Public Information Notice: IMF Concludes Article IV Consultation with Japan

August 13, 1999

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On August 4, 1999, the Executive Board concluded the Article IV consultation with Japan1.


Japanese growth has been lackluster through most of the 1990s. Since the asset price bubble burst in 1991, the economy has grown at an average of 1 percent per annum, in striking contrast to the rapid growth achieved in previous decades. This disappointing performance has occurred despite expansionary macroeconomic policies. A series of fiscal stimulus packages raised the structural general government deficit by more than 5 percentage points of GDP between FY1991 and FY1998, while monetary policy has been progressively eased, with the overnight call rate being reduced from more than 8 percent in 1991 to effectively zero at present.

After a short-lived recovery in 1996, the economy moved back into recession in early 1997. The downturn was initiated by a larger-than-anticipated fall in household spending after the April 1997 consumption tax hike, compounded by a sharp reduction in domestic bank lending partly associated with disruptive impact of the failure of three major financial institutions in late 1997, and the Asia crisis. GDP declined almost 3 percent in 1998, with all of the main components of private domestic demand experiencing far deeper and more prolonged declines than in previous recessions. However, a surge of public investment starting in the fourth quarter of 1998, together with steps to ease financial constraints, contributed to stabilize private demand and a pick-up in output in the first quarter of 1999.

The drop of business investment over the past two years has been particularly severe. By the fourth quarter of 1998, business investment was almost 20 percent below its early 1997 peak. To an important extent, the abrupt decline has reflected continued efforts to address excess indebtedness and over-investment inherited from the "bubble" period. More generally, an increasing focus on profitability rather than market share and reduced expectations of long-term growth encouraged firms to cut-back plans for capital accumulation. Limits on the availability of bank credit also seem to have been a negative factor, although recently this constraint has been alleviated by policy actions.

Private consumption has been dampened by falling incomes and concerns about labor market adjustment. Even with tax cuts, disposable income has declined about 1½ percent over the past year, while expectations of future earnings have been undermined by a rising unemployment rate and by prospects for further increases in the period ahead as a number of major corporations have announced employment reduction plans. Against this, the receding threat of financial crisis has been a positive influence on consumer sentiment, which may partly explain a modest pick-up in spending in early 1999.

Support from external demand has receded. Export volumes declined through 1998 and into the first quarter of 1999, despite the moderating impact of the downturn in Asian trade, as the boost to exports to other parts of the world coming from earlier yen depreciation waned. Real imports also fell through 1998, mainly reflecting weak domestic demand. The current account surplus rose 1 percentage point of GDP to 3¼ percent of GDP in 1998, boosted by declining oil prices and the J-curve effect from yen appreciation in the second half of the year.

Deflationary pressures have so far remained moderate. Excluding the impact of falling commodity prices, the 12-month rate of decline of the WPI has been about 1½ percent, not very different from the average rate of decline during the 1990s. The 12-month change in the core CPI (excluding fresh food and energy) has been slightly negative since last fall.

Responding to increasing evidence of weak activity, the authorities have acted to inject substantial fiscal stimulus. A ¥16.7 trillion (3 percent of GDP) package of public works and temporary income tax cuts in April 1998 was followed by a ¥24 trillion (5 percent of GDP) package in November, including permanent cuts in personal and corporate income tax rates, increased credit guarantees for bank loans to SMEs, temporary consumption vouchers, and a further boost to public works spending. The FY1999 budget confirmed the expansionary overall fiscal stance, and included additional tax incentives aimed at boosting residential investment and investment in information technology. A further ¥500 billion package of measures to support employment creation and retraining was announced in June 1999.

The Bank of Japan (BOJ) has continued to ease monetary conditions over the past year by cutting interest rates and supporting credit intermediation, while other government financial institutions have also been mobilized to relax financing constraints. The target rate in the overnight call market was steadily eased and by March 1999 had been reduced to virtually zero. In April, the Governor announced that this "zero interest rate policy" would be sustained untildeflationary concerns were dispelled. Stepped-up BOJ participation in commercial paper (CP) repo operations have been used to facilitate corporate financing while public funds have been provided to increase the availability of loan guarantees from local government credit guarantee associations.

