The collapse in global trade has contributed to the nosedive in Japanese GDP over the past two quarters. Although the economy probably won't continue to contract at a double-digit pace, any upturn in Japan will need to await stronger export growth. We believe that Japan will remain in recession for most of 2009.

Nosedive in Exports Helps to Pull Down Japanese GDP

Real GDP in Japan plunged at an annualized rate of 15.2 percent in the first quarter relative to the previous quarter (see top chart). Japan changed its GDP methodology in 1994 so comparisons with prior years are not strictly comparable. That said, the nosedive in GDP in the first quarter appears to be the steepest decline on record, Moreover, the unprecedented drop in real GDP in the first quarter follows three previous quarterly contractions that leave the Japanese economy 9.1 percent smaller than it was last year at this time. If a nine percent drop in GDP does not qualify for depression status, it surely is close to it.

Why has the Japanese economy been hammered so badly in recent quarters? After all, there was not a housing bubble in Japan like in the United States or the United Kingdom that are suffering through there own deep recessions. Rather, net exports have been an important driver of Japanese GDP growth over the past few years. The collapse in global trade, which was exacerbated by the virtual disappearance of trade finance last autumn as credit markets seized up, has imparted a sizeable negative shock to the Japanese economy. Indeed, real exports of goods and services plunged at an eye-popping annualized rate of 70 percent in the first quarter. The sharp drop in real net exports accounted for 6.6 percentage points of the 15.2 percent decline in real GDP in the first quarter.

However, real net exports were not the only reason the Japanese economy was so weak in the first quarter. Non-residential investment spending tanked-it fell at an annualized rate of 35 percent-and consumer spending declined about 4 percent. The only bright spot was the slowdown in inventory accumulation relative to the previous quarter. That said, stocks were not actually liquidated in the first quarter.

We project that the Japanese economy will continue to contract throughout most of 2009, albeit less rapidly than over the past two quarters. For starters, inventory liquidation likely will drag on growth for the next quarter or two. Moreover, in our view, any economic recovery in Japan likely will be driven by exports, at least initially. Most major economies have not yet started to grow again. Although Japanese exports may not collapse further, they are not likely to grow strongly anytime soon. Until the rest of the world starts to recover, which probably won't be until later this year, the Japanese economy likely will remain in recession. Therefore, we project that the Japanese yen will depreciate modestly versus the dollar and most other major currencies in the quarters ahead. Not only will the reduction in risk aversion reduce the safe-haven appeal of the yen, but low rates of return on Japanese assets should induce capital to leave the country.