Japan's economy shrank in the latest quarter, data showed Monday, raising fears it could slip into recession due to financial turmoil in Europe, a strong yen and a painful diplomatic row with China.

The world's third-largest economy contracted 0.9 percent between July and September from the previous three months, equivalent to an annualised 3.5 percent drop which Prime Minister Yoshihiko Noda described as "severe".

The fall is yet more bad news for an economy that was already showing signs of strain, with tumbling factory output and the worst September trade figures in three decades.

Commentators warned the future is bleak, with a litany of worries including the Chinese consumer boycott of Japanese goods caused by a territorial row, an export-denting strong yen and the expiry of incentives for car buyers.

Noda – under pressure to call a general election – told parliament on Monday he would work "with a sense of crisis" to address the country's economic woes.

"I have also been instructing ministers concerned to draw up an economic package, possibly this month," Noda said, as he pointed to the first US$5.0 billion tranche of a previously-announced stimulus.

The package came on top of measures taken in the wake of last year's quake-tsunami disaster, when Tokyo tried to spur growth by offering incentives for fuel-efficient vehicle purchases and measures to rebuild the northeastern coastline after the disaster.

While the latest figures beat market expectations of a 3.9 percent annualised contraction, it was the sharpest decline since last year's crisis, with household and company spending as well as exports all slowing.

Another three months of shrinkage in the October-December quarter would mean Japan has slipped back into a technical recession, which is defined as two successive quarters of contraction.

Economy minister Seiji Maehara pointed to those fears on Monday with comments likely to heap pressure on the Bank of Japan for further stimulus.

"We cannot deny the possibility that the Japanese economy has entered into a recessionary phase," Maehara told a press briefing.

Last month, the Bank of Japan unveiled $138 billion in fresh monetary easing after central banks in the United States and debt-hit Europe also announced fresh measures to fuel growth.

The central bank, which also said it would provide new loans to banks, had been under pressure from politicians calling for urgent action. It was likely to face renewed calls for stimulus in light of the growth data Monday.

Japan's trade picture has become increasingly bleak as exports to China, especially in the car market, suffer because of a consumer boycott.

This was sparked by Japan's nationalisation in September of an East China Sea island chain claimed by both Tokyo and Beijing.

RBS Securities chief Japan economist Junko Nishioka told Dow Jones Newswires that the economy was unlikely to show growth again "until the April-June period at the earliest".

The strong yen is a particularly acute problem for major exporters such as automakers, with Honda and Nissan recently warning their full-year profits would shrink because of the surging currency and the China dispute.

Last month, Japan posted its worst September trade figures since 1979 due partly to the China row as well as weakness in the United States and Europe, two key export markets.

US-bound shipments were up just 0.9 percent in September, while exports to debt-hit Europe dived 21.1 percent. Exports to China were down 14.1 percent.