JAPAN: Concluding Statement of the 2015 Article IV MissionMay 22, 2015
1. Abenomics has lifted Japan out of the doldrums but its arrows now need to be reinforced for the reform program to live up to its promise of being the “once in a lifetime” regime shift. Building on initial positive results, policies now need to embark on a sustained long-term effort to meet the unprecedented challenges Japan is facing—that of ending an entrenched deflationary mindset, raising growth, restoring fiscal sustainability, and maintaining financial stability. More vigorous structural reforms, backed by further efforts to raise wages and investment, will be essential to lift growth, facilitate fiscal consolidation, and unburden monetary policy. A concrete and credible plan for medium-term fiscal consolidation—in structural terms and backed by stronger fiscal institutions—should remove the uncertainty about the direction of policies that is holding back investment and consumption. Additional monetary easing while strengthening its effectiveness through more explicit guidance would enhance inflation dynamics. Such a complete policy package would bring about important synergies and avoid excessive reliance on exchange rate depreciation and its potential adverse spillovers.
The economic outlook is improving, but fragilities remain…
2. A modest recovery is underway. Exports have started to recover and consumption is regaining its footing. The labor market is tightening, leading to a moderate but historically significant acceleration in wage growth. Higher corporate profits, portfolio rebalancing and share buybacks are boosting equity valuations with overall positive confidence effects. Financial system soundness has broadly improved, with internationally-active banks showing stronger capital positions and progress in meeting Basel III capital requirements. Credit has revived, including to small and medium-sized enterprises (SMEs). In this context, real GDP growth should accelerate to about 1 percent in 2015 and 1¼ percent in 2016. Long-term prospects have improved modestly, riding the trend of increasing female labor participation and supported by structural reforms, especially of corporate governance.
3. Inflation is expected to increase gradually. Three factors put upward pressure on the price level: rising oil and commodity prices, the lagged effect of the recent episode of yen weakening, and the closing of the output gap. The Bank of Japan’s (BoJ’s) accommodative monetary policy stance should help maintain positive inflation expectations, while steadily rising wages could initiate favorable price dynamics in the years to come. As a result, under current policies, staff expects inflation to pick up toward the end of 2015 and rise gradually to about 1½ percent per year over the medium term.
4. Risks to the outlook are tilted to the downside. Lower-than-expected growth in China and the U.S. could lead to a faltering of the export-led recovery, including through safe-haven appreciation, before domestic demand picks up. However, the most important risks stem from weak domestic demand and incomplete policies, particularly with regard to the second and third arrows which could result in either stagnation or stagflation. In both cases, doubts about long-term fiscal sustainability could lead to higher sovereign risk premiums, forcing abrupt further fiscal adjustment with adverse feedback to the financial system and the real economy. This could compound low profitability of the banking system and trigger excessive volatility in the JGB and currency markets.
Requiring more structural reforms…
5. Japan should be at the vanguard of structural reform. The economy faces the formidable challenge of a shrinking labor force which needs to be met by higher labor force participation and faster productivity growth. The authorities have made some progress on their structural reform agenda, with many initiatives at various stages of adoption, but their impact has yet to substantially materialize and potential growth remains far below what is required to realize the authorities’ “revitalization” scenario. While swift implementation of already announced reforms is essential, it should be accompanied by a clearly articulated and bold program of further reforms to boost confidence and contribute to higher domestic demand.
6. Further high-impact reforms would provide a robust long-term outlook and underpin near-term demand. There is an urgent need for bold action on:
Labor market reform: Building on encouraging progress, female labor force participation can be boosted further by eliminating tax-induced disincentives to work and raising the availability of child care through deregulation. Drawing more aggressively than planned on foreign labor and incentivizing older people to work longer would help address labor market shortages that hamper investment. New hiring should take place under contracts that balance job security and flexibility to reduce labor market duality and raise horizontal mobility, contributing to higher productivity and wage growth. The authorities should clarify the legal and regulatory environment surrounding these “intermediate” contracts.
Corporate governance reform: Governance reforms should unlock renewed dynamism in product markets and can be further strengthened. Building on welcome ongoing reforms, more ambitious requirements for independent directors and additional measures to reduce excessive corporate cash hoarding should be adopted.