Exchange rate policy has been geared to resisting movements in the yen to extreme levels and avoiding unstable market conditions. In the context of turbulent global market conditions which prompted an easing of U.S. monetary policy and an unwinding of yen carry trade positions, the yen appreciated during the second half of 1998, and reached ¥109 per dollar in early January 1999. Subsequently, the further easing of monetary policy together with exchange market intervention encouraged the yen to depreciate, and it moved around ¥120 per dollar during most of the first half of 1999. However, upward pressures on the yen resumed in June and July in the context of positive economic news and a more generalized downward movement in the U.S. dollar.

A framework for dealing with banking problems has now largely been put in place, reducing immediate concerns for systemic risk. In October 1998, the government set aside ¥60 trillion (12 percent of GDP) for financial support for banks. The 15 major banks received ¥7.5 trillion in capital injections in early 1999, based on detailed restructuring plans. The newly-created Financial Supervisory Agency (FSA) has effectively increased regulatory pressure on banks while the new framework for dealing with failed institutions was used to proactively nationalization of the Nippon Credit Bank in late 1998 and, more recently, the placing of three second-tier regional banks under government administration based on the results of FSA audits. However, the changes have not yet gone far enough to fully resolve banks' balance sheet and profitability problems.

Structural reforms over the past year have mainly focussed on the financial sector and changes to promote corporate restructuring. The "Big Bang" financial reforms have remained on schedule and are now nearing completion. These reforms are being complemented by the progressive introduction of improved accounting standards and accelerated plans to reform insolvency law. A package of tax and regulatory measures to promote corporate restructuring were announced in July 1999.

Despite the strong first quarter rebound, a sustained recovery is not yet assured. The staff's current forecast is for ¼ percent growth in 1999 rising to 1 percent in 2000. The monthly indicators of activity for the second quarter suggest a continued rise in private consumption, but business investment looks likely to have renewed its decline. Moreover, rising unemployment may dampen consumer sentiment in the second half of 1999, when the recovery will already be under pressure from the expected contraction in public investment. Nevertheless, the staff expects growth to pickup in 2000 based on a turnaround in business investment and a positive contribution from the external sector, provided that macroeconomic policies remain supportive.

Executive Board Assessment

Executive Directors observed that over the last year and a half the Japanese authorities had implemented a wide-ranging series of fiscal, monetary, and banking initiatives to support the economy and relieve financial strains. These actions had contributed importantly to the emerging signs of a bottoming out of activity and a turnaround in business confidence and market sentiment, and had averted the immediate threat of a deflationary spiral. Despite these benefits, however, Directors believed that the economic outlook remained uncertain. In this connection, they noted that the financial and corporate restructuring now in progress could continue to weigh on both business investment and household spending in the short term, although such restructuring was vital to restore the vigor and profitability of Japanese business.

Directors endorsed the government's evolving strategy, which gives increased emphasis to promoting restructuring efforts, while maintaining macroeconomic support. Most Directors felt that, while the scope for additional fiscal and monetary stimulus is now limited, it is still too early to start unwinding the support for aggregate demand from macroeconomic policies, given the uncertain short-term prospects. Directors also underscored that recent signs of improvement in activity should not detract from efforts to foster the resolution of underlying structural problems in the banking and corporate sectors, without which an effective expansion of credit to the private sector, and an enduring recovery overall, would not be possible.

