Japan GDP growth collapses amid sales tax shock

August 13, 2014: 9:41 PM ET
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HONG KONG (CNNMoney)

Japan's economy suffered its worst contraction since 2011 in the second quarter as consumer spending on big items slumped in the wake of a sales tax rise.

Gross domestic product shrank by an annualized 6.8% in the three months ended June, Japan's Cabinet Office said Wednesday. The result was actually better than the 7% contraction expected by economists.

On a quarterly basis, Japan's GDP dropped by 1.7% as business and housing investment declined. Japan's economy last suffered a hit of this magnitude after the 2011 tsunami and nuclear disaster.

The performance is the second half of a boom and bust cycle resulting from the sales tax hike that drastically changed consumer spending patterns.

Japan's consumption tax was increased to 8% in April in a bid to improve the country's fiscal position. If needed, the government has the option to implement an additional increase to 10% by 2015.

Earlier in the year, consumers responded in a big way, bringing forward big purchases -- and all the extra shopping contributed to the strong first quarter numbers. But now that the sugar rush is over, economists had expected Japan's growth rate to return to Earth in the second quarter.

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Marcel Thieliant, an economist at Capital Economics, said it was always unlikely that the impact of the consumption tax hike would fade overnight.

But consumer spending is already improving, Thieliant said, and other indicators suggest business investment in machinery and equipment should increase.

"The upshot is that we still expect the recovery to resume in coming months," Thieliant said.

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Japan is facing a crucial period as the government presses ahead with its much-ballyhooed Abenomics revival strategy.

The country has been mired in a malaise brought on by falling prices and a strong yen for years. But the economy's prospects have brightened since Prime Minister Shinzo Abe announced fresh spending by the government and encouraged the central bank to unleash a wave of asset purchases.

Under his leadership, the yen has fallen sharply and stocks have risen dramatically. The IMF has endorsed the plan and Japan has largely avoided charges of currency manipulation.

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But the third pillar of the Abenomics plan -- structural reforms -- has been tougher to implement.

Abe's government has proposed reforms that would make the labor market more flexible, encourage immigration, bring nuclear power plants back online and draw more Japanese women into the workforce.

Many of those proposals have foundered, or have been slow to develop.

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