After a substantial strengthening in 1996 and early 1997, the Japanese economy subsequently fell into recession. Real GDP dropped sharply in the second quarter of 1997, largely due to the reversal of an earlier surge in household spending ahead of the increase in the consumption tax rate in April. Activity rebounded modestly in the third quarter, but declined again in the fourth quarter of 1997 and the first quarter of 1998.
Monthly data suggest that activity continued to weaken in the second quarter.
Financial sector strains were an important factor behind the slowdown. Long-standing balance sheet fragilities in the banking sector, and the impending introduction of a stricter regulatory framework in April 1998, resulted in a tightening of credit conditions. The failure of several major financial institutions in late 1997 was associated with considerable turbulence in short-term money markets and a sharp increase in the Japan premium. Concerns about the health of the financial sector was reflected in a sharp drop in stock prices from mid-1997 and to a decline in consumer confidence. Activity was further dampened by a shift toward fiscal consolidation and the Asia crisis.