The long-awaited recovery of Japan overshadowed by China’s economic downturn

China’s economic downturn is raising concerns in Japan, with policymakers worried that it could negatively impact Japan’s fragile recovery. If China does not implement meaningful stimulus measures to shore up demand, it could potentially delay Japan’s exit from ultra-loose monetary policy. With the United States also experiencing slower growth due to aggressive interest rate hikes by the Federal Reserve, Japan’s export-dependent economy would have little external support.

The Bank of Japan’s September policy meeting will discuss the risks from China, according to sources familiar with the bank’s thinking. This raises questions about Governor Kazuo Ueda’s efforts to reduce the massive monetary stimulus of the past decade. A downturn in China could diminish the chance of sustained wage growth in Japan, which is crucial for phasing out monetary stimulus.

The Japanese government’s monthly economic report for August also expressed concerns about China’s outlook as a risk to Japan’s recovery. A senior Japanese government official stated anonymously that they believe China’s growth will never return to 5%. As the largest trading partner for Japan, accounting for 20% of its exports, a downturn in China could have a significant impact on Japan’s annual growth, potentially slowing it down by 1-2 percentage points. This would lead to an extended slowdown in Asia’s two largest economies, which together make up about a fifth of global GDP.

Japan’s manufacturers are already reducing their exposure to China, with some shifting operations away from the country. The CEO of Komatsu Ltd, one of the world’s largest construction machinery makers, stated they would cut down production capacity in China to match actual demand. Diplomatic tensions between Japan and China could also affect tourism, delaying a broader recovery in Japan’s service sector.

The risks from China make it challenging for the Bank of Japan to wind down its bond yield control, a key part of its monetary policy. With weak exports to China and potential headwinds to inbound tourism, it is difficult to justify tightening monetary policy in the near future. While Japan’s core inflation has exceeded the BOJ’s 2% target for 16 consecutive months and firms have promised wage hikes, the darkening outlook for Japan’s recovery may push back the timing of a policy shift.

The current quarter is expected to see slower economic growth in Japan after a strong expansion in the April-June period. Rising inflation is already impacting consumption, as household spending experienced its biggest drop in nearly 2-1/2 years in July. China’s weakness heightens the challenge for Japan to achieve sustainable 2% inflation.