2014 Article IV Consultation with Japan - Concluding Statement of the IMF Mission
May 30, 2014
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.
Abenomics has been successful in planting the seeds for a more dynamic Japan. The near-term outlook remains favorable and the economy is expected to weather well the consumption tax increase. Over the medium term, transitioning to self-sustaining growth requires greater structural and fiscal reform efforts to avoid slipping back into deflation, overburdening monetary policy, and undermining confidence in the sustainability of government debt.
Abenomics is gaining traction, but medium-term risks remain substantial
1. Japan appears to be weathering well the effects of the consumption tax increase. Preliminary GDP data for the first three months of this year suggest that rush demand ahead of the consumption tax increase was stronger than anticipated. At the same time, underlying growth has been strengthening: business investment is picking up, labor markets are tightening, and capacity utilization is rising. Although the consumption payback in the second quarter will lead to a sharp growth contraction, we expect the recovery to resume in the second half of the year with further job growth and rising wages supporting moderate consumption growth. Exports are also forecast to rise on the back of last year’s yen depreciation and robust partner- country demand. Staff projects growth of 1.4 percent in 2014 and to remain above potential at 1 percent in 2015.
2. The Bank of Japan (BoJ) has made steady progress with raising inflation. Inflation expectations have picked up further recently, and there has been a notable rise in bank lending, including to small and medium-sized enterprises (SMEs). Policy transmission will likely strengthen further as portfolio rebalancing toward higher-yielding assets accelerates and inflation expectations rise with actual inflation. Annual inflation—excluding the temporary impact of the consumption tax increase—is projected at 1.1 percent in 2014 (calendar year). Staff expects that 2-percent inflation will be achieved by 2017, later than envisaged by the BoJ as we expect a more gradual closure of the output gap and rise in inflation expectations.
3. Near-term risks to the outlook are balanced, but the sustainability of the recovery over the medium term is at risk. The strong performance in the first quarter suggests that growth could be higher than currently forecast, but this upside is broadly offset by external risks. A sharper than expected moderation of growth in China could delay the recovery of net exports. Geo-political risks, including in the Ukraine and Thailand, could raise energy prices, disrupt supply chains, trigger safe-haven appreciation, and weaken inflation momentum. Failure to implement ambitious structural reforms in Japan could derail confidence in the near term and limit gains to potential growth over the medium term. A sharp rise in bond yields is the key medium-term tail risk, which could be triggered if monetary policy becomes overburdened and markets lose faith in the ability of policies to restore fiscal sustainability.
More forceful structural reforms are needed for Abenomics to succeed
4. Structural factors are a brake on growth and perpetuate a deflationary mindset and passive firm behavior. Because of further declines in the working-age population due to aging, staff projects potential growth to remain below 1 percent over the medium term. The
rising share of non-regular workers is impeding wage and productivity growth. Weaknesses in corporate governance are holding back investment. Barriers to entry and exit in the SME sector are undermining growth and job creation. Taken together, these factors have contributed to a lack of risk taking and weaker competitiveness as illustrated by greater import penetration and weak export growth amid rising overseas production.
5. Structural reforms are progressing in a number of areas. Energy sector deregulation, the creation of farmland banks and agricultural subsidy and Government Pension Investment Fund (GPIF) reforms are important measures to transition to more private-sector led growth. The launch of the JPX Nikkei 400 index should assist portfolio reallocation and strengthen corporate governance incentives. Gains from a Trans Pacific Partnership agreement and strategic economic zones (SEZs) could be substantial provided they remove investment barriers in Japan.
6. However, more forceful reforms are needed to tackle growth impediments. Concrete measures should aim to increase the supply and productivity of labor, put savings to more productive use, and eliminate barriers to investment. In combination, these reforms would create important synergies, by stimulating demand already in the near-term, aiding monetary policy transmission, and reducing fiscal consolidation needs. Specific measures include:
• Raising the employment of women and older workers and accepting more foreign labor. A faster roll-out of child care facilities, gradually raising the retirement age, and relaxing immigration restrictions in areas with labor shortages could raise labor supply. Revenue reforms could remove disincentives to work by reforming the spousal deduction in the income tax and social security legislation. Addressing labor market duality, through contract reform, would stimulate productivity growth and increase the pass-through of labor market tightness into higher wages.
