Japan may be the first leading economy to fall officially from recession into depression, with GDP shrinking at an annual rate of almost 10 per cent as its export-focused business model is tested to the limit.

The latest figures, for the period from January to March, showed the worst decline in Japan’s economy, the world’s second-largest, since 1947 and sparked a fierce debate among analysts over whether the country is now due for a sharp recovery or a long phase of anaemic performance.

In the first quarter, GDP plunged by a record 4 per cent from the previous three-month period, leaving it down by 9.7 per cent from a year earlier.

The first-quarter slump was less savage than the 4.2 per cent drop predicted in the markets, but economists took a grim view, nonetheless. Glenn Maguire, Société Générale’s chief Asia economist, said: “Generally, a 10 per cent contraction in growth is considered a depression. Japan has come terribly close to this, with the economy contracting by 9.7 per cent over the year. This point serves to highlight that Japan is the developed economy on which the financial crisis has had the most pernicious impact.”

Nomura’s economists raised a red flag over the prospect of Japan revisiting its old nightmare of deflation, the economic phenomenon that crushed growth in the late 1990s.

A key indicator of deflationary risk, the “domestic demand deflator”, which measures price changes for the domestic economy, excluding Japan’s external trade, fell back into negative territory in the first quarter for the first time in eight quarters. Taken with a March decline in consumer prices, the Japanese economy “is again on the threshold of deflation”, Nomura’s analysts said.

Plunging exports, a strong yen and an unprecedented drop in production were the chief culprits in the GDP fall, although an acute drop in consumer spending also did significant damage to growth.

Capital spending by companies slid by a record 10.4 per cent from the previous quarter, and exports tumbled by 26 per cent.

Kaoru Yosano, the Finance Minister, warned of further pressure on the economy as “significant adjustments” to the job market continued to weigh on families, reducing the likelihood that they will become big spenders again soon.

Taro Aso, the Prime Minister, described the economy as being in a “severe situation”, bemoaning the speed with which deterioration in the corporate sector had fed through to a downturn in the household sector and its spending patterns.

In the hour of trading after the release of the latest figures, the Nikkei surged 1.2 per cent, as initial market comment reflected a sense that the worst of the crisis may be over. However, the momentum eased quickly as concern about Japan’s longer-term prospects resurfaced and began to weigh on sentiment.

All eyes are now on how closely the Government’s huge stimulus package will revive consumption and growth. Richard Jerram, Japan economist for Macquarie, said the fact that public investment had its first year-on-year gain in eight years was a sign that the package may be starting to work.

Optimists point to the ferocity of Japan’s plunging production and corporate restructurings as evidence that the nation may return to growth by the end of the year and may even have done so this quarter. Consumer confidence had a surprise rebound in April and a 32 per cent rise in the Nikkei 225 since March has begun to draw domestic investors back to the stock market.

Having learnt hard lessons in the 1990s “lost decade”, Japan’s companies have attacked their inventories with a speed that few felt possible, and leaders of some of its largest groups, such as Toyota and Panasonic, have been uncharacteristically ruthless in shuttering factories and shedding workers.

However, Nomura economists said that even a return to positive GDP growth would not signify genuine economic recovery. “Although we expect the domestic economy to recover in the near term, we continue to expect it to lose steam from some time from early autumn through to the end of this year or early next year as export recovery fades, benefits from stimulus measures tail off and structural adjustments in the corporate sector lead to cuts in capex and personnel spending,” Nomura told investors.

Questions remain over Japanese exports. The most optimistic view for the current year foresees only stabilisation of exports, rather than the high-pace export trade on which Japan’s economy relies. Analysts say that even well-run companies may have let themselves be too reliant on American and European markets and are now not well placed to benefit from the growth of China and other emerging economies.

Hiroshi Shiraishi, an economist for BNP Paribas, said: “The export boom of the last few years that drove the Japanese economy was the effect of various bubbles around the world and it is hard to see it coming back.”

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