Japan’s economy will likely withstand the recent disasters, but it was extremely vulnerable before these events, and cyclical and structural economic forces could still make the recovery path uneven, The Conference Board reports in a new analysis. The earthquake on March 11 and the resulting aftershocks and tsunami occurred just as Japan’s long weak economic performance was beginning to show some improvement. Given the country’s preexisting structural problems, however, a return to a robust expansion is a big challenge.

By December 2010, the six-month growth rate of The Conference Board Leading Economic Index® (LEI) for Japan had been negative for four consecutive months, pointing to a significant slowdown in economic activity at the end of 2010 and even a possible second economic contraction coming less than two years after the Great Recession ended there in March 2009, according to research by The Conference Board. That weakness was partly reversed as the LEI regained some traction through February just before the natural disasters hit.

As Immediate Market Reaction Wanes, Longer-Term Impact Surfaces

The effect of non-economic events such as the recent earthquake and tsunami on broader economic trends tends to be short-lived. However, subsequent electricity shortages caused by the nuclear plant malfunction will continue to impact industrial output for many months, which may be enough to tip an already weak economy into recession – especially if consumer sentiment and spending turn more cautious. Underlying that risky outlook is a weak structural economic context: an economy that was not well balanced before the earthquake, relying too much on exports and lacking strong domestic consumption. Japan is also hugely in debt, and its aging population will be a problem in coming years.

“The widespread expectation is that after a brief, short-term contraction, reconstruction efforts and spending will spur the Japanese economy in the second half of the year,” says Ataman Ozyildirim, Economist at The Conference Board. This is consistent with the typical economic pattern following natural disasters, when an initial drop in output is followed by a reconstruction-driven rebound. However, a return to a vigorous economic expansion is not guaranteed. “In the context of ongoing structural problems in Japan’s economy, including persistent deflationary risk, inflexible labor markets, and an aging population, return to a strong economic expansion is unlikely, even if the recovery that started in 2009 resumes in the second half of this year,” adds Ozyildirim.

Structural Weaknesses Hold Back Strong Growth

Japan is facing strong demographic headwinds due to its aging population, low birth rate, and restrictive immigration policies. These trends make domestic market expansion very difficult to achieve. Under these conditions, the economy would shrink unless Japan’s productivity rises faster than its workforce declines, which seems unlikely. Given this structural environment, a strong expansionary trend cannot easily be established.

The impact of the global recession and subsequent stimulus programs generated huge government debt in Japan. The need to pay for reconstruction and rebuilding will continue to increase the public debt burden, putting upward pressure on interest rates.