Japan's economy shrank at an annual pace of 2.3 per cent in the fourth quarter as manufacturers were battered by the strong yen, weak export demand amid the European debt crisis and flooding in Thailand.

A drop in public investment during the quarter, due largely to political bickering delaying parliamentary approval for a 12 trillion yen ($156 billion US) extra budget for tsunami reconstruction, also contributed to the year-on-year decline reported Monday.

The world's No. 3 economy should get a boost once that rebuilding money kicks in, but the outlook for the country's vital exporters remains unclear, said Masayuki Kichikawa, chief Japan economist at Bank of America Merrill Lynch.

"This should be viewed as temporary setback," Kichikawa said. "To what extent will the European crisis continue to affect overseas demand -- that is the big question."

Drop in exports

Japan's major manufacturers, such as Sony Corp. to Honda Motor Co., were hit badly during the fourth quarter by a drop in export demand and flooding in Thailand, a regional factory and supply base, which disrupted their production.

Those problems arose just as many exporters appeared to have recovered from the March 11 earthquake and tsunami, which interrupted their manufacturing at home.

Japan last month reported its first trade deficit since 1980, reflecting broader changes in its economy as manufacturers shift production overseas to escape the strong yen and be closer to their markets. But the Thai flooding underlined that basing production overseas also has risks.

The drop in gross domestic product was worse than expected. Economists polled by Kyodo News agency projected a 1.4 per cent decline.

Compared to the previous quarter, October-December GDP fell 0.6 per cent, the Cabinet Office said. At an annual pace, the economy would shrink 2.3 per cent. The contraction comes after 1.7 per cent increase in the July-September quarter, reflecting some recovery after the tsunami disaster.

Domestic private consumption, which accounts for over half the economy, edged up 0.3 per cent from the previous quarter, the data showed.

Corporate capital investment rose 1.9 per cent, while private housing investment fell 0.8 per cent and public investment declined 2.5 per cent.

Recovering from the tsunami

Along the tsunami-battered coast, most of the debris has been cleared away, but rebuilding has yet to begin in many towns and communities as local leaders finalize reconstruction plans. Reconstruction is expected to stimulate economic growth, although export demand still appears weak.

"The growth rate will turn positive and stay positive this year because reconstruction demand will continue to push up GDP," said Kichikawa. "But the pace of growth will depend on whether the decline in exports will stabilize."

Economy and fiscal policy minister Motohisa Furukawa said in a statement that exports and production increased in December in a "rebound to the impact of flooding in Thailand."

"If we take into account these factors and look at the overall economic situation, we can say that upward movement is continuing," he said.

Furukawa also said that the U.S. economy is moderately recovering and global business sentiment is improving.

"We expect steady increase of exports amid moderate improvement of the global economy," he said. "However, we need to be fully aware of the downside risk."

For all of 2011, Japan's economy contracted 0.9 per cent from 2010, when GDP grew a robust 4.4 per cent. In 2009, the economy shrank 5.5 per cent in the wake of the global financial crisis.