Recession in Japan: Causes and the Road Ahead

Japan, the world’s fourth-largest economy, has slipped into a technical recession in the last quarter of 2023, losing its spot as the third-largest economy to Germany. The country’s nominal GDP, which is not adjusted for inflation, stood at $4.2 trillion in 2023, compared to $4.5 trillion for Germany. The real GDP, which measures the value of goods and services, shrank by 0.1% in the October-December period, following a 0.8% contraction in the previous quarter.

Main Causes and Factors of Japan’s Recession and Economic Decline

A Weak Yen

The Japanese currency has depreciated by almost 20% against the US dollar in 2022 and 2023, due to the Bank of Japan’s ultra-loose monetary policy and the US Federal Reserve’s interest rate hikes. The Bank of Japan has kept its short-term interest rate at -0.1%, its 10-year government bond yield at around 0%, and its asset purchase program at an annual pace of 80 trillion yen ($760 billion). The US Federal Reserve, on the other hand, has raised its benchmark interest rate four times in 2022 and three times in 2023, reaching 2.75% by the end of 2023.

A weak yen makes imports more expensive and erodes the purchasing power of consumers and businesses. Japan relies heavily on imports for its energy and food needs, as well as for intermediate goods and raw materials for its manufacturing sector. A weak yen increases the cost of these imports and reduces the real income of households and firms. It also contributes to inflation, which has been hovering around 1% in 2023, well below the Bank of Japan’s target of 2%.

A weak yen also reduces the profits of exporters when they convert their earnings back to yen. Japan’s exports account for about 16% of its GDP, and are mainly composed of automobiles, machinery, electronics, and chemicals. A weak yen can boost the competitiveness of these products in the global market, as they become cheaper for foreign buyers. However, this effect is partly offset by the lower profitability of exporters when they repatriate their revenues. Moreover, a weak yen also exposes the country to external shocks and trade tensions, such as the slowdown of the Chinese economy, the US-China trade war, and the Brexit uncertainty.

An Ageing and Shrinking Population

Japan has one of the lowest birth rates and the highest life expectancy in the world, resulting in a rapidly ageing and declining population. The country’s population peaked at 128 million in 2010 and is projected to fall below 100 million by 2050. The proportion of people aged 65 and over is expected to rise from 28% in 2020 to 38% in 2050, while the proportion of people aged 15 to 64 is expected to decline from 60% to 52%.

This poses a serious challenge for the country’s economic growth, as it reduces the labor force, the consumer base, and the tax revenue. Japan’s labor force participation rate, which measures the proportion of working-age people who are employed or looking for work, was 61.8% in 2023, compared to 77.9% for Germany and 63.4% for the US. Japan’s labor productivity, which measures the output per worker, was also lower than the average of the OECD countries. Japan’s consumer spending, which accounts for more than half of its GDP, was weak in 2023, as households faced rising living costs, stagnant wages, and low confidence. Japan’s tax revenue, which finances its public services and social security, was also insufficient to cover its expenditures, resulting in a fiscal deficit of 3.5% of GDP and a public debt of over 200% of GDP in 2023.

An ageing and shrinking population also increases the social security and health care costs, putting pressure on the public finances and the fiscal sustainability. Japan’s social security spending, which includes pensions, health care, and long-term care, amounted to 33% of its GDP in 2023, the highest among the OECD countries. Japan’s health care spending, which covers medical services, drugs, and devices, was 11% of its GDP in 2023, also above the OECD average. Japan’s long-term care spending, which covers home care, institutional care, and community-based services, was 2.5% of its GDP in 2023, the highest in the world. These costs are expected to rise further as the population ages and the demand for care increases.

A lack of structural reforms

Japan has been slow to implement structural reforms that could enhance its productivity, innovation, and competitiveness. Some of the areas that need improvement are the labor market, the corporate governance, the regulatory environment, the education system, and the digital transformation. Japan also faces barriers to foreign investment, immigration, and diversity, which limit its potential to attract talent, capital, and ideas from abroad.

Japan’s labor market is rigid, segmented, and gender-biased, with a large gap between regular and non-regular workers, a low female labor force participation rate, and a high seniority-based wage system. Regular workers, who account for about 60% of the total workforce, enjoy high job security, benefits, and wages, but face long working hours, low mobility, and low incentives. Non-regular workers, who account for about 40% of the total workforce, face low job security, benefits, and wages, but have more flexibility and autonomy. The gap between the two types of workers creates inequality, inefficiency, and dissatisfaction in the labor market. The female labor force participation rate, which measures the proportion of women aged 15 to 64 who are employed or looking for work, was 71% in 2023, lower than the 76% for men and the 80% for Germany. The gender wage gap, which measures the difference between the average earnings of men and women, was 23% in 2023, higher than the 14% for the OECD average. The seniority-based wage system, which links the pay to the length of service rather than the performance or skills, discourages innovation, productivity, and meritocracy in the labor market.