Deregulation: The swift conclusion of the Trans-Pacific Partnership (TPP) trade agreement would provide a substantive boost to activity, especially when it leads to deregulation of agriculture and domestic services sectors. Deregulation in special economic zones should be expedited with a view to rolling out these reforms nation-wide as soon as possible.
Financial sector reform: The financial sector should become a force for change, by taking advantage of the recent corporate governance reforms to unwind cross-share holdings, fostering consolidation in the enterprise sector, and promoting exit of unviable SMEs. The authorities should phase out financial sector support schemes for SMEs that do not invest or hire workers and support the expansion of financial markets such as for securitization and the provision of risk capital. Private-sector led consolidation in the financial system, in particular among regional banks, needs to be further encouraged. Given the substantial changes to the portfolio allocation of the Government Pension Investment Fund, it will be important to strengthen its governance structure.
Backed by favorable wage dynamics…
7. As part of the tripartite dialogue, the authorities are rightly calling for higher wage increases. The labor market is very tight with the unemployment rate at historic lows and participation rising. With booming profits, corporations have the opportunity to establish favorable wage-price dynamics. Ongoing wage increases are a good start, and their momentum should be further strengthened. The authorities should make a concerted effort to raise all administratively controlled wages and prices and call for a supplementary wage round, a conversion of some of the seemingly permanent bonuses into base wages, and a stronger-than-usual winter bonus round. Higher-than-usual minimum wage increases and strengthening tax incentives for firms that raise wages should also be considered.
Concrete and credible fiscal consolidation…
8. Sound principles need to underpin the upcoming fiscal consolidation plan to secure its credibility. Low and stable JGB yields should not be taken for granted as shifts in investor sentiment could happen abruptly. A concrete and credible medium-term plan would remove uncertainties about fiscal intentions, which could be hampering domestic demand, and help to respond to downside risks. Planned adjustment in 2015 and 2016—mainly withdrawal of past stimuli and waning reconstruction spending—is appropriate. In 2017, the consumption tax increase should be implemented with a single rate structure, but mitigating measures should be introduced in order not to jeopardize growth and inflation momentum. Accordingly, structural fiscal adjustment of about ¾ percent of GDP should continue over the medium-term even after the primary surplus is achieved to put debt on a downward trajectory.
9. Although details have yet to be announced, the authorities’ emerging plans need to be strengthened along several dimensions. The target of achieving a primary surplus by fiscal year 2020 provides a useful anchor to guide fiscal policy in Japan. The pace of adjustment targeted in the authorities’ plan to achieve a primary surplus by fiscal year 2020, including the additional measures of about 1½ percent of GDP, appears to be appropriate. However, to be credible, the emerging plan needs to be strengthened in the following ways:
Usage of prudent and realistic economic assumptions;
Specification of adjustment in terms of structural fiscal balance;
Adoption of a long-term goal of putting debt on a downward path; and
Upfront identification of specific structural revenue and expenditure measures.
Using overly optimistic macroeconomic assumptions as in the “revitalization” scenario limits the structural adjustment required to meet the target of achieving a primary surplus by fiscal year 2020 to little more than containing social security spending, but risks harming confidence in the authorities’ ability to restore fiscal sustainability. Any interim targets should be set consistent with the medium-term structural adjustment plan to avoid procyclical policies and force the identification of specific measures upfront.
10. Stronger fiscal institutions will be necessary to impart credibility to fiscal consolidation. Continuous large deficits, the record high level of public debt, the use of optimistic growth assumptions, and the uncertainty introduced by recurrent recourse to supplementary budgets suggest large benefits from anchoring fiscal discipline in a more credible medium-term budget framework. As the fiscal adjustment will span at least a decade, such a framework should include rules to curb expenditures, limits on the use of supplementary budgets, and publication of independent assessments of the outlook and budget projections by the Fiscal System Council. This would prevent procyclical policies, remove a source of volatility, and establish clear visibility about the direction of policies.
11. Consolidation will require both expenditure and revenue measures. The focus of the authorities on containing the secular rise in social security spending is appropriate but will not suffice to eliminate deficits. Hence, the base for social security contributions may need to be broadened and tax reforms will need to be pursued. The ongoing reduction in statutory corporate tax rates accompanied with base broadening and the planned increase in the consumption tax are a welcome start. With the need for significant medium-term adjustment to put debt on a downward path, further increases in the consumption tax rate will be required, while the broad base needs to be maintained by avoiding multiple rates. Any regressivity concerns should be addressed by targeted cash transfers.
