Stimulus measures in Japan helped the world's second-largest economy grow at its fastest pace in more than two years, but it's unlikely policymakers will reduce spending despite the nation's rapidly growing debt.

Gross domestic product (GDP) in Japan grew at 4.8% annual rate in the third quarter, surpassing all the forecasts of 20 economists polled by Bloomberg News. That follows a revised gain of 2.7% in the three months ended June 30, according to Japan's Cabinet Office. Japan's economy grew 1.2% on a quarterly basis.

"The turnaround in public investment has definitely contributed to the rebound in GDP, so if they do start to cut it'll weigh on growth,” Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group AG (NYSE ADR: CS), told Bloomberg.

Stimulus measures around the world helped Japan's exports grow 6.4%, but as global economies withdraw stimulus measures, growth in Japan is expected to slow. Programs like the United States' “Cash for Clunkers” ended in August and China's cut on sales taxes for small cars is scheduled to stop after 2009 ends.

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Without these props in place, auto sales could fall 10%, taking 0.16% off economic growth, The Wall Street Journal reported, citing estimates from the Japan Research Institute.

In a troubling sign for unemployment and its overall economy, Japan's inventories are on the rise again, accounting for 0.4% of third-quarter growth. Should overseas demand falter, Japan – which already has one-third of its factories idle – this newfound economic growth could slow.

Japan's unemployment rate is currently at a near-record 5.3%.

“Manufacturers are saddled with massive overcapacity so you can't expect a strong recovery for quite some time. That's a given,” Hiroshi Shiraishi, an economist at BNP Paribas SA in Tokyo told Bloomberg. “That means this initial bounce-back in the economy won't really accelerate.”

Despite an expected slowdown in growth, most economists say overseas demand will prevent a double-dip recession in Japan, Reuters reported.

The Shift in Stimulus

Newly elected Japanese Prime Minister Yukio Hatoyama'sDemocratic Party of Japan (DPJ) blocked the outgoing Liberal Democratic Party's (LDP) additional $32.4 billion (2.9 trillion yen) in stimulus, and may hold the funds until next year amid declining tax revenue.

Unlike the LDP, which spent stimulus largely on infrastructure, Prime Minister Hatoyama and his fellow DPJ policymakers plan to use the money for social welfare spending, such as subsidized child care and lower tuition fees at schools.

While the stimulus measures are expected to help domestic demand, Japan will still be faced with reducing its record deficit, which accounts for 170% of its $5 trillion GDP. Estimates say the figure will balloon to between 200% and 250% sometime next year.

“The problem is that you can't expand fiscal spending forever because we've got this fiscal deficit to worry about,” Credit Suisse's Shirakawa told Bloomberg. “They're concerned about the economy on the one hand, on the other they're concerned about the deficit.”

To combat declining tax revenue and its rising deficit, Japan could issue at least $550 billion (50 trillion yen) in bonds, Finance Minister Hirohisa Fujii suggested.

“There's no mistaking the budget deficit stems from the past year's global recession. Now is the time to be bold and issue more deficit bonds,” Fujii told reporters at the National Press Club last month. "Those who may call this pork-barrel spending — that's a total lie.”

Ten-year yields fell to their the lowest level in almost four weeks as shares on the Japan's Topix slipped on concern companies will sell more equities to raise funds.

“The GDP report paints a positive picture of the Japanese economy, but the shape of the economy going forward is still unclear,” Makoto Yamashita, chief Japan interest-rate strategist at Deutsche Securities Inc. in Tokyo told Bloomberg. "We'll see some rapid adjustments in the bond market today following last week's gains.”

News and Related Story Links:

• Bloomberg News:
  Japan GDP Accelerates, Easing Risk of Renewed Slump
• The Wall Street Journal:
  Double Dip for Japan?
• Reuters:
  Japan Extra Stimulus Likely, GDP Fails to Convince
• Wikipedia:
  Yukio Hatoyama
• Wikipedia:
  Democratic Party of Japan
• Wikipedia:
  Liberal Democratic Party (Japan)
• The New York Times:
  Rising Debt a Threat to Japanese Economy
• Bloomberg News:
  Japan Bonds Rise a 5th Day as Stock Losses Outweigh GDP Growth