After a brief recovery last year, the Japanese economy has been returned to intensive care. GDP in Japan contracted by 0.2 per cent in the first quarter of 2001 compared to the final quarter of 2000. GDP data for the second quarter, which are due to be published next month, are expected to show a particularly sharp decline of almost 1 per cent in output. This would confirm that Japan is back in recession for the fourth time in the past decade.

As well as declining output, Japan also remains in the grip of deflation. Unlike other economies that have seen rising inflation on the back of higher oil prices, Japan has experienced falling prices since 1999. Deflation distorts economic activity as its causes spending and investment plans to be postponed, adding to the economic downswing.

A number of factors have contributed to the latest downturn in the Japanese economy. The weakening of global demand, especially for high-tech electronic goods, combined with the lagged effects of the appreciation of the yen in the late 1990s have seen exports weaken significantly. The volume of exports looks set to fall by some 4 per cent this year in marked contrast to the 12 per cent rise recorded in 2000.

The manufacturing sector has been particularly hard hit in this slowdown, with industrial output falling by 4 per cent in the second quarter following a 3.7 per cent decline in the opening quarter of the year.

The corporate sector has suffered a double blow to earnings this year. Weakening demand as well as continued deflation are eating into profits, forcing a major retrenchment in business investment.

Meantime, consumer spending remains very weak. Spending by households continues to be restrained by low wage growth, continuing deflation, an ageing population with a high propensity to save and falling employment.

In the second quarter, household spending fell by 3.6 per cent from the same period last year.

The ongoing problems in Japan stem from the fact that, over the past decade, the authorities put the emphasis on trying to strengthen the economy via lower interest rates and boosting government spending while long-fingering badly needed structural reforms.

Bad debt problems in the financial system have not been confronted and banks remain weighed down by non-performing loans. The jobs market is still very rigid with corporates extremely slow to shed excess labour. Many goods and services markets remain characterised by a lack of real competition.

Meanwhile, government spending has been frittered away on numerous public-work projects that are of limited economic value.

In the recent general election, the new reformist Japanese Prime Minister, Mr Junichiro Koizumi, received a strong mandate from voters for his plans to revitalise the slumping economy.

A major problem for the new administration, however, is that it can no longer rely on conventional policy instruments to help revive the flagging economy.

Interest rates are already at zero per cent. Fiscal policy is constrained by the public spending excesses of the past decade. Government debt as a proportion of GDP has doubled to 130 per cent in recent years, pointing to the need to tighten budgetary policy.

Further, the reform plan to revitalise the economy put forward by Mr Koizumi is likely to deepen the downswing in the short term. It includes persuading banks to cut their bad debts, which is likely to lead to a rise in bankruptcies. This, along with plans to cut government spending, will increase lay-offs, causing unemployment to rise.

Even more radical measures will be needed, however, if Japan is to pull out of its present slump. These include major corporate restructuring, greater liberalisation of labour and goods markets, substantial depreciation of the yen, reflation and monetisation of debt. Incentives are also needed to get the household sector to dip into its substantial savings and start spending again to help boost domestic demand.

Mr Koizumi faces formidable opposition from the "old guard" within his party, who feel threatened by reforms, as well as those who argue that his reform programme will only worsen the economic situation.

However, Japan needs to get its act together soon.

The public finances are now in a perilous state. The banking system is coming under severe pressure. The sharp fall in Japanese equity prices this year has added to balance sheet problems. All major Japanese banks have substantial equity holdings and recent stock market falls could erode the banks' capital.

The debt rating agency Fitch downgraded the main Japanese banks this week because of these concerns.

Finally, Japan may still be the second-largest economy in the world but a formidable new competitor is taking shape in the form of China.

It is becoming increasingly well placed to take advantage of Japan's economic malaise. Perhaps this growing threat to its status as the region's economic superpower will be the catalyst for reform and eventual recovery in Japan in the years ahead.

Oliver Mangan is chief bond economist at AIB Group Treasury.