Third recession in a decade for Tsunami stricken Japan

The economy fell 3.7 % on reduced output and power, said Moody’s.

Last Thursday, the Japanese government reported that Japan’s economy contracted at an annualized rate of 3.7% between January and March, reflecting the severity of the 11 March earthquake and tsunami. The contraction significantly exceeded economists’ forecasts of a 1.9%-2.3% decline, and the downturn will likely persist in the current quarter as well. Following a 3.0% drop in GDP in the October-December 2010 period, the earthquake has resulted in two consecutive quarters of falling GDP and has sent the economy into its third recession in a decade. Moreover, the Cabinet Office revised downward its estimate for fourth-quarter GDP of calendar year 2010. These developments are credit negative in terms of their economic and policy effects.

Reconstruction and relief expenditures will eventually lead to a rebound in economic growth later this year and in 2012. But the scale of the loss in output and income caused by the earthquake may already have lowered the future growth trajectory of the Japanese economy, thwarting Japan’s long-term growth rate, which is currently around 1%.

The shock from cutbacks in the electrical power supply in the greater Tokyo region will be temporary, but the risk of a permanent loss of global market share by Japanese companies encountering supply chain disruptions is more damaging. Moreover, private consumption has been depressed by the earthquake and is exacerbating deflationary pressures on the economy. In nominal terms, GDP shrank an annualized 5.2% in first-quarter 2011. In the past decade, it was only during the global financial crisis of 2008-09 and the recession of 2001 that the Japanese economy contracted more.

The worse-than-expected drop in GDP adds urgency to Prime Minister Naoto Kan’s plan to introduce a second supplemental budget for reconstruction, which will likely need to be much larger than the first one. The Diet early this month approved an initial ¥4 trillion yen (0.8% of GDP) supplemental budget. However, Mr. Kan will need to overcome discord within the ruling Democratic Party and gain cooperation from the opposition Liberal Democratic Party, which can impede legislation through its control of the Upper House.

Another uncertainty overshadowing Japan’s fiscal outlook is the extent to which the government will share the burden of Tokyo Electric Power’s rising earthquake-related liabilities. The Bank of Japan, for the time being, has refrained from further augmenting its post-quake liquidity and asset-purchase program. Should the rebound in Japan’s economy be weaker than forecast or delayed entirely, additional actions by both the Ministry of Finance and Bank of Japan may be needed.