Japan has lost its spot as the world’s third-largest economy to Germany, after slipping into recession in 2023. The country’s GDP in dollar terms fell to $4.2 trillion, compared with $4.5 trillion for Germany, according to data released on Thursday. Japan’s economy contracted by 0.1% in the fourth quarter of 2023, following a revised 0.8% decline in the previous quarter, due to weak consumer and business spending.
What went wrong for Japan?
Japan’s economy has been struggling with a number of challenges, including a weak yen, an ageing and shrinking population, low productivity growth, and rising energy costs. The yen’s depreciation against the dollar over the past two years has eroded the value of Japan’s exports, which account for about 16% of its GDP. The country’s population has been declining since 2011, and is expected to shrink by more than 20% by 2050, reducing the size of the labor force and domestic demand. Japan also faces a low birthrate, which has not been boosted by government policies to encourage more women to work and have children. Japan’s productivity growth has lagged behind other advanced economies, partly due to rigid labor markets, low innovation, and barriers to foreign investment. Japan also relies heavily on imported fossil fuels for its energy needs, which makes it vulnerable to price fluctuations and geopolitical tensions.
How the weak yen hurt
The yen has lost about 19% of its value against the dollar since 2022, reaching a low of 125 yen per dollar in December 2023. This has made Japanese goods cheaper on the international market, boosting the competitiveness of exporters such as Toyota, Sony, and Panasonic. However, it has also increased the cost of importing raw materials and energy, which account for about 15% of Japan’s GDP. Moreover, the weak yen has not translated into higher profits for many firms, as they have hedged their currency exposure or kept their overseas earnings abroad. The weak yen has also contributed to higher inflation, which reached 1.5% in 2023, eroding the purchasing power of consumers and businesses.
How demographic decline affected Japan
Japan’s population peaked at 127.8 million in 2011 and has been declining ever since. According to the latest projections by the National Institute of Population and Social Security Research, Japan’s population will fall to 105.6 million by 2050 and 88 million by 2100. This means that Japan will lose about a third of its population in this century. The main drivers of this decline are a low birthrate and an ageing population. Japan’s total fertility rate – the average number of children a woman has in her lifetime – was 1.36 in 2023, well below the replacement level of 2.1. Japan also has the highest life expectancy in the world, at 84.5 years in 2023, meaning that more people are living longer and requiring more health care and social services. Japan’s old-age dependency ratio – the ratio of people aged 65 and over to those aged 15-64 – was 48% in 2023, the highest among OECD countries. This puts a heavy burden on the working-age population to support the elderly through taxes and social security contributions.
How productivity lagged behind in Japan
Japan’s productivity growth has been sluggish for decades, partly due to structural factors such as rigid labor markets, low innovation, and barriers to foreign investment. Japan’s labor productivity – the amount of output produced per hour of work – was $51 in 2023, compared with $68 for Germany and $76 for the United States, according to OECD data. Japan’s labor market is characterized by a dual structure, where regular workers enjoy high wages and job security, while non-regular workers face low wages and precarious employment conditions. This reduces labor mobility and incentives for skill development. Japan also ranks low in terms of innovation indicators such as research and development spending, patent applications, and venture capital investment. Japan’s business environment is hampered by complex regulations, high corporate taxes, and low openness to foreign trade and investment.
How energy dependence hurt Japan
Japan is one of the world’s largest energy consumers, but it produces only about 10% of its own energy needs domestically. The rest is imported from abroad, mainly from the Middle East and Australia. Japan relies heavily on fossil fuels such as oil, coal, and natural gas for its electricity generation and transportation sectors. These fuels are subject to price volatility and supply disruptions due to geopolitical events or natural disasters. Japan also faces environmental challenges such as greenhouse gas emissions and air pollution from burning fossil fuels. Japan’s nuclear power industry, which used to provide about 30% of its electricity before the 2011 Fukushima disaster, has been largely shut down due to safety concerns and public opposition. Only nine out of 54 reactors were operating as of February 2024, and the prospects for restarting the others remain uncertain.
What can Japan do to recover?
The OECD projects that Japan’s GDP growth will recover to 1.3% in 2023 and 1.1% in 2024, driven by domestic demand. The government has announced a stimulus package worth $490 billion, or about 10% of GDP, to support households and businesses affected by the pandemic and boost public investment in green and digital infrastructure. The Bank of Japan has maintained its ultra-loose monetary policy stance, keeping interest rates at -0.1% and expanding its asset purchases. The OECD expects that these measures will help cushion the impact of the recession and support the recovery, but warns that downside risks remain, such as a prolonged pandemic, a further appreciation of the yen, or a deterioration of fiscal sustainability.
How fiscal and monetary policy can help Japan
The government’s stimulus package, announced in December 2023, aims to mitigate the economic and social consequences of the pandemic and promote structural reforms for long-term growth. The package includes cash handouts to low-income households, subsidies to small and medium-sized enterprises, tax breaks for green and digital investment, spending on health care and education, and infrastructure projects such as renewable energy, hydrogen, and 5G networks. The package is expected to raise Japan’s fiscal deficit to 14% of GDP in 2023 and increase its public debt to 270% of GDP by 2024, the highest among OECD countries. The government has pledged to achieve fiscal consolidation in the medium term, but has not specified concrete measures or targets. The Bank of Japan has continued its quantitative and qualitative easing program, under which it buys government bonds, corporate bonds, exchange-traded funds, and real estate investment trusts to lower long-term interest rates and support financial stability. The bank has also introduced a negative interest rate policy, under which it charges commercial banks for holding excess reserves at the central bank. The bank has stated that it will not hesitate to take additional easing measures if necessary to achieve its 2% inflation target, which remains elusive despite years of aggressive monetary stimulus.
How structural reforms can boost Japan’s potential
The government has also committed to implementing structural reforms to enhance Japan’s growth potential and competitiveness in the post-pandemic era. These reforms include promoting digital transformation, strengthening human capital, increasing female labor participation, diversifying energy sources, improving corporate governance, and opening up to foreign trade and investment. Some progress has been made in these areas, such as the launch of a digital agency to streamline online public services, the expansion of free preschool education and childcare support, the development of a hydrogen strategy and offshore wind power projects, the revision of the corporate governance code and stewardship code, and the signing of free trade agreements with the European Union and the United Kingdom. However, many challenges remain, such as overcoming bureaucratic inertia, vested interests, social norms, and public resistance to change.
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