Nov. 13 (Bloomberg) -- Japan’s economy probably expanded at the fastest pace in more than a year in the third quarter, helped by emergency spending by the former government that Prime Minister Yukio Hatoyama wants to phase out.

Gross domestic product grew an annualized 2.9 percent, following a 2.3 percent expansion in the three months ended June 30, according to the median forecast of 20 economists surveyed ahead of the GDP release due Nov. 16.

Domestic demand will make up more than half of the expansion for the period, the first time that’s happened since the first quarter of 2007, according to the median projection. Hatoyama’s plan to redirect what he termed the wasteful spending implemented by the ousted Liberal Democratic Party clouds the outlook for growth in 2010, analysts say.

“The plan is to divert the money to more constructive measures,” said Takahide Kiuchi, chief economist at Nomura Securities Co. in Tokyo. “The problem is that in this very delicate period, a stop-and-go approach poses a huge risk,” he said, adding that delays in implementing stimulus policies may trim growth by 0.5 percentage point in the six months to March.

Hatoyama’s Democratic Party of Japan inherited policies that helped stabilize the economy at the cost of increasing a debt that’s approaching double the size of GDP. The DPJ last month blocked about 3 trillion yen ($33 billion) in stimulus spending it says is wasteful.

Consumer Spending

Consumer spending, which makes up about 60 percent of the economy, rose 0.6 percent last quarter, the survey indicates. More than 20 trillion yen in stimulus that includes subsidies for companies that choose not to dismiss workers has helped stem job losses and lift household sentiment to a two-year high.

Incentives to encourage purchases of energy-saving appliances also added to sales at retailers including electronics dealer Yamada Denki Co.

Government spending on day-to-day operations increased 0.5 percent last quarter, while public investment in roads, bridges and other projects fell 0.6 percent, according to the survey.

Since Hatoyama took office in September, the government has frozen 2.9 trillion yen of the LDP’s supplementary budget, including public works and some subsidies to local governments. While the DPJ plans to divert the funds to its own programs, it hasn’t determined when or how to use them.

Deputy Prime Minister Naoto Kan said today that the government has 2.7 trillion yen available to compile a second extra budget for this fiscal year, without elaborating on how the money would be used.

DPJ Pledges

The party has said it needs to find 7.1 trillion yen in the year beginning April 1 to fulfill pledges ranging from childcare subsidies to lowering school tuition costs.

“The sustainability of growth could be impacted by the policy fluctuation under the Democratic Party,” said Tetsuro Sugiura, chief economist at Mizuho Securities Research Institute in Tokyo. “As long as they cut 3 trillion yen out of the budget, it will negatively affect economic activity in the near future, particularly if it’s public works.”

Uncertainty about the economy’s longer-term prospects has weighed on the Nikkei 225 Stock Average, which has fallen 1.8 percent since June 30, even as companies report profits nearly double those of the previous period.

Corporate Spending

Still, profits may have grown enough to allow businesses to resume buying plant and equipment. Economists predict capital spending rose 0.5 percent in the three months through September, the first gain in six quarters.

Machinery orders, which tend to lead capital spending by three to six months, are projected to rise 1 percent in the current quarter. The rebound follows a quarter in which bookings sank to the lowest level since records started in 1987.

Japan’s recovery has benefited from spending by governments abroad as well. Exports accounted for almost half of the country’s growth last quarter, increasing 6.2 percent from the previous quarter, according to the survey.

Demand from China, which is implementing 4 trillion yuan ($586 billion) of extraordinary spending, has helped Japanese companies as diverse as Hitachi Construction Machinery Co. and Honda Motor Co. Sales there helped Hitachi clear an inventory backlog and return to profit last quarter. Honda last month tripled its full-year profit forecast, even as its U.S. revenue slumps.

Japan’s expansion in the half year since March doesn’t make up the ground lost during the previous four quarters of contraction, when the economy shrank to its 2003 size. Industrial production is still about 20 percent below last year’s level and the slump in domestic demand has depressed consumer prices, which have dropped for seven straight months.

The Bank of Japan last month forecast deflation to persist through the 2011 fiscal year, leaving little room to raise interest rates from near zero. Governor Masaaki Shirakawa on Nov. 7 pledged to maintain an “extremely accommodative monetary environment.”

To contact the reporter on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net

Last Updated: November 12, 2009 23:04 EST