I. The Outlook
1. We share the authorities' view that growth is likely to moderate in the near-term.
• Baseline: We project GDP growth to moderate to around 1½ percent in 2008 and 2009, somewhat below potential. Private consumption and business investment should slow, offset in part by a turnaround in construction and robust exports to non-U.S. destinations. Headline CPI inflation is expected to rise to around 1 percent in 2008 and 2009, reflecting higher commodity and fuel prices, but core inflation will likely remain low.
• Risks: Compared to several months ago, the risks to the outlook appear more evenly balanced, as concerns over a global credit squeeze have eased and growth outside the United States has so far held firm. However, the outlook is still subject to considerable uncertainty surrounding the depth of the U.S. slowdown and future developments in commodity prices and financial conditions. Domestically, the weak small and medium enterprise (SME) sector is a concern, while the deterioration in the terms of trade is weighing on corporate profits and household incomes. On the other hand, growth in exports to emerging markets could continue to surprise on the upside.
II. Macroeconomic and Financial Policies
The current policy mix is broadly appropriate for the near-term. Fiscal policy is governed by the already high debt burden and the growing demands associated with an aging population. Given the uncertainties in the outlook, monetary policy should remain accommodative and interest rates held steady until concerns over domestic activity and the global environment have eased. Financial policies should guard against spillovers from the global market turmoil and risks from a slowing economy.
A. Macroeconomic Policies to Sustain the Expansion
2. Fiscal policy is rightly focused on reducing the high level of public debt. Over the past several years, buoyant tax revenue and public investment cuts have led to a large reduction in the general government primary deficit (excluding social security)-to an estimated ¾ percent of GDP in FY2007. This improvement is welcome, but the revised medium-term fiscal plan fails to build on the progress as it targets a broadly unchanged deficit for FY2008 and no more than primary balance (excluding social security) by FY2011. This would imply that the net public debt ratio would remain high and begin to rise thereafter in the absence of a sharp fiscal adjustment. For this reason, we recommend a faster pace of adjustment supported by comprehensive tax reform.
• Near-term fiscal stance: The FY2008 budget targets a broadly neutral stance with a slight increase in total expenditures and lower tax buoyancy. Notwithstanding the uncertain growth outlook, we believe a somewhat more ambitious budget aimed at reducing the primary deficit would have been desirable. In the event that revenues fall short of the budget target, it would be prudent to constrain spending (and avoid a supplementary budget) in order to prevent undermining fiscal consolidation.
• Pace of consolidation over the medium-term: Starting in FY2009, we recommend an adjustment of the primary balance (excluding social security) of ¾ percent of GDP per year, or about ½ percent of GDP more than in the authorities' reference path.1 If maintained, this is projected to lead to a primary surplus of 1½ percent of GDP in FY2011 and put the public net debt ratio firmly on a downward path. Faster consolidation would take advantage of the current low interest rates and help dispel concerns over the pension system that may be weighing on consumption.
• Fiscal reforms: With expenditure cuts nearing their limit, the focus of fiscal consolidation should shift towards tax measures, including raising the consumption tax and broadening the income tax base. These actions should be part of a comprehensive reform of the tax system that aims to improve efficiency and secure fiscal sustainability. The proposal to discontinue the earmarking of tax revenues to road construction beginning in FY2009 may provide an opportunity to discuss broader tax reform options. Also, additional revenues are needed to finance the government's plan to raise its funding share for the basic national pension program from one-third to one-half starting in FY2009.
• Strengthening social security: The pension system review planned next year should lead to reforms that support medium-term fiscal sustainability. At the same time, reforms will need to address the challenges created by rapid aging and concerns over increasing inequality in pension benefits between generations, as well as between those covered and not covered by the system.
3. Given the uncertainties surrounding the outlook, we agree with the Bank of Japan (BoJ) on its flexible "wait and see" approach to the conduct of policy.
• Background: Monetary conditions remain accommodative with headline inflation now above the policy rate. Despite the increase in commodity and fuel prices, wage pressures and core inflation (excluding food and fuel) remain weak and inflation expectations seem to be contained.