• Enhancing risk capital provision to spur more corporate dynamism. Entrepreneurship would benefit from better access to financing through less reliance on personal guarantees, greater sharing of credit information, and more asset-based lending. Allowing unprofitable firms to exit or restructure is also needed. Here, credit guarantees for SMEs should be scaled back and restructuring of firms through out-of court workouts encouraged. For households, the introduction of individual savings accounts will help with asset diversification, but the 5-year term limit and the maximum contribution limit could be raised. Together, these measures would create a more favorable environment for venture capital to fund new businesses.
• Implementing comprehensive corporate governance reform. Complementing the recently introduced Stewardship Code for institutional investors with a corporate governance code for firms and introducing measures to expand the use of independent outside directors beyond current plans would strengthen management accountability and investment by unlocking corporate savings.
• Deregulating agriculture and domestic services sectors further would help to raise productivity, competition, and inward investment. For example, agricultural land ownership by corporations should be permitted and it should be clarified what specific regulatory measures will govern SEZs to encourage investment.
Fiscal policy can support the recovery by focusing on medium-term sustainability
7. Successive consumption tax increases are critical to establish a track record of fiscal discipline. The first increase in April was a major achievement and going ahead with the increase to 10 percent would strike the right balance between establishing fiscal policy credibility and preserving the recovery. There is a valid concern that the increase in October 2015 could harm low-income households. These equity concerns are best addressed through targeted subsidies instead of reducing tax rates on essential items as this would hurt efficiency, increase compliance and administrative costs, and result in permanent revenue losses.
8. Beyond the near term, no concrete steps have been announced to restore debt sustainability. Fiscal risks are substantial and despite the consecutive consumption-tax increases, the gross debt-to-GDP ratio will remain above 240 percent. Staff estimates that fiscal consolidation of at least 10 percent of GDP is needed over the next decade to put the debt-to- GDP ratio on a downward trajectory. About half of the adjustment is expected to come from the second consumption tax rate increase, winding down of stimulus and reconstruction spending, and expenditure restraint, leaving a sizeable gap of yet to be identified measures.
9. A post-2015 fiscal consolidation plan is urgently needed. Such a plan should be as growth friendly and equitable as possible and would allow more near-term flexibility to respond to downside risks. Options include gradually increasing the consumption tax to at least 15 percent, broadening the personal income tax base, and taking measures to contain pension and health care spending. As the consolidation effort will span a decade, it needs to be grounded in a stronger fiscal framework through adoption of medium-term rules to curb expenditures in the context of multi-year budget planning and limits on the use of supplementary budgets.
10. Reducing the corporate income tax (CIT) rate would likely have economic benefits, but would require offsetting fiscal measures to prevent a further rise in fiscal risks. A CIT cut raises investment and growth, but not sufficiently to make them self- financing, adding further to fiscal consolidation needs. Therefore, compensating revenue and expenditure measures need to be identified. In this regard, there is some scope for CIT base broadening, but it is limited, and the removal of some allowances (such as for accelerated depreciation) and incentives (R&D) could actually weaken the positive investment effects of a rate cut. The rise in fiscal risks could be limited by announcing the new tax schedule and identifying offsetting revenue sources upfront, but phasing in the rate reductions over time. As an alternative to a CIT rate cut, consideration could be given to opt for an Allowance for Corporate Equity (ACE) system, which would be a more cost effective way of encouraging investment. An ACE treats debt and equity financing in the same manner and has recently been adopted in some advanced and emerging economies.
Monetary easing should stay the course, but communication could be enhanced
11. Monetary easing by the BoJ is delivering the anticipated effects. With actual and expected inflation steadily progressing toward the 2-percent target, increasing asset purchases now to raise the probability of meeting the target sooner is not needed and policy space should be preserved to address downside risks. However, the current aggressive pace of monetary
easing may need to be maintained for an extended period, suggesting that providing more information about asset purchases beyond end-2014 could further enhance transparency.
12. The BoJ should act quickly if actual or expected inflation stagnates or growth disappoints. Policy options include expanding purchases of private assets and government bonds, and further lengthening the maturities of assets being purchased. The latter would accelerate portfolio rebalancing by insurance companies and pension funds and further reduce banks’ duration risks, thereby facilitating risk taking. In addition, to further enhance the monetary policy transmission, there is room to expand the Loan Support Program, including by increasing the size, reducing the funding cost, and lengthening the term beyond the current 4 years.
