Japan—2010 Article IV Consultation Concluding Statement
May 21, 2010
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
Japan’s economy is gaining strength, but vulnerability to sovereign risk is rising. Decisive policy action and strong external demand are driving the recovery, but large fiscal deficits have pushed public debt to unprecedented levels. With global scrutiny of public finances increasing, the need for early and credible fiscal consolidation has become critical. Fiscal adjustment should start in FY2011 beginning with a modest increase in the consumption tax. Such efforts would be helped by policies to spur growth and combat deflation. This statement summarizes our preliminary findings, which will be more fully discussed in the forthcoming Article IV IMF staff report.
I. Outlook and Risks
1. The outlook has improved, but the pace of recovery will likely moderate. Based on the IMF’s April World Economic Outlook projections, we expect GDP to grow by around 2.0 percent in both 2010 and 2011.1 Private consumption will likely pick up as robust exports, particularly from Asia, lift business investment. However, the current pace of recovery is likely to moderate in the second half of the year as stimulus measures expire and export growth levels off. Inflation is projected to turn positive in late 2011, as the output gap narrows.
2. There is considerable uncertainty around our forecast. Current volatility in global financial and exchange markets could dampen external demand, as sovereign risk pressures force governments around the world to scale back their spending. Similarly, lower growth in China would slow imports from the region and Japan. Domestic risks to growth stem primarily from a worsening of deflation, which could dampen investment and consumption. On the upside, more robust growth in the U.S. and Asia could further boost exports.
3. Recent events in Europe have increased the chances of a tail risk event. A loss of market confidence in sovereign debt could lead to a sharp rise in risk premia worldwide and push up long-term interest rates in Japan. Under such a scenario, growth would slow sharply in Japan, prolonging deflation and aggravating the fiscal problem.
|(Calendar Year, Growth Rate)|
Total domestic demand
Net exports (contribution)
CPI inflation (average)
Current account balance
In billions of U.S. dollars
In percent of GDP
General government balance 1/
Structural balance 1/
Primary balance excluding social security 1/
Gross debt (in percent of GDP) 2/
Net debt (in percent of GDP) 2/
Source: World Economic Outlook, April 2010.
1/ In percent of GDP. Fiscal year basis.
2/ In percent of GDP. Calendar year basis.
Japan: Near-Term Projections
II. Mapping A Credible Fiscal Reform Strategy
4. The need for credible fiscal adjustment has assumed center stage. The decisive fiscal policy response to last year’s recession was necessary and effective, but resulted in large fiscal deficits that have boosted net public debt to an estimated 122 percent of GDP in FY2010 (227 percent in gross terms). With the attention of global financial markets now focused on countries’ fiscal positions, Japan stands out as having the highest level of debt among advanced economies.
5. In this light, fiscal consolidation should start next year. The cyclical recovery provides an opportunity to begin fiscal adjustment in FY2011 and minimize risks of a potential loss in confidence. The government has rightly recognized the critical importance of fiscal adjustment and is preparing to release a new “Fiscal Strategy” in June. In our view, the strategy should aim to begin adjustment next year, as further delay would leave public debt at unsustainably high levels long into the future (see chart).
6. Gradual fiscal adjustment should continue for a decade. Based on IMF staff’s estimates, stabilizing the net (gross) debt-to-GDP ratio at 140 (240) percent of GDP in 2014 and then placing it on a downward path would require a reduction of the structural primary deficit by about 1 percent per year for the next 10 years, or a total of 10 percent of GDP over the next decade. Given the limited scope for cutting expenditure, fiscal adjustment needs to rely on new revenue sources as well as measures to contain the growth of spending. Raising growth above current projections under the government’s growth strategy would also help stabilize public debt.
7. The fiscal adjustment could be achieved in a number of ways centered around an increase in the consumption tax rate (see Table for a menu of options). The key elements of a credible package could include:
• Exit from stimulus. Given the improved economic outlook, the government should allow stimulus measures to expire in FY2010, which would contribute savings of about 1–1.5 percent of GDP.
• Comprehensive tax reform. A gradual increase of the consumption tax to 15 percent or more should begin with a modest increase in FY2011. Distributed over several years, the consumption tax hike could generate 4–5 percent of GDP of revenue. This measure could be combined with a reduction of personal income tax allowances and a corporate tax reform to stimulate domestic investment. In this regard, we welcome progress towards introduction of a single numbering system for taxpayers and social security.
• Limiting expenditure growth. By containing public spending growth and reforming pension entitlements in line with rising life expectancy, sizeable additional savings would be generated over the next decade (3–4 percent of GDP). Measures could include freezing non-social security spending in nominal terms; limiting fast-rising health-care costs and other social entitlements; introducing an income cap on social transfers; and raising the statutory retirement age.
