By Leika Kihara and Tetsushi Kajimoto

TOKYO (Reuters) – Japan’s economy expanded more than expected in the fourth quarter, extending its recovery from its worst postwar recession thanks to a rebound in overseas demand that boosted exports and capital spending.

But the recovery slowed from the third quarter’s brisk pace and new state of emergency curbs cloud the outlook, underscoring the challenge policymakers face in preventing the spread of COVID-19 without choking off a fragile recovery, especially in the battered consumer sector.

“Conditions are such that Japan will not be able to avoid negative growth in the first quarter,” said Takumi Tsunoda, senior economist at Shinkin Central Bank Research.

“There is a high possibility that there will be a repeating cycle of coronavirus infections spreading and being contained this year, which means that consumption is not likely to recover at the expected pace.”

The world’s third-largest economy grew an annualised 12.7% in October-December, government data showed on Monday, exceeding a median market forecast for a 9.5% gain.

It was slower than the revised 22.7% surge in the previous quarter, when the economy got a lift from pent-up demand after a previous state of emergency was lifted in May.

For the full coronavirus-stricken year, Japan’s economy contracted 4.8%, the first annual fall since 2009.

But Japan’s October-December performance was stronger than U.S. growth of 4% and a 2.8% slump in the euro zone. With two straight quarters of solid growth, Japan’s economy likely recouped 90% of pandemic-induced losses, analysts say.

“Japan’s recovery proceeded at a much faster pace than initially expected,” said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute.

“There’s still some distance toward a full normalisation, but economic activity is recovering toward pre-pandemic levels.”

A global rebound in manufacturing activity gave exports and capital expenditure a much-needed boost as shipments to China’s rapidly recovering economy heated up.

External demand, or exports minus imports, added 1.0% point to fourth-quarter GDP growth thanks to a 11.1% surge in exports.

Capital expenditure also grew 4.5%, marking the first increase in three quarters, as companies proceeded with spending that had been put off last year due to the pandemic.

Private consumption, which makes up more than half of the economy, rose 2.2%, slowing from the 5.1% increase in the previous quarter but exceeding market forecasts for a 1.8% gain.

The outlook, however, remains highly uncertain as Japan lags western countries in rolling out vaccines.

A resurgence in infections forced the government to terminate a controversial travel discount campaign that had supported service spending in October and November.

Analysts expect the economy to contract in the current quarter, as retailers take a hit from renewed state of emergency curbs rolled out in January and set to last until early March.

“If state of emergency measures are lifted in March, Japan’s economy will probably rebound in April-June,” said Yusuke Shimoda, senior economist at Japan Research Institute.

“But we can’t count on a big expansion as it’s likely to take time for vaccine shots to reach the wider population.”

(Reporting by Leika Kihara and Tetsushi Kajimoto; Additional reporting by Kaori Kaneko and Daniel Leussink; Editing by Chris Gallagher and Sam Holmes)