13. Over time, sustained easing without complementary reforms would raise risks to financial stability and complicate the exit. Asset purchases are already unprecedented: each year that the Quantitative and Qualitative monetary Easing (QQE) program is maintained, the BoJ will add approximately 5 percent of the outstanding stock of JGBs to its existing holdings, estimated at 23 percent at end 2014. Continuing with QQE in its current form for too long could impair market liquidity or give rise to financial stability risks as asset prices could become disconnected from fundamentals. As such, there are clear risks from potentially overburdening monetary policy. Therefore, structural and fiscal reforms are critical to strengthen policy transmission in a sustained manner and facilitate an earlier exit from QQE.
14. BoJ communication has been effective, but more could be done going forward to help anchor inflation expectations. The BoJ should continue to highlight the overarching goal of achieving 2 percent inflation in a stable manner, but could explain better the indicators used to assess whether inflation is on track. In due course, when exit comes in sight, the criteria for determining whether inflation has been sustainably achieved could be spelled out to guide expectations about the future course of monetary policy.
The yen is broadly in balance assuming that all three arrows are launched successfully
15. The external position is broadly in line with fundamentals, provided Abenomics succeeds in raising inflation, growth, and restoring debt sustainability. The yen’s large depreciation last year has not led to an improvement in Japan’s trade balance, partly because of temporarily higher imports including due to rush demand ahead of the consumption tax increase. The expectation is that the external balance will strengthen as these effects fade and exports start to pick-up. However, compared to last year, we assess now that Japan’s external balance will not improve beyond levels consistent with economic fundamentals and the implementation of growth and fiscal reforms because exports have become less responsive to exchange rate movements. In particular, the shift of manufacturing production abroad and lower competitiveness in certain industries, notably in parts of the electrical machinery and appliances sector, is containing the growth of exports.
New risks to financial sector stability should be proactively managed
16. Financial sector stability has further improved. Amid low credit costs, capital positions of major financial institutions have benefited from securities trading income and valuation gains on equity holdings. QQE has reduced interest rate risk for major banks which have sold part of their JGB holdings. However, declining net interest margins on domestic
loans and rising excess reserves are exerting downward pressure on banks’ core profitability. Interest rate risk for regional banks remains high and profitability pressures are most evident in this sector.
17. However, the search for higher yield by Japanese investors, while welcome, could generate new risks. As they rebalance their portfolios, banks may incur new risks in a number of areas:
• Major banks continue to expand abroad, suggesting that securing stable and long-term dollar funding will increasingly become a challenge. While internationally-active banks remain on track to meet Basel III capital requirements, supervisors should continue to encourage these banks to strengthen their funding sources, such as by reducing their reliance on FX swaps, issuing longer term dollar-denominated bonds, and building a depositor base in overseas operations. Additional cross-border collateral arrangements—already in place with Singapore and Thailand, and agreed to establish with Indonesia —could also help reduce local-currency funding risks in overseas markets.
• Regional banks. The authorities should continue to strengthen capital standards of domestically-active banks, including by reassessing the treatment of unrealized losses in capital. The authorities should develop a strategy to establish a stronger regional banking sector, including through private sector-led consolidation, as recommended by the 2012 FSAP Update.
Completing Abenomics is beneficial for the global economy
18. Launching all three arrows will create positive spillovers to the region and the global economy. During its first year, spillovers via the trade channel have been mild. However, they are expected to increase as exports and imports adjust to the weaker yen, adversely affecting some competitors, at least in the near term. Spillovers through capital markets are also expected to rise as Japanese investors, especially banks, pension funds, and insurance companies, start diversifying their investments overseas. These outflows will help to cushion the effects of tightening global financial conditions, including in emerging economies. As long as Japan continues to proceed with its reform agenda, these positive spillovers will dominate. But they could turn negative if monetary easing is not adequately supported by fiscal and structural reforms, leading to further yen depreciation, concerns about fiscal sustainability, and potentially higher interest rates. Hence, carrying forward structural and fiscal reforms is essential for Abenomics to sustain its positive spillovers.
We are grateful to the authorities for their generous hospitality and very constructive discussions.