• Conduct of monetary policy: Under our baseline scenario, growth is expected to moderate to somewhat below potential while headline CPI inflation would stabilize at around 1 percent. At the same time, there are no indications of growing imbalances under the "second perspective" and the risks that low interest rates in Japan are fueling carry trades and complicating monetary management elsewhere have diminished. Given the uncertain outlook, we agree that the policy rate should be maintained at the current level until concerns over domestic activity and the external environment have eased.
4. The team has several observations relating to communications under the monetary framework and ways to strengthen the BoJ's role in helping to secure financial stability.
• Communications under the monetary framework: With inflation now moving towards the center of the "understanding of medium- to long-term price stability" and pressures on global commodity prices, there are new challenges to guiding inflation expectations. The greater discussion of the risks to the outlook and of the views of the Policy Board Members on growth and CPI inflation in the BoJ's April "Outlook for Economic Activity and Prices," should be useful in enhancing public understanding of the outlook and conduct of monetary policy. Moreover, the greater emphasis on the 1 percent median of the "understanding of price stability" could help firms and households adjust to the new price environment and anchor inflation expectations.
• Securing financial stability: The BoJ's flexible approach to liquidity operations has helped stabilize money market conditions and ensure market stability. Nonetheless, it may be useful to strengthen the BoJ's monitoring of the overall financial system by expanding the sharing of information between the BoJ and the Financial Services Agency (FSA) on activities of systemically important financial institutions outside the banking system.
5. The market-determined exchange rate policy remains appropriate. Notwithstanding the appreciation since mid-2007, the yen in real effective terms remains below its level at the beginning of the expansion in 2002. We continue to support the official policy that the yen exchange rate should be market determined with intervention only justified to counter disruptive exchange rate movements.
6. A sharper-than-expected slowdown and rising global inflation are also potential scenarios to consider.
• A sharp slowdown: Under an alternative scenario where the economy slows substantially, the scope for countercyclical fiscal policy would be constrained by the need to bring down the high debt ratio. Moreover, the unsuccessful experience with the 1990s fiscal stimulus casts doubt on the effectiveness of boosting public spending. For monetary policy, in addition to reducing interest rates, the BoJ has a wide arsenal to meet exceptional liquidity needs and maintain market stability.
• Global monetary tightening: Rising global inflation that triggers a tightening international response could complicate monetary policy in Japan. In this case, the BoJ may need to consider normalizing interest rates at a faster pace than might be warranted by domestic conditions alone.
B. Financial Policies to Safeguard Stability
7. The impact of the global market turmoil on Japan's financial system has so far been manageable, but risks remain. Japanese banks' reported subprime-related losses have increased but remain well within their capital and operating earnings. However, the financial system still faces risks from the global market turmoil and a slowing domestic economy. The reverberations through various markets in Japan from the financial turbulence have highlighted how closely integrated global financial markets have become.
8. Financial policies are appropriately focused on guarding against spillovers from the global market turmoil. The authorities have taken a number of useful steps, including disclosing banks' subprime holdings and providing exceptional liquidity, which have helped support market confidence. Looking ahead, we would highlight the following policy priorities—consistent with those recommended by the Financial Stability Forum—for further strengthening the financial system.
• Greater disclosure for structured holdings: Following subprime write-downs, attention has shifted to Japanese banks' holdings of other structured credits where losses so far have been more limited. Greater disclosure of structured holdings, including on the underlying assets and hedging coverage, and of off-balance sheet vehicles would strengthen market confidence and discipline. Consideration could also be given to extending enhanced disclosure to nonbanks, such as insurers, with the understanding that the accounting and regulatory treatments may differ from banks.
• Adequacy of capital cushions: Japanese major banks should be encouraged to continue efforts to improve the quality of their "core" capital as their Tier 1 capital ratios remain below those of other leading banks. For regional banks, in light of their expansion into securities and overseas investments, consideration could be given to raising the minimum capital requirement for domestic banks above the current 4 percent level (compared to the 8 percent required for internationally active banks under the Basel framework). This would not only be more in line with current trends (most regional banks are already above 8 percent), but also give the supervisor more flexibility in dealing with distressed banks at an earlier stage. Gradually raising the minimum capital requirement would give banks sufficient time to adjust.