8. Such fiscal adjustment may dampen growth in the near term but lead to faster growth over the medium-term. We estimate that relative to our baseline, the fiscal reform program would slow growth by about ⅓ percentage point per year on average over the first few years. Thereafter, GDP would expand at a faster rate than in the baseline as public debt declines and gains in confidence boost investment and consumption. If accompanied by reforms to boost productivity, longer-term growth benefits could be larger.
9. Fiscal adjustment would be aided by the adoption of a fiscal rule. We welcome the consideration being given to introducing a “pay-as you-go” requirement (where new expenditures would be funded by offsetting spending cuts or additional revenue) and a multi-year expenditure framework. In addition, an explicit long-term fiscal rule would strengthen the commitment to cap public debt and anchor expectations. Such a framework was recently adopted in Germany and has generally been effective in constraining debt growth in Switzerland (“debt brake”).2 In Japan, a new fiscal framework could target a primary fiscal balance consistent with a particular debt limit. Such a strategy should be based on prudent economic assumptions and narrowly defined escape clauses.
10. Given the large and growing public debt stock, effective debt management remains critical. The authorities have taken steps to gradually raise the average maturity of outstanding public debt to an estimated 5–5 ½ years. Nonetheless, gross public financing needs for maturing and new debt is large partly due to a sizeable share of short-term financing bills, which account for 11 percent of overall debt. Although there are differences between financing bills and JGBs, adopting an asset-liability management approach covering both types of debt could strengthen public debt management and the monitoring of maturity risk.
III. Monetary Policy Options to Combat Deflation
11. The Bank of Japan’s (BoJ) current accommodative policy stance has helped stabilize financial markets and support the recovery. The re-emergence of deflation is to a large part the result of a sharp drop in external demand in 2009 against the backdrop of a structurally low inflation rate. The BoJ’s accommodative stance should support the recovery and ease deflation pressures, but the decline in long-term inflation expectations could indicate that inflation may be slow to return.
12. Further measures could help ease deflation pressures.
• Additional easing. The BoJ’s recent decision to double the size of its funds supplying operation has helped lower short-term interest rates. Building on this success, the BoJ could consider extending the size and maturity of its funds supplying operation (6–12 months) to reduce still sizeable term-spreads, which in turn might also alleviate appreciation pressures.3 In addition, the BoJ could consider purchasing a wider array of assets, such as low-rated corporate bonds, to stimulate activity and help close the output gap.
• Supporting growth. As part of the BoJ’s research on supporting lending by private financial institutions to innovative firms,4 consideration could be given to improving access to credit for small and medium-sized enterprises (SME), which continue to face financial constraints according to the Tankan survey. For example, the BoJ could broaden the scope of acceptable collateral to include low-rated securitized SME loans, which could encourage the development of a new market for lending to SMEs.
13. During a period of heightened uncertainty, clear communication is essential. This is especially so in light of a number of administrative price changes (e.g. to high school tuition and tobacco taxes) and the rebasing of the CPI in 2011 which could affect inflation expectations. The BoJ has already clarified that the Policy Board does not tolerate year-on-year inflation that is equal to or below zero percent. To further guide expectations, the BoJ could consider communicating its intention to maintain easy monetary conditions until Policy Board members’ one-year inflation forecast exceeds 1 percent (the midpoint of the understanding of price stability) provided that financial imbalances remain absent under the “second perspective”.
IV. Strengthening the Financial System
14. Japan’s financial system has so far largely been unaffected by recent events in Europe, but risks remain. Japanese banks’ direct exposure to Southern European banks is limited at around $40 billion (½ percent of total assets), but reliance on European cross-border funding is large ($484 billion). While Japanese banks thus far have not experienced any funding problems, a pull back by European banks could lead to difficulties. In this regard, the BoJ’s recent decision to join other central banks in re-establishing US$ swap facilities with the U.S. Federal Reserve Bank provides a useful backstop.
15. The main risks to the financial system are a slow recovery and market volatility. Although banks’ financial conditions strengthened in 2009, pressures to raise capital could constrain lending and undermine the recovery.
• Deflation and credit risk. For banks, prolonged deflation undermines profitability through low net interest margins. Looking ahead, nonperforming loans could rise if the recovery slows and financial conditions tighten. In this environment, supervisors should encourage banks to rigorously monitor credit risks and, where appropriate, take action to restructure distressed borrowers.
• Interest rate risk. As loan demand has fallen, banks have shifted to holding more government bonds, elevating interest rate risk.5 In this light, supervisors should ensure that banks apply proper risk management strategies and emphasize the need to follow prudential guidelines for managing interest rate risk, as recently done by the FDIC in the United States.