Japan’s corporate sector is inefficient, conservative, and overprotected, with a low return on equity, a high cash-holding ratio, and a weak governance structure. The return on equity, which measures the profitability of a company relative to its shareholders’ equity, was 8% for Japan in 2023, lower than the 12% for the US and the 10% for Germany. The cash-holding ratio, which measures the liquidity of a company relative to its assets, was 52% for Japan in 2023, higher than the 23% for the US and the 28% for Germany. The governance structure, which measures the quality of the board of directors, the shareholders’ rights, and the disclosure practices, was also weaker for Japan than for the US and Germany, according to the World Bank’s Doing Business indicators. These factors indicate that Japan’s corporate sector is less profitable, less efficient, and less transparent than its peers.

Japan’s regulatory framework is complex, bureaucratic, and restrictive, with a high entry barrier, a low competition intensity, and a low ease of doing business. The entry barrier, which measures the difficulty of starting a business, was higher for Japan than for the US and Germany, according to the World Bank’s Doing Business indicators. The competition intensity, which measures the degree of market concentration and the presence of antitrust laws, was lower for Japan than for the US and Germany, according to the OECD’s.

What is the road ahead for the Japanese economy?

The Japanese economy faces a difficult road ahead, as it tries to recover from the recession and overcome the long-term challenges. Some of the possible steps that could help the Japanese economy are:

• Expanding fiscal stimulus: The Japanese government has announced a series of fiscal stimulus packages to support the economy amid the pandemic and the recession. The latest package, worth 73.6 trillion yen ($700 billion), was unveiled in December 2023 and included measures such as cash handouts, subsidies, infrastructure spending, and green investment. The government should continue to provide fiscal support to the sectors and groups that are most affected by the crisis, while ensuring the sustainability of the public debt, which is the highest among the developed countries at over 200% of GDP. The government should also pursue fiscal consolidation in the medium to long term, by raising the consumption tax, cutting wasteful spending, and reforming the social security system.

• Pursuing monetary easing: The Bank of Japan should maintain its accommodative monetary policy stance, which includes keeping the short-term interest rate at -0.1%, the 10-year government bond yield at around 0%, and the asset purchase program at an annual pace of 80 trillion yen ($760 billion). The central bank should also be ready to adjust its policy tools as needed, depending on the inflation and growth outlook, the exchange rate movements, and the global financial conditions. The central bank should also monitor the side effects of its negative interest rate policy, such as the erosion of bank profitability, the distortion of market signals, and the dampening of consumer sentiment.

• Implementing structural reforms: The Japanese government should accelerate the implementation of structural reforms that could boost the country’s potential growth, productivity, and competitiveness. Some of the key areas that need reform are the labor market, which should be more flexible, inclusive, and diverse; the corporate sector, which should improve its governance, transparency, and efficiency; the regulatory framework, which should be more conducive to innovation, entrepreneurship, and foreign investment; the education system, which should foster creativity, skills, and lifelong learning; and the digital transformation, which should enhance the use of technology, data, and e-commerce. The government should also promote the participation of women, youth, and foreigners in the economy and society, by providing more childcare facilities, flexible work arrangements, and visa options.

• Enhancing regional and global cooperation: Japan should strengthen its regional and global cooperation, especially with its major trading partners such as the US, China, and the EU. Japan should also play a more active role in promoting free trade, multilateralism, and environmental protection, as well as addressing common challenges such as the pandemic, the climate change, and the security issues. Japan should leverage its leadership in the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), the Regional Comprehensive Economic Partnership (RCEP), and the EU-Japan Economic Partnership Agreement (EPA) to expand its market access, diversify its trade partners, and set high standards for trade rules. Japan should also deepen its strategic partnership with the US, its main ally, and seek a stable and constructive relationship with China, its main rival, while balancing its economic and security interests.

Japan’s recession and economic decline are the result of a combination of factors, such as a weak yen, an ageing and shrinking population, and a lack of structural reforms. The country faces a difficult road ahead, as it tries to recover from the crisis and overcome the long-term challenges. The Japanese government should pursue a balanced mix of fiscal stimulus, monetary easing, and structural reforms, while enhancing its regional and global cooperation, to revive its economy and regain its position as a world leader.

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