Japan’s economy is on the brink of recession again, and is unlikely to experience a meaningful recovery for the next several years, say TD economists in their latest report, “Tokyo, We Have a Problem”.

“Real GDP in Japan is expected to shrink this year, as critically important fiscal and financial sector reforms put more pressure on an economy already buckling under a fresh downturn in domestic and external demand,” says Gillian Manning, Economist at TD Bank Financial Group.

“Although the Japanese government and the Bank of Japan have come under pressure at home and abroad to take more vigorous action to stimulate the economy, the scope for monetary and fiscal policy to produce a sustained revival in domestic demand is limited in the near term.”

Since the collapse of an asset price bubble in the late 1980s, Japan’s economy has languished, periodically showing signs of recovery, only to suffer a subsequent relapse. Real GDP growth contracted again in the first quarter of 2001, and the economy appears likely to shrink for at least another quarter.

“In addition to the longstanding weakness of the consumer sector, Japan is being sideswiped by the slowdown in global economic growth, which is constraining exports and business investment — two key drivers of last year’s modest growth,” notes Manning. “Confirming the severity of the deterioration, the Japanese government has now joined the Bank of Japan in downgrading its outlook for the economy, indicating late last week that economic growth in Japan would likely average less than 1 per cent for the next two to three years.”

Falling prices continue to hurt the economy. “Deflation encourages consumers to defer spending, it cuts into firms’ profit margins, and it makes debt burdens more onerous — in every case, exacerbating existing points of weakness in the Japanese economy,” observes Manning.

TD says the long, slow process of corporate and banking sector reform in Japan kicked into higher gear this spring, but even this will cause short-term pain. “Although this marks an important step forward in restoring the health and vitality of Japan’s corporate sector, it will boost corporate bankruptcies in the near-term. And that’s creating more problems for Japan’s banks, which are still awash in bad loans – in spite of having written off more than twice their operating profits’ worth over the last eight years,” says Manning.

TD notes that Japan remains the second largest economy in the industrialized world, and still boasts many of the fundamentals to support an eventual economic recovery, including a skilled workforce, a modern and competitive export sector, and a strong external liquidity position. However, it says that recovery is still several years away.

According to Manning, “The impact of a near-term recession in Japan on the rest of the world is likely to be similarly well-contained, and will not prevent an upswing in global growth once a U.S. recovery takes hold later this year. Rather, the world economy will further reduce its reliance on Japan, shifting its attention to other markets, while the Japanese economy makes its long, slow journey back to health.”