* Slump in output, exports imperils recovery scenario
* BOJ may face pressure to ease, further tax hike complicated
* Worst output drop since 2011 disasters
* Export slump reflects industrial hollowing out
By Stanley White and Leika Kihara
TOKYO, July 30 (Reuters) - Japan could be flirting with recession after the weakest factory output since 2011, which, following a surprising fall in exports last week, could pressure the central bank to ease policy and complicate a decision on whether to raise taxes.
The severe contraction in output and pileup of inventories after an April increase in the national sales tax are much worse than after the previous tax hike in 1997, which ushered in a steep recession, government data showed on Wednesday.
Two months of unexpected export declines from the world’s third biggest economy, meanwhile, are calling into question the Bank of Japan’s case that shipments overseas would by now be taking up the slack from the tax hike’s blow to consumption.
The sputtering recovery is a far cry from Prime Minister Shinzo Abe’s early success in lifting growth and halting deflation through aggressive monetary stimulus and government spending.
“We may not have a recession, but you cannot say that the economy is on track,” said Norio Miyagawa, senior economist at Mizuho Securities Research & Consulting Co.
“The government will become more reluctant to raise taxes,” he said of an end-year decision on whether to proceed with a planned further sales-tax increase.
“The BOJ can argue that inflation is still on track, but this argument may not last into next year.”
Industrial production sank 3.3 percent in June from May, Wednesday’s data showed, the fastest fall since the earthquake and tsunami of March 2011, and much deeper than the 1.2 percent fall forecast in a Reuters poll.
The fifth consecutive drop in shipments is reminiscent of Japan’s last recession, said an official at the Ministry of Economy, Trade and Industry.
“Output is clearly weakening, enough to make you even wonder if the economy is OK,” said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute.
Japan’s June exports fell 2.0 percent from a year earlier, compared with expectations of a 1.0 percent rise and on top of the first annual drop in 15 months in May, data showed last week.
Last week economists were expecting the economy to contract at an annualised rate of 5.6 percent for April-June from the previous three months, then rebound 2.5 percent this quarter, according to a Reuters survey.
But this week’s data throw that scenario into doubt. Economists are considering cutting their forecasts, with some pencilling in a 7-9 percent plunge. That could be so deep that Japan barely grows in the fiscal year to March.
BOJ Governor Haruhiko Kuroda has been resolutely upbeat that the central bank’s massive stimulus, the pickup from “Abenomics” and capacity restraints such as a growing labour shortage would ensure that Japan escaped nearly two decades of falling prices and hit the bank’s 2 percent inflation target in the fiscal year from next April.
Generating mild but steady inflation is key to Prime Minister Shinzo Abe’s strategy to pull the long-tepid economy from two decades of deflation.
Before the latest data, economists uniformly predicted the BOJ would miss its inflation target even as they lowered their expectations for further easing, given Kuroda’s confidence that he was engineering a sustained rise in prices with the bank’s enormous purchases of government bonds and other assets.
BOJ and government officials have consistently overestimated the resilience of exports, partly because data are patchy and slow to reflect how Japanese manufacturers are shifting production overseas, hollowing out domestic manufacturing.
Japan’s top four automakers said on Wednesday their exports fell in June - not because global demand had shrunk but largely because they increased production abroad to be nearer their sales markets.
Honda Motor Co had the biggest decline, with exports down 45 percent from a year earlier, after the company started making its popular Fit subcompact at a new Mexico plant this year and quit exporting the car to North America.
“The export weakness is puzzling,” said an official familiar with the BOJ’s thinking. “At some stage, exports need to pick up to achieve a sustained economic recovery.”
Companies have been shifting production overseas for some time, bedevilled by years of deflation and a declining population, and the exodus accelerated in 2011 as domestic production capacity started falling.
And even though the economy has rebounded under Abe and a weaker yen has made Japanese exports more competitive, companies remain interested in moving factories abroad, say management consultants who advise Japanese firms on setting up overseas.
Abe is seeking to lure business investment to Japan with a promise to cut corporate tax rates and create special economic zones meant to reduce red tape, but such measures alone are not likely to revive production and investment in Japan, some economists say.
The output slump may nudge the BOJ into cutting its assessment that production is “rising moderately as a trend” at its policy meeting next week. The government on Wednesday downgraded its view, saying output is “weakening.”
The BOJ may also be forced to tone down its upbeat language on the economic outlook as central bankers become less sure about when - or if - exports will rebound.
“The key is whether the positive economic cycle is sustained in July-September,” said a person familiar with the central bank’s thinking. (Additional reporting by Yoko Kubota; Editing by William Mallard)