Japan's economy shrank slightly in the final quarter of 2010 but analysts expect a recovery this year as stronger exports to China and other parts of fast-growing Asia offset persistently weak domestic demand.

The data confirmed Japan lost its place to China last year as the world's second-largest economy and highlighted Tokyo's increasing reliance on its giant neighbor, which buys nearly a fifth of Japan's exports.

Gross domestic product (GDP) shrank 0.3 percent in the October-December period from the previous quarter, slightly less than a 0.5 percent fall expected by markets but still the first contraction in five quarters.

That translated into an annualized contraction of 1.1 percent, with analysts largely blaming the weakness on a temporary hit to consumption after the September expiry of government incentives to buy low-emission cars.

The data showed Japan's economy was the weakest among major rich nations, compared with annualized growth of 3.2 percent in the United States in the same quarter. European data due out on Tuesday is expected to show slight growth in the 17-nation euro zone.

The data confirms that the economy entered a lull on a downturn in private consumption, but recent monthly economic indicators such as output and exports show it is unlikely that the lull will be prolonged, said Yoshiki Shinke, senior economist at Dai-ichi Life Research Institute.

The economy will continue to depend on external demand for growth, as domestic demand is likely to be capped by subdued income growth and the anticipated negative impact from the expiry of subsidies for energy-efficient electrical appliances.


The latest GDP figures confirmed analysts' estimates that China pulled ahead of Japan in 2010 as the world's second-biggest economy behind the United States on a seasonally unadjusted, nominal dollar basis, at $5.8786 trillion against $5.4742 trillion.

Economics Minister Kaoru Yosano said Japan needed to make the most of China's growth to boost its own fortunes, as it increasingly relies on demand from its Asian neighbor.

The fact that China's economy is booming is welcome news for Japan as a neighboring country, Yosano told reporters after the release of the data. We want to deepen the amicable economic relationship between Japan and China.

Japan's shipments to mainland China accounted for 19.4 percent of its overall exports last year, making it the No.1 destination for Japanese goods, followed by the United States at about 15.4 percent.

The signs of an export-led recovery prompted the government to upgrade its economic assessment last month and dampened expectations of any imminent monetary easing by the Bank of Japan.

BOJ policymakers meeting this Monday and Tuesday may see no immediate need to ease policy further through an increase of asset purchases and may instead focus on assessing the strength of the recovery.

While recent data showed exports and industrial output rose more than expected in December, a pick-up in the corporate sector is seen unlikely to spill over to personal consumption, which makes up about 60 percent of GDP.

Capital expenditure rose 0.9 percent from the previous quarter, slower than the 1.5 percent pace of gains in July-September.

Analysts said the increase in capital spending may not lead to stronger consumer spending as companies remain reluctant to boost wages due to fierce global competition, and as workers put a higher priority on job security than wage hikes.

The roll-back of government incentives for purchases of energy-efficient household electronics in December will also weigh on private consumption, which fell 0.7 percent from the previous quarter after a 0.9 percent increase in July-September.

External demand, or net exports, shaved 0.1 percentage point off GDP, with the yen's spike to a 15-year high against the dollar during the period hurting exports.


As the economy remains mired in stubborn deflation, the BOJ is in no position to roll back its comprehensive easing anytime soon. That is in stark contrast with policymakers in other parts of Asia, Europe and elsewhere where the focus is shifting from supporting sustainable recoveries to controlling inflation.

China raised interest rates last week for the second time in just over six weeks and further policy tightening is expected from Beijing in the coming months, raising the prospect of a slowdown in Chinese demand for everything from imported electronics to construction equipment and cars.

Nissan Motor Co, Japan's No.2 automaker, raised its annual profit and sales forecasts last week as its big drive into emerging markets such as China pays off.

But with Japan's domestic demand expected to remain weak, a heavy reliance on exports to fuel recovery is expected to pose a risk if external demand stumbles.

Risks from overseas economies and currency moves need to be closely watched, Economics Minister Yosano said, noting that financial markets were also monitoring the government's ability to enact legislation in a divided parliament.

Highlighting concerns about prolonged political paralysis, a Kyodo news agency survey showed support for Prime Minister Naoto Kan's government had fallen below 20 percent, a level where some premiers have been nudged out of power in the past.

(Editing by Edmund Klamann and Kim Coghill.)