Within this framework, most Directors suggested that, notwithstanding the longer-term need for fiscal consolidation, the present supportive fiscal stance should be sustained until a recovery in private demand takes hold. Some Directors expressed concern that the recent surge in public investment spending could be reversed in the second half of the year, particularly given financial constraints on local governments, and that the recently announced budgetary guidelines for fiscal year 2000 could imply a considerable fiscal tightening in that year. Given the uncertain outlook for private demand, they suggested that a substantial further supplementary budget would be needed for fiscal year 1999 to ensure that fiscal stimulus is not withdrawn prematurely. Many other Directors, however, felt that the potential benefits from continued expansionary fiscal policy were limited, raising concerns about the productivity of recent public investment projects, pointing to the implications of further large fiscal packages for Japan's already high debt-to-GDP ratio, and stressing that, more fundamentally, an enduring recovery would depend on determined implementation of structural reforms. Some Directors also drew attention to the need to gear any short-term fiscal expansion to enhancements in the efficiency of fiscal policy, consistent with the objective of longer-term fiscal consolidation.

While continuing macroeconomic uncertainty means that it is too early to lay out a detailed road map for long-term fiscal adjustment, Directors emphasized that it would be critical to push ahead with fiscal reforms to lay the groundwork for eventual consolidation once a self-sustaining recovery is achieved. They suggested that priorities should include comprehensive reforms to ensure the long-term viability of the public pension system; extending recent initiatives to increase the efficiency of public works spending; and tax reforms to assist labor mobility, support corporate restructuring, and broaden the tax base. Directors also emphasized that greater fiscaltransparency would increase the public's understanding of the intended fiscal policy stance, and thus enhance the economy's responsiveness to fiscal policy initiatives.

Directors commended the Bank of Japan's (BOJ) commitment to maintaining a zero interest rate policy until deflationary concerns are dispelled, and emphasized that monetary policy is providing critical support for the economy, thereby helping to alleviate immediate deflationary concerns. In the unlikely event that price declines intensify significantly, several Directors suggested that the BOJ would need to find ways to apply additional monetary stimulus, for example, by extending monetary operations up the yield curve and broadening the range of assets involved in such operations. While noting the recent significant measures to increase transparency, some Directors felt that further steps would be especially appropriate in such circumstances, for example, by making the BOJ's long-term inflation objectives more explicit and adopting a supplementary operating target to signal intended changes in the monetary policy stance. Other Directors felt that current procedures provided a high degree of flexibility for monetary policy and did not need to be changed.

Many Directors felt that a substantial strengthening of the yen could undermine the recovery, and felt that the authorities should, in the short term, resist sustained upward pressure on the currency. Several Directors observed, in this connection, that a stable yen would also be conducive to promoting the recoveries of the crisis-affected countries in the region. However, some Directors felt that recent upward pressure on the yen was the natural result of improved prospects for Japan, and that intervention aimed at resisting this market response could interfere with the process of adjustment over time to existing large global current account imbalances, as well as with carrying forward the necessary structural reforms at home. A number of Directors felt that intervention, in any case, might not be effective, even if it was unsterilized.

Directors complimented the authorities on the effective framework for resolving banking system problems that has now been put in place, which has reduced the immediate risk of financial turbulence. They underscored that the focus now needs to turn to implementation, noting that the current environment of greater stability in the banking system offers Japan the opportunity to pursue a more aggressive strategy in tackling banking system weaknesses. Directors emphasized the need for further initiatives to restore the banking sector to full health and raise profitability toward international levels, particularly in light of the planned return to partial deposit insurance after March 2001. They suggested that by this date the minimum capital adequacy standard for all banks should be raised to 8 percent, consistent with the Basle standard, although this would need to be implemented gradually to moderate any initial negative impact on bank lending. Moreover, a robust structure for deposit insurance needs to be in place by this time, including a well-financed insurance fund and efficient mechanisms to deal with failed institutions.

While recognizing progress over the past year to tighten bank supervision, Directors emphasized that the restoration of the banking system to full vigor would require continued pressure on banks to classify loans appropriately and to raise provisioning against impaired loans, particularly since recent weakness in activity had probably contributed to the further deterioration of loan portfolios. Regulators would also need to ensure that banks that have received public capital injections achieve their performance objectives. In addition, a number of Directors considered that everyeffort needs to be made to ensure that nationalized banks are quickly returned to the private sector, including by selling marketable assets of the banks separately to investors if buyers cannot be quickly found for such banks as going concerns, and to ensure that public bodies given the task of disposing of nonperforming loans act expeditiously, before the value of their assets erodes further.

