The first estimate of Japan’s third quarter GDP growth shows that trade surpluses are no longer one of the key drivers of economic activity.

All the 1.6% growth in the first nine months of this year has been generated by domestic demand – private consumption, investments and government spending.

That seems set to continue the experience observed over the last four years (2021-2024), when the negative trade balance reduced the GDP growth by 0.6%.

The picture emerging from the latest numbers suggests that domestic demand will not be able to sustain the current growth rates because of policy constraints imposed by accelerating price inflation, budget deficits and excessive national debt.

With all the negative comments, it sounds odd to say that the Japanese economy is overheating. But that’s what is going on. With a 1.6% growth rate the economy is moving along way above its physical limits to potential and noninflationary growth of 0.4%. And those are structural limits since they are based on the stock and quality of human and (physical) capital.

A growth recession is inevitable

The resulting huge imbalance between demand and supply in labor and product markets is the obvious source of price inflation shooting up to 2.9% in September from 2.7% in August.

With inflation being always and everywhere a monetary phenomenon that simply means interest rates must keep rising to levels necessary to bring down excess demand.

Under those circumstances, tax cuts or increasing public spending the Japanese government seems to be counting on to support domestic demand would only lead to higher interest rates to fund the rising government loan demand.

A substantial downward pressure on Japan’s domestic spending is inevitable.

Only exports could provide some relief from the looming growth recession, but the question is where that external demand can come from.

China is Japan’s by far the largest trading partner. According to Japanese trade statistics, during the first nine months of this year bilateral trade with China accounted for 23% of Japan’s total foreign trade.

That is far ahead of Tokyo’s bilateral trade with the United States (15% of the total) and the European Union (10% of the total).

Significantly, during the same period, Japan’s imports from China were more than double compared to its imports from the U.S. and the E.U. And that could mean that Japan relies on China for key inputs to its economic activity.

Do business with the free trading ASEAN

A similar predominance of Japan’s China trades is observed in Tokyo’s export sales. Again, during the first three quarters of this year, Japan’s exports to China were 22% and 150% larger than its exports to the U.S. and the E.U., respectively.

Looking beyond Japan’s traditional export partners, it turns out that the eleven countries of the Southeast Asian trading bloc (ASEAN), plus South Korea, offer Japan rapidly growing and diversified markets with a trading volume that closely approximates the Sino-Japanese bilateral trade.

In fact, that group of Japan’s 12 Asian neighbors accounts for slightly more than one-fifth of Tokyo’s almost perfectly balanced foreign business transactions.

A vigorous foreign trade is a growth strategy that Japan must pursue if it wants to escape binding policy constraints in managing its domestic demand.

That would be a return to its well-established growth model where strong exports used to support jobs and incomes, leading to rising household consumption, business investments – and a sustained noninflationary growth.

In that context, Japan’s primary focus should be on the free-trading group of its Southeast Asian neighbors where no unresolved issues of political and security contingencies can stand in the way of free and balanced business transactions in product and service markets.

Sound and sustained external accounts would provide support to economic growth while reinforcing Japan’s reserve holdings ($1.35 trillion) and an already stellar international investment position of $3.5 trillion.

All that would also allow more room to deal with structural problems, such as productivity and labor supply, and huge fiscal imbalances that are preventing an appropriate monetary and fiscal policy mix to keep the economy on a stable growth path.