It may come as a bit of a surprise to learn that Japan’s sluggish economy expanded for four straight quarters in calendar 2002. The truth is, though, it expanded only after the effect of deflation, or the continued decline in the prices of goods and services, was applied. The nation’s deflation-adjusted (real) gross domestic product in October through December increased 0.5 percent from the previous quarter, or at an annualized rate of 2 percent, according to the latest GDP report from the Cabinet Office. With real GDP for all of 2002 climbing 0.3 percent, Japan has posted four consecutive calendar years of growth since 1999.

Exports, which surged 4.5 percent quarter to quarter, provided the main thrust of growth, with external demand — exports minus imports — boosting GDP by 0.3 percent. However, foreign sales remain unstable, partly reflecting the prospect of war and the slowing of the U.S. economy. In the previous quarter, July through September, exports contributed negatively, by minus 0.2 percent, to GDP growth.

The main drag on the economy continues to be weak domestic demand. In the October-December quarter, the rate of internal growth dropped to 0.2 percent from 0.9 percent in the previous three-month period. Thus GDP growth needs to be taken with a grain of salt, as the domestic economy is showing increasing signs of weakness.

On the face of it, the government’s growth projections appear closer to reality than private forecasts. As things stand, it is likely that the official 0.9 percent growth target for fiscal 2002 will be achieved even if real GDP for January through March drops as much as 3.3 percent from the previous quarter. If quarter-to-quarter growth rate remains flat, says the government, the annual growth rate will reach 1.7 percent.

On the other hand, most private economic think tanks — which had projected negative growth rates of minus 1 percent for the last quarter — have missed the mark. They had forecast an average 0.7 percent drop in consumer spending, which makes up nearly 60 percent of the GDP. It turns out, however, that consumers spent slightly more, by 0.1 percent, than they did the previous quarter. The Cabinet Office attributes this to better-than-expected spending on video and game machines and on household appliances such as refrigerators, particularly in December.

Business spending on new machinery, another major engine for domestic growth, also increased. Contrary to general forecasts, capital investment expanded 1 percent from the quarter before, contributing positively to GDP growth. But this increase in business investment, along with the unexpected strength in consumer spending, is no assurance that the economy is headed for a steady recovery.

What is worrisome is that nominal GDP — before adjustments for deflation — has continued to shrink. This says more about the state of the economy than does the growth of real GDP. In the last quarter, it declined 0.1 percent from the previous period, or 0.5 percent in annualized terms. In nominal terms, the GDP for all of 2002 shrank 1.4 percent, following a 1.2 percent fall in 2001.

The GDP deflator, which follows general price trends, dropped 2.2 percent in the October-December quarter from the previous three months. The downtrend — which has continued for 19 consecutive quarters since the second quarter of 1998 — has accelerated in recent quarters. This clearly shows that Japan’s economy is falling into a deflationary spiral. In this sense, the four-quarter streak of real GDP expansion — which excludes the deflator — is no cause for celebration.

Consumer spending is key to domestic growth, but prospects are dimming. The rate of growth in services fell markedly, from 0.8 percent to 0.1 percent in the last quarter. In particular, spending on items such as life insurance, sports and recreation, is losing strength. Stepped-up layoffs and pay cuts — the main focus of the current “shunto” spring labor offensive — are also clouding the outlook for private consumption. Moreover, public works investment is already past its peak. Housing investment is also in the dumps.

Externally, too, the economy faces increasingly cloudy prospects. Exports to the United States, the largest market for Japanese products, will likely suffer a severe setback in the event of a war with Iraq, particularly if hostilities last for an extended period. Already world oil prices are edging up. Sharp rises are bound to hurt an economy that depends on the Middle East for most of its oil needs. By all indications, the economy appears headed for more difficult times.

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