Directors were pleased to note that the Big Bang financial reforms are now nearly complete and are already catalyzing changes in the financial system. Welcoming the increasing attention being paid by the government to structural issues, they suggested that priority now be given to pushing through further initiatives to strengthen the financial system, enhance the environment for corporate restructuring, foster greater labor mobility, and accelerate deregulation. Steps to reduce the public sector's role in financial intermediation and strengthen further the regulation of the broader financial system, including the troubled life insurance sector, would complement the Big Bang reforms. Directors welcomed recent steps to support corporate restructuring by reducing legal and regulatory impediments, and by accelerating plans to reform the bankruptcy code to provide a more flexible approach to corporate rehabilitation. In this connection, some Directors attached particular importance to improving corporate governance. Directors also emphasized the need to provide increased impetus to deregulation efforts through comprehensive sectoral programs. In the view of many Directors, the potential short-term strains in labor markets from restructuring could be relieved by steps to enhance the flexibility of the labor market.

A number of Directors observed that Japan's economic data in some areas suffered from important weaknesses, which complicate the monitoring of developments in the formulation of macroeconomic policies. They encouraged the authorities to place a high priority on improving the timeliness and coverage of these statistics.

Directors commended Japan for its continuing role as the world's largest provider of official development assistance. They particularly welcomed the initiatives taken over the past year to provide increased financial support to East Asian crisis countries, which have played an important part in fostering a strong regional recovery.

Directors welcomed the authorities' decision to participate in the pilot project for the release of Article IV consultation staff reports.

Japan: Selected Economic Indicators

  1995 1996 1997 1998 Proj.

  Percent changes, unless otherwise noted
GDP 1.5 5.0 1.4 -2.8 0.2
Private consumption 2.1 2.9 1.0 - 1.1 0.8
Nonresidential investment 5.2 11.3 7.1 - 11.3 - 6.0
Residential investment - 6.5 13.6 - 16.3 - 13.7 - 5.7
Public investment 0.6 9.2 - 10.4 - 0.3 14.2
Public consumption 3.3 1.9 1.5 0.7 1.5
Stock building 1/ 0.2 0.4 - 0.1 - 0.1 - 0.2
Foreign balance (contribution) - 0.8 - 0.5 1.4 0.6 - 0.2
   Exports 5.4 6.3 11.6 - 2.3 - 0.5
   Imports 14.2 11.9 0.5 - 7.5 1.1
GDP deflator - 0.6 - 1.4 0.1 0.3 0.0
CPI - 0.1 0.1 1.7 0.6 - 0.2
Unemployment rate (period average) 3.1 3.3 3.4 4.1 5.0
Industrial production 3.4 2.3 3.6 - 7.1 0.1
Current account balance
Billions of U.S. dollars 111.4 65.8 94.1 121.0 143.1
Percent of GDP 2.2 1.4 2.2 3.2 3.5
General government balances (percent of GDP)
Balance including social security - 3.6 - 4.2 - 3.4 - 5.3 - 7.7
    Structural balance - 3.0 - 4.6 - 3.5 - 3.8 - 5.8
Balance excluding social security - 6.5 - 6.8 - 5.9 - 7.5 - 9.8
    Structural balance - 6.0 - 7.1 - 6.0 - 6.5 - 8.6
Monetary aggregates
M1 8.2 13.7 8.8 8.5 ...
M2 + CDs 3.2 3.2 3.0 4.4 ...
Exchange rates (period average)
Yen/dollar rate 94.1 108.8 121.0 130.9 ...
Real effective exchange rate 2/ 151.1 127.7 120.0 110.2 ...
Interest rates (period average)
3-month CD 1.1 0.5 0.5 0.4 ...
10-year bond 3.3 3.0 2.1 1.3 ...

Sources: Nikkei Telecom and IMF staff estimates.

1/ Contribution to GDP growth.
2/ Based on normalized unit labor costs; 1990 = 100.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.


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