^{Photo: The Business Times}

Japan’s economy recorded its first contraction in a year and a half, with third quarter GDP slipping as weakening exports and a sharp drop in residential investment dragged overall growth into negative territory. The decline, while milder than analysts expected, underscores the challenges facing the world’s fourth largest economy as external demand softens and domestic sectors struggle with policy driven disruptions.

GDP Performance and Key Drivers

Government data released Monday shows Japan’s GDP shrank 1.8 percent on an annualized basis in the July to September period. On a quarter-on-quarter basis, the economy contracted 0.4 percent, ending a streak of six consecutive quarters of expansion.

The downturn, however, was not as severe as the Reuters poll forecast, which anticipated a 2.5 percent annualized decline and a 0.6 percent quarterly drop. Domestic demand, particularly consumption, prevented a deeper fall. Government spending rose 0.5 percent, while private consumption ticked up 0.1 percent.

Despite this modest support, private demand overall fell 1.8 percent, making it the largest negative contributor to GDP. The sector was heavily hit by a steep 32 percent annualized decline in residential investment, reflecting tightened energy efficiency regulations implemented for all new housing projects starting April 2024. On a quarterly basis, residential investment plunged 9.4 percent, dragging GDP down by 0.3 percentage point.

Public demand provided a notable offset, rising 2.2 percent on an annualized basis and adding stability to what may have otherwise been a wider contraction.

Export Weakness and Global Trade Pressures

Exports suffered a 4.5 percent annualized drop in the third quarter, reversing a brief recovery in September. Quarter-on-quarter, exports declined 1.2 percent after growing 2.3 percent in the previous quarter. Japanese shipments have fallen for four out of the last five months as U.S. tariffs weakened demand for autos, machinery and high tech components.

Tokyo’s July agreement with Washington to reduce tariffs on Japanese exports—from 25 percent down to 15 percent beginning August 7—helped ease some pressure, but the improvement has not yet translated into sustained export growth.

The yen dipped slightly against the dollar following the GDP release, while the Nikkei 225 index slipped 0.29 percent. Yields on 10-year Japanese government bonds rose by 3 basis points to 1.73 percent as investors assessed the economic outlook.

Economic Outlook and Expert Commentary

Analysts expect the downturn to be temporary. Harumi Taguchi, principal economist at S&P Global Market Intelligence, said he anticipates a rebound in growth as the effect of new housing regulations recedes and trade uncertainties ease.

Taguchi also noted that the recent agreement between the United States and China to reduce reciprocal tariffs is beginning to support new orders for Japanese manufacturers. With two of Japan’s most important trading partners lowering trade barriers, external demand is expected to stabilize over the coming quarters.

Policy Response and Stimulus Plans

The economic slowdown is likely to strengthen Prime Minister Sanae Takaichi’s push for aggressive stimulus. The administration has signaled plans for what it describes as “bold and strategic” investments focused on crisis preparedness and long term growth industries.

According to draft documents reported by Reuters, the government is prepared to increase spending “without hesitation” to accelerate Japan’s emergence from years of stagnation. Priority sectors include artificial intelligence, semiconductor manufacturing, shipbuilding and defense related technologies.

Earlier reporting from the Nikkei indicated that the stimulus package could exceed 10 trillion yen (approximately $64.6 billion). Proposed measures include subsidies for electricity and gas bills, financial support for small and medium-sized enterprises to raise wages and targeted incentives aimed at revitalizing domestic industries.

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While Japan’s third quarter contraction reflects real pressures from global trade shifts and policy changes at home, strong government spending and resilient consumer demand prevented a larger downturn. With a sizable stimulus package in the pipeline and improving clarity on international trade conditions, economists expect Japan to regain momentum heading into the next year.