16. New global financial regulations pose an additional challenge for banks. To strengthen the resilience of the financial system, the BIS has proposed raising standards for capital bases and limiting leverage. While the authorities support these objectives, they are rightly concerned that insufficient time for banks to adjust to the new rules could curtail lending and slow the recovery. Phasing-in the new global regulations would help in this regard as it gives banks more opportunity to build capital out of retained earnings or by tapping capital markets when profitability has recovered. To help banks meet new standards, the authorities should also continue to stand ready to inject public funds where necessary and facilitate the consolidation of banks with weak capital bases.
17. Creating a larger Japan Post carries risks. Doubling the deposit ceiling (to ¥20 million) and expanding the range of Japan Post’s lending activities would increase an already large financial institution raising the potential for systemic risk. New lending activities may also weaken profitability of private banks through unfair competition.
V. Raising Growth
18. An ambitious pro-growth agenda would help support fiscal adjustment and allow Japan to capitalize on faster growth in the region. In the outline of the growth strategy from December 2009, the authorities focused on creating new demand in areas such as the environment, health, and technology. Rapid growth in these sectors would make an important contribution towards reaching the government’s ambitious long-term growth target of 2 percent. Policies to foster start-ups, boost employment, and raise competition might also assist in reaching this goal:
• Promoting start-ups. Business start-up rates are low compared to the United States and have fallen below closure rates since the mid-1990s. This trend could be reversed by reorienting public support away from blanket credit guarantees to reforms that promote more risk-based (as opposed to guarantee based) lending. Positive impulses to business creation could also come from larger venture capital pools, which could be funded by long-term risk capital provided from public pension funds, including the Government Pension Investment Fund (GPIF), as done in other countries.6
• Boosting employment. We support the authorities’ plans to raise female labor force participation by addressing workplace needs for families with children. Introducing a new and more flexible regular labor contract could improve employment by encouraging new hires, especially among temporary workers.
• Increasing competition. Further deregulation and market opening, particularly in health, childcare, and services, would give a boost to productivity and make Japan a more attractive destination for foreign investment.
19. The cyclical upturn provides an opportunity to embark on critical fiscal reforms. A credible package of fiscal reforms that begins in FY2011 with a rise in the consumption tax is necessary to re-establish fiscal sustainability. Such action would boost confidence in Japan’s growth prospects, especially if combined with structural reforms to raise productivity and employment.
We are grateful to the authorities for their hospitality and the collegial and constructive tone of the discussions. 1 The mission will update its growth projections prior to the Article IV Board meeting in July on the basis of the Q1 GDP data release and other indicators. 2 Switzerland’s debt brake rule from 2003 sets a one-year ahead ceiling on government expenditures and mandates that any cyclical overruns are offset by adjustments in future budgets. 3 According to IMF staff analysis, the current value of the yen is consistent with medium-term fundamentals. We continue to support the policy that the exchange rate should be market determined. 4 Announced in the Monetary Policy Meeting of April 30, 2010. 5 According to the Bank of Japan’s March Financial System Report, the share of JGBs in total assets has grown from 11 to 16 percent since September of 2008. As a result, interest rate risk relative to Tier 1 has risen to 10-15 percent for the major banks and around 30 percent for the regional banks. 6 Presently, the GPIF does not undertake any alternative investments (such as venture capital, real estate and private equity). By contrast, a number of OECD countries allocate non-trivial shares of their assets to such investments, including CalPERS in the U.S. (14 percent), New Zealand Superannuation Fund (11 percent), Government of Singapore Investment Corporation (11 percent), and Korea National Pension Service Fund (2.5 percent).
1 The mission will update its growth projections prior to the Article IV Board meeting in July on the basis of the Q1 GDP data release and other indicators.
2 Switzerland’s debt brake rule from 2003 sets a one-year ahead ceiling on government expenditures and mandates that any cyclical overruns are offset by adjustments in future budgets.
3 According to IMF staff analysis, the current value of the yen is consistent with medium-term fundamentals. We continue to support the policy that the exchange rate should be market determined.
4 Announced in the Monetary Policy Meeting of April 30, 2010.
5 According to the Bank of Japan’s March Financial System Report, the share of JGBs in total assets has grown from 11 to 16 percent since September of 2008. As a result, interest rate risk relative to Tier 1 has risen to 10-15 percent for the major banks and around 30 percent for the regional banks.
6 Presently, the GPIF does not undertake any alternative investments (such as venture capital, real estate and private equity). By contrast, a number of OECD countries allocate non-trivial shares of their assets to such investments, including CalPERS in the U.S. (14 percent), New Zealand Superannuation Fund (11 percent), Government of Singapore Investment Corporation (11 percent), and Korea National Pension Service Fund (2.5 percent).