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Nov 17, 5:34 AM EST

Japan slides into recession in wake of tax hike, undermining global growth prospects

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TOKYO (AP) -- Japan's economy unexpectedly slipped back into recession as housing and business investment dropped following a sales tax hike, hobbling its ability to help drive the global recovery.

The world's third-largest economy contracted at a 1.6 percent annual pace in the July-September quarter, the government said Monday, confounding expectations that it would rebound after a big drop the quarter before.

The news cast a pall over financial markets: Japan's share benchmark fell 3 percent, and many others in Asia also declined. Shares were lower in early trading in Europe and Dow Jones and S&P futures were off 0.5 percent, suggesting a dismal start for the week on Wall Street.

An economy is generally considered to be in recession when it shrinks for two consecutive quarters.

"GDP for July-September wasn't good, unfortunately," Prime Minister Shinzo Abe told a political gathering in Tokyo shortly after his return to Japan from the Group of 20 leading economies in Brisbane, Australia.

The downturn deepens global uncertainty as growth slows in China and remains stubbornly flat in the 18-country eurozone.

Japan's weakness could hinder growth elsewhere if its companies cut investment and buy fewer imports such as machinery, electronics and raw materials. Though it is a small, island nation, Japan is one of the world's biggest importers of food and the third-biggest buyer of natural gas.

The U.S. economy, which grew at a 3.5 percent pace last quarter, is outpacing most of the developed world.

Japan's gross domestic product data showed across-the-board weakness in demand among consumers and manufacturers, who had stepped up purchases before the sales tax was raised in April to 8 percent from 5 percent.

"The impact of the sales tax was much more severe than expected," said Junko Nishioka, an economist at RBS Japan Securities.

Housing investment plunged 24 percent from the same quarter a year ago, while corporate capital investment sank 0.9 percent. Consumer spending, which accounts for about two-thirds of the economy, edged up just 0.4 percent.

Given the contraction, Abe is expected to announce Tuesday that he will delay a second sales tax hike - to 10 percent - planned for next October. That would relieve pressure on the economy, but slow progress on efforts to rein in Japan's government debt, the largest among industrialized nations.

Abe is also likely to use the decision to delay the tax hike as a reason to call a snap election in mid-December to secure a public mandate for delaying progress on fixing Japan's finances. That choice may be puzzling to some, but the ruling Liberal Democrats have a solid majority and hope to consolidate their power further at a time when opposition parties are viewed as weak and in disarray.

Japan emerged from its last recession just as Abe took office in December 2012, saying he would end two decades of stagnation with a combination of lax monetary policy, strong fiscal spending and "drastic" economic reforms - a strategy dubbed "Abenomics."

But consumer spending is faltering as the population shrinks and grows older. Japanese manufacturers have lost their leading edge in innovation while shifting production to cheaper locations offshore.

Household incomes, meanwhile, peaked more than a decade ago, and a growing share of workers are having difficulty making ends meet with part-time, contract work. Wage increases - mostly limited to a small share of workers in big-name companies - have lagged behind inflation.

Most economists had forecast that Japan would expand at about a 2 percent pace after a sharp 7.1 percent annual pace drop in April-June immediately following the tax hike. Compared to the previous quarter, GDP declined 0.4 percent.

Delaying the next tax hike could undermine confidence in Japan's ability to repair its battered finances, but the risk to the recovery too great, said economist Koichi Hamada, who likened April's tax increase to excess payload on the "rocket of Abenomics."

Hamada, an Abe adviser, had publicly urged the prime minister to raise the sales tax in smaller stages rather than by 3 percentage points at one time.

"Tax rate increases are not meaningful if they don't increase tax revenues," he said.

In early 2013, Abe and Bank of Japan Gov. Haruhiko Kuroda united in seeking to end the long spell of deflation that they say is discouraging companies and consumers from spending money.

So far, price increases have fallen short of their 2 percent inflation target, while import costs have risen as the Japanese yen weakened to about 116 to the U.S. dollar from about 80 to the dollar two years ago.

On Oct. 31, Kuroda announced the central bank would step up its asset purchases, accelerating Japan's "quantitative easing" just as the U.S. was winding its QE down.

On the same day, the government announced it would shift a large share of the public pension fund's investments out of government bonds and into higher yielding but riskier shares.

Monday's data is preliminary, with a revision due Dec. 8. Some of the decline was due to reductions in inventory, and rising orders for industrial equipment and other big ticket items should boost output in coming months, said Pierre Ellis, senior economist at Decision Economics in New York.

Abe is planning extra stimulus worth about 3 trillion yen to 4 trillion yen ($26 billion to $35 billion) that could include subsidies to low-income families and help for smaller companies squeezed by rising costs for imported energy and materials, Nishioka said.

Critics say Abe has failed to deliver on promises for drastic reforms of labor regulations, the tax system and the health industry, among other areas. Meanwhile, companies have failed to pass windfall gains from higher share prices and surging profits on to their workers in the form of higher wages.


AP Writers Mari Yamaguchi in Tokyo and Christopher S. Rugaber in Washington contributed to this report.


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