Japan's economy shrank slightly in the final quarter of 2010 but analysts expect a recovery this year as stronger exports to China and other parts of fast-growing Asia offset persistently weak domestic demand.

Gross domestic product (GDP) shrank 0.3 percent in October-December from the previous quarter, slightly less than a 0.5 percent fall expected by markets but still the first contraction in five quarters.

That translated into an annualized contraction of 1.1 percent, far worse than U.S. growth of 3.2 percent in the same quarter, although analysts blame the weakness mostly on a temporary hit to consumption after the September expiry of government incentives to buy low-emission cars.

The data confirms that the economy entered a lull on a downturn in private consumption, but recent monthly economic indicators such as output and exports show it is unlikely that the lull will be prolonged, said Yoshiki Shinke, senior economist at Dai-ichi Life Research Institute.

The economy will continue to depend on external demand for growth, as domestic demand is likely to be capped by subdued income growth and the anticipated negative impact from the expiry of subsidies for energy-efficient electrical appliances.

CHINA THE NEW NO.2

The latest GDP figures also confirmed that China overtook Japan as the world's second-largest economy in 2010 on a seasonally unadjusted, nominal dollar basis, at $5.8786 trillion against $5.4742 trillion.

Economics Minister Kaoru Yosano said Japan needed to make the most of China's growth to boost its own fortunes, as it increasingly relies on demand from its Asian neighbor.

The fact that China's economy is booming is welcome news for Japan as a neighboring country, Yosano told reporters. We want to deepen the amicable economic relationship between Japan and China.

Japan's shipments to mainland China accounted for 19.4 percent of its overall exports last year, making it the No.1 destination for Japanese goods, followed by the United States at about 15.4 percent.

While recent data showed exports and industrial output rose more than expected in December, a pick-up in the corporate sector is seen unlikely to spill over to personal consumption, which makes up about 60 percent of GDP.

Capital expenditure rose 0.9 percent from the previous quarter, slower than the 1.5 percent pace of gains in July-September.

Private consumption, on the other hand, fell 0.7 percent from the previous quarter after a 0.9 percent increase in July-September.

Analysts expect personal consumption to remain weak due to sluggish wages and the roll-back of government incentives for purchases of energy-efficient household electronics in December.

RISKS FROM OVERSEAS, CURRENCIES

External demand, or net exports, shaved 0.1 percentage point off GDP, with the yen's spike to a 15-year high against the dollar during the period putting a damper on exports.

Risks from overseas economies and currency moves need to be closely watched, Economics Minister Kaoru Yosano said after the release of the data.

While weakness will remain for the time being, Japan's economy is expected to pick up on improvements in overseas economies and effects from government policy steps.

Yosano added that there were risks in how markets will view the government's ability to enact legislation in a divided parliament.

Highlighting concerns about prolonged political paralysis, a Kyodo news agency survey showed support for Japanese Prime Minister Naoto Kan's government has fallen below 20 percent, a level where some premiers have been nudged out of power in the past.

With domestic demand expected to remain weak, a heavy reliance on exports to fuel a recovery also poses a risk if external demand stumbles, analysts added.

China raised interest rates last week for the second time on just over six weeks, intensifying its battle against inflation, and further policy tightening is expected from Beijing, raising the prospect of a slowdown in its demand.

Japan's economy is emerging from a lull and is seen recovering moderately this year as demand from China, the United States and emerging nations bolsters exports and factory output.

The encouraging signs prompted the government to upgrade its economic assessment last month and dampened expectations of an imminent monetary easing by the Bank of Japan.

BOJ policymakers meeting this Monday and Tuesday may see no immediate need to ease policy further through an increase of asset purchases and may instead focus on assessing the strength of the recovery.

(Editing by Edmund Klamann & Kim Coghill)

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