Japan, which was eclipsed by Germany as the third-largest economy in 2023, is entering a recession

Japan lost its status as the world's third-largest economy to Germany last year and unexpectedly slipped into recession in the final quarter of 2023 due to weak domestic demand, government data showed on Thursday.

Japan's nominal gross domestic product (not adjusted for inflation) was $4.21 trillion, the fourth largest in the world after Germany's $4.46 trillion, largely due to the sharp decline in the yen.

The United States retained the top spot, followed by China, which overtook Japan as the second-largest economy more than a decade ago.

According to the Cabinet Office, the economy contracted by 0.1 percent in the October-December period compared to the previous quarter, or at an annual rate of 0.4 percent, with both households and businesses lacking momentum due to stalled inflation.

Two consecutive quarters of decline meant the economy was in a technical recession, posing a challenge for the government and the Bank of Japan as they seek domestic demand-led growth while keeping wages rising.

Private sector economists surveyed by the Japan Center for Economic Research had forecast annual growth of 1.28 percent. GDP is the total value of goods and services produced in a country.

“The problem is not just that Japan had negative growth. Domestic demand also collapsed and the data was extremely poor,” said Toru Suehiro, chief economist at Daiwa Securities Co., calling the result a “negative surprise” for markets.

“This was despite (support from) COVID-related pent-up demand last year. Until real wages begin to recover, there will be no more euphoria,” he said, adding that the BOJ will continue to take steps to end its negative interest rate. As expected by financial markets, policy will change this spring.

Japan's economic decline has become increasingly clear in recent decades. The country enjoyed high growth in the post-World War II period, but its malaise began with the bursting of the asset bubble in the early 1990s and has been plagued by deflation ever since.

Japan lost its place as the world's second largest economy to China in 2010. Its growth remained modest and domestic demand weak, even with the help of the BOJ's unprecedented monetary easing.

Private consumption, which accounts for more than half of the economy, fell 0.2 percent, marking the third straight quarter of decline as households struggled with rising living costs and falling real wages.

Capital spending was also not strong enough, falling 0.1 percent, a worrying sign that Japanese companies remain cautious about expanding their investments despite their robust plans.

Nominal GDP rose 0.3 percent in the October-December quarter, or at an annual rate of 1.2 percent.

“Germany overtaking Japan shows that it is essential for us to push forward structural reforms and create a new stage for growth,” Economic Revitalization Minister Yoshitaka Shindo told a news conference.

“We will take all policy measures to support wage increases” to pave the way for sustainable, demand-led economic growth, he added.

Despite weak domestic demand, exports continued to rise by 2.6 percent, supported by an increase in inbound tourism. Spending by foreign visitors to Japan is treated as exports in GDP data.

While concerns about a global slowdown persist, the U.S. economy has proven resilient despite the Federal Reserve's aggressive rate hikes. Increased car deliveries to the US supported the Japanese economy last year.

According to the data, public investment fell by 0.7 percent for the second quarter in a row.

On an annual basis, Japan's economy grew by 1.9 percent in real terms and by 5.7 percent in nominal terms.

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