Japan's economy scored the highest growth among major nations in the December quarter but economists warned that its heavy reliance on exports and stubborn deflation hindered it from leaving decade-old doldrums.
Japan has a small window of opportunity, they said, to spur domestic demand by spreading the current export-led recovery in large-scale manufacturers to smaller firms and service sectors, given expectations the US economy, the world's largest consumer market, will slow in about a year.
Demand for Japanese-made high-tech gadgets, such as flat-screen TVs, DVD recorders and cellular phones, has been strong in Asia, particularly China.
Japan's exports of machinery to China also have been robust because many Japanese carmakers and consumer electronics firms have production bases there.
Booming exports have sparked Japan's blue chip companies to upgrade their factories and better equip their offices.
And that has driven the Japanese economy, the world's second largest, to grow 1.7 percent in inflation-adjusted terms in the October-December quarter, the highest rate since the last days of asset inflation 13 years ago and up from 0.6 percent in the previous quarter.
The growth was translated into an annual rate of a whopping 7 percent rise, also the highest since April-June 1990, when the economy expanded 10.5 percent.
For the whole of last year, GDP expanded 2.7 percent, reversing a 0.4 percent contraction in 2002.
While the current recovery looks stronger than the previous one that lasted only 21 months to October 2000, economists said it may run out of steam before even matching the second recent upturn that lasted over three years to May 1997.
The level of domestic economic output topped the 1995 level last year but stayed below a recent peak hit in 1997, both in nominal terms or actual prices that reflect the deflationary trend.
"While the GDP level stays below a peak, companies are reporting record profits," said Kagehide Kaku, deputy chairman of the Institute of Daiwa Research Ltd.
"This means it's squeezing other elements in the economy, capping growth in employees' income and widening the gap in corporate earnings between big and small companies."
Investors look at top companies, such as Toyota -- Japan's largest and now the world's number two in sales volume -- and high-tech makers Canon and Toshiba, all of them supported by a cyclical recovery in the US economy and the booming Chinese market.
But those manufacturers account for only 20 percent of the total domestic output.
"It's possible that the euphoria of export-backed recovery will spread, given booming exports to China, but I don't expect it to push the economy out of the prolonged doldrums," said Ryutaro Kono, chief economist at BNP Paribas.
Kono and other economists forecast that the US economy, where Japan exports directly or via China, was likely to slow down early next year, dampening exports.
Corporate investment is supported only by strong exports and demand for digital consumer electronics, raising the question of how Japan can boost and sustain consumer spending.
That has to come with regular pay hikes but overall salaries in Japan have stopped merely falling and are stagnant, because the bulk of economic output comes from non-manufacturers.
"In order to raise profits, non-manufacturing firms have to cut costs, including salaries, which means household income will not increase," Kono said.
In the previous recovery cycle of 1999-2000, exports expanded, raising hopes they would have a ripple effect. But time ran out before non-manufacturers could catch up.
"That environment has not changed," Kono said.
"The Japanese economy has remained trapped in a deflationary cycle, in which non-manufacturers cannot increase sales, which prompts them to cut salaries and depress consumption, which in turn hurts their sales."
Japanese consumers have benefited from the lower prices in general and the emergence of ?100 (about US$1) stores that accompanied them, but deflation has also squeezed corporate profits, triggering broad-based salary cuts and layoffs.
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