• Strengthening the market for securitization: Although securitization has grow steadily since the late 1990s, the market remains small with the volume of secondary trading limited. Greater disclosure by the originator on the underlying assets, such as for SME-ABSs, and the creation of reliable market benchmarks (e.g., for commercial real estate) would improve price discovery and liquidity in the secondary market.
9. A slowing domestic economy also presents risks. Widening credit spreads for low-rated companies and rising corporate bankruptcies, led by SMEs, suggest the need for vigilance against credit risk, particularly for regional banks with their greater domestic exposure and higher levels of nonperforming loans (NPLs).
• Strengthening risk management: Supervisors will need to ensure that banks, particularly regional banks with exposure to weak SMEs, have appropriately classified and provisioned against problem loans. At the same time, the subprime crisis has created an opportunity for Japanese banks to expand into overseas markets to fill in lending space created by European and U.S. banks. Having in place robust credit risk assessment systems to manage overseas portfolios will help Japanese banks to take advantage of new lending opportunities while guarding against possible risks.
• Reducing market risk: Japanese banks' large equity holdings expose the banking system to considerable market risk and exacerbate the procyclicality of capital ratios. Banks should be encouraged to continue efforts to reduce their stockholdings as part of an overall strategy for improving their risk-return profile. This reduction will be promoted by the increase in capital charge for existing equity holdings to the same level as that for new equity purchases, which is set for 2014.
10. Over the longer-term, further reforms are needed to improve financial intermediation and promote stability. These would include: encouraging further bank consolidation to boost core profitability; managing the privatization of Japan Post to ensure a level playing field for all institutions, and promoting a broader sharing of credit information to strengthen risk pricing and financial stability. Further development of the capital markets would also help enhance Tokyo's appeal as an international financial center.
III. Structural Reforms to Enhance Potential Growth
11. We believe that it would be highly desirable to reinvigorate structural reforms. In the near-term, reforms would support growth by providing a boost to investment and confidence. Over the longer-run, broader reforms would raise potential growth and help address widening economic dualities arising from globalization. There has been some progress in implementing initiatives under the IMF's Multilateral Consultation, but more needs to be done. The priorities remain to enhance labor market flexibility and promote competition through further deregulation and market opening.
• Enhancing labor market flexibility: Labor utilization would improve with more flexible work arrangements, easier rules for dismissal, greater portability of pensions, and more balanced employment conditions for regular and temporary workers. A more liberal and bolder approach to immigration policy would also address special labor needs and shortages. In this regard, we look forward to the recommendations of the government panel for accepting more skilled professionals into Japan.
• Promoting competition: Further deregulation and market opening, particularly in agriculture, retail, and services, would give a boost to productivity and make Japan a more attractive destination for foreign investment. Applying successful reforms in the Special Zones on a nationwide basis and opening further "government-driven" markets to the private sector could build support for deeper reforms.
12. Structural reforms would also support an orderly adjustment in global imbalances and contribute to external stability. Japan's current account surplus is expected to narrow over the medium-term, as population aging reduces household savings and pushes firms to substitute capital for labor. This adjustment would be facilitated by far-reaching reforms that raise labor participation rates, enhance productivity, and increase the return on capital. It would also likely be associated with a strengthening of the yen over the medium-term and contribute to an orderly reduction of global imbalances.
13. In summary, Japan faces significant economic policy challenges over the medium-term. Stabilizing the public finances, managing the return to more normal monetary conditions, strengthening the financial sector, and boosting productivity through labor reforms and deregulation would lay the foundation for a sustained expansion and allow Japan to benefit more fully from its close integration with the global economy. We encourage the government to spare no efforts in helping to create a more resilient, competitive, and dynamic economy whose benefits would be shared with the rest of the world.
Finally, we thank the authorities for their close cooperation and warm hospitality. We have benefited a great deal from our discussions over the past week and look forward to your views on these preliminary conclusions.
1 The need for a faster pace of adjustment reflects a more ambitious debt reduction target and more conservative growth and interest rate assumptions than under the authorities' plan.
IMF EXTERNAL RELATIONS DEPARTMENT