Continuing supportive monetary policy…
12. Despite progress, lifting inflation is taking longer than expected. Policy actions thus far have raised underlying inflation and yielded promising results. With reduced real interest rates, a depreciated yen, and a booming equity market, financial conditions have become very supportive. Credit has started to pick up and land and real estate price growth has turned positive, underpinning a nascent revival of construction activity. The output gap is closing and wage pressures are gradually rising. However, the transmission to inflation is taking longer than expected, in part because of the effect of lower energy prices, the deep entrenchment of the deflationary mindset, and structural impediments to stronger wage-price dynamics.
13. Persistent differences between market expectations and the BoJ’s inflation target and timeframe pose a dilemma. While inflation expectations rose markedly since the introduction of quantitative and qualitative monetary easing (QQE), they have been broadly flat at around 1 percent in recent months, suggesting that the desired regime shift has not yet materialized. Maintaining the BoJ’s timeframe would underscore its commitment, and preserve the desired “anticipation effects” of additional easing on the part of the market. However, the monetary transmission is weak so that even with further easing, reaching 2 percent inflation in a stable manner is likely to take longer than envisaged by the BoJ.
14. On balance, this suggests that the BoJ needs to stand ready for further easing, provide stronger guidance to markets through enhanced communication, and put greater emphasis on achieving the 2 percent inflation target in a stable manner:
Additional easing: Reflecting the weak and delayed transmission, further easing should take the form of increased asset purchases and lengthening their duration. This would further lower the long end of the yield curve and strengthen the commitment to low interest rates for as long as it takes, while accelerating portfolio rebalancing by institutional investors. At the same time, further fiscal and structural reforms remain imperative to unburden monetary policy and mitigate financial stability risks.
Enhancing communication to guide markets: The BoJ should communicate more clearly the drivers that underpin its forecasts, including the output gap and wage-price dynamics and the factors that are believed to raise inflation expectations. Similarly, clarifying the conditions that would trigger additional actions would be helpful. In this context, the publication of the oil price assumption underlying its forecast and studies of the effectiveness of its quantitative easing and progress of the regime shift it is trying to engineer are highly welcome.
Reaffirming the BoJ’s commitment to achieve the 2 percent inflation target in a stable manner. To strengthen this commitment the BoJ should reiterate that it remains open to all further avenues of easing when and if appropriate by: raising the amount of purchases of assets, lengthening their duration, broadening their range, and lowering the deposit rate on excess reserves and the policy rate.
15. Financial sector policies should mitigate any unintended but risky consequences of unconventional policies. The doubling of the BoJ’s securities lending facility is a welcome backstop to JGB market liquidity, while its cost and access criteria should remain under review to ensure its effective use. Continuing consultations with market participants and close monitoring of liquidity will be essential. Financial institutions need to continue to be tested for their resilience to higher volatility of asset prices, exchange rates and interest rates, and lower liquidity in markets, especially in the all-important JGB market. Banks look well capitalized, but their risk management needs to be further strengthened and business models adapted to raise profitability in the medium term. Banks lending in foreign currency should secure robust funding sources. Insurance companies need to enhance profitability to work through the legacy of guaranteed return products. While there are no immediate concerns, macroprudential policies should be readied in case exuberant equity and real estate market developments and lending (including abroad) threaten financial stability.
Preparing for downside risks
16. Policy adjustments will be required in the event of renewed weakness or financial risks. With little fiscal space and monetary policy already stretched, the policy reaction will need to be closely aligned with the nature of the risk that materializes. Soft growth and flagging inflation without rising credit risk could be countered by attuning fiscal consolidation to economic conditions, further monetary easing and additional high-visibility structural reforms. Stagflation would argue for more structural reform, while rising sovereign credit risk may dictate additional fiscal consolidation. In all cases, it will be important to anchor the policy response in a credible medium-term framework and clear communications.
And mitigating adverse spillovers
17. Without further strengthening of policies, the balance of spillovers is likely to turn negative. Increased portfolio outflows and continued expansion of overseas’ bank lending and foreign direct investment are positive spillovers from Japan. However, further weