillion, for the first time.

Monetary options are arguably even more limited. Though interest rates have been at zero since 2000, Kuroda spent the last nine years turbocharging the BOJ’s experiment with quantitative easing. The plan was to drive the yen lower to boost exports and corporate profits.

That, in many ways, is now coming back to haunt Japan’s present. Since Jan. 1, the yen is down more than 12% versus the dollar. At a more perfect moment for global trade, this would have champagne corks popping all around Tokyo. But with global supply chains in turmoil and Russia’s Ukraine invasion raising commodity prices, a falling yen is having disastrous effects.

In a less precarious global moment, Kuroda’s BOJ would be tapping on the brakes. It would be withdrawing stimulus to get a handle on inflation and signal “we’re on top of risks” to jittery global markets. After 20 years of free money, though, that could slam the stock market and spook bond traders.

“Higher bond yields will make it harder for Japan to stabilize or reduce its public debt/GDP ratio,” notes Fitch Ratings analyst Krisjanis Krustins. He adds that “the effects of inflation on fiscal dynamics, growth and monetary policy in the medium-term are uncertain and there is a risk of outcomes that would damage Japan’s creditworthiness.”

So, the extreme risk of a BOJ misstep is another way things really are different this time.

One underappreciated problem is monetary addiction. It’s been two decades since politicians, corporate CEOs, bankers, households or investors have had to worry about the BOJ closing the liquidity spigot. Japan really is the economic equivalent of an athlete that long relied on steroids forced to figure out how to thrive without performance-enhancing substances.

Another problem: Japan’s biggest export markets are sputtering, too. That means all its main growth drivers are shifting into neutral, at best.

China, Japan’s top market, may grow as little as 2% this year, according to Capital Economics. That’s less than half Beijing’s 5.5% target. Where China goes these days, so too does export-reliant Southeast Asia. Recession talk is gaining momentum in the U.S., while headwinds are bearing down on Europe from all angles.

That leaves domestic demand. Trouble is, years of ultraloose BOJ policies and yen weakness haven’t given workers the sizable raises a succession of government had hoped. Since 2013, when Kuroda took the top BOJ job, the plan was to unleash a virtuous cycle of wage and consumption gains. Things never gelled.

Now that inflation is arriving, it’s hitting the land of flatlining living standards at arguably the very worst moment. The blow to consumer and business confidence is sure to exact some collateral damage all its own.

Along with the first quarter contraction, government statisticians downgraded the economy’s performance in the October-December period. This amounts to a six-month period in which Japan is lagging global peers in returning to pre-Covid GDP levels.

The good news, perhaps, is that Japan is beginning to reopen its borders to tourism. That, along with a recently passed $21 billion supplementary budget, explains why some analysts expect GDP to stabilize in the months ahead. The bad news is that both Kishida and Kuroda have very few options to avoid a recession that may be all but inevitable.