Japan's economy shrank in the second quarter as a rise in the country's sales tax hit spending. The government expects the downturn to be temporary, although survey data so far point to a mere stabilisation of the economy at the start of the third quarter. If growth fails to revive, pressures will be felt by policymakers to reinvigorate the economy with more stimulus.

Sales tax rise hits spending

Gross domestic product fell 1.7%, more or less in line with analysts' expectations of a 1.8% decline, according to a poll by Reuters.

The contraction can be attributed to the increase in Japan's sales tax from 5% to 8% on 1 April, which itself reflects part of the government's aim to reduce public sector debt. Consumption had risen sharply in the first quarter as households and businesses brought forward spending ahead of the tax rise, pushing GDP 1.5% higher. Private consumption slumped 5% in the second quarter, with consumer spending down 3.7%.

Temporary downturn?

There is a possibility that the drop in consumption in the second quarter merely represents a temporary pay-back after the strong rise in spending earlier in the year, and that growth of consumption will recover in the second half of the year. There is a concern, however, that the economy is unable to withstand the higher tax rate, meaning a renewed downturn may be underway.

History provides few clues. The last time that the sales tax was hiked in Japan was in 1997, with an increase from 3% to 5%. The hike was followed by a deep downturn and drop in consumption, but the hike also coincided with the Asian financial crisis, meaning it is impossible to disentangle the impact of the tax hike and the crisis on consumption.

Economy stagnating at start of Q3

The monthly data have been mixed, but generally point to a weak picture of an economy merely stagnating. Official data showed manufacturing output dropping 3.5% in June after a 0.7% rise in May. Over the three months to June, output was down 1.9% compared to the prior three months, painting the worst picture of the manufacturing economy since the earthquake-related disruptions of May 2011. This trend should improve, albeit only modestly. Markit's PMI data showed manufacturing operating conditions improving in June and July after two months of deterioration in April and May, although the rate of growth faltered in July to near-stagnation. By comparison, the manufacturing PMI had been hitting all-time highs earlier in the year.

The services PMI has also stabilised in July, having signalled contracting business levels in April through to June.

The combined picture from the PMI surveys suggests that the economy has stabilised in June and July after contracting sharply in April and to a lesser extent in May.

While the surveys raise hopes that the economy is not seeing the same downward trajectory experience in the aftermath of the 1997 sales tax hike, there are few signs of spending rebounding after the initial hit from the tax hike.

Business confidence still elevated

A ray of hope is provided by the services PMI surveys showing firms' expectations about their future business activity rising in July to one of the highest seen in the survey history with the exception of the Abenomics-fuelled upturn in sentiment seen early last year.

However, unless stronger growth is seen as we move through the third quarter, pressure will be placed on policymakers to reinvigorate the economy and take measures to offset the sales tax rise. The flash manufacturing PMI for August, published on 21st August, will provide an important policy clue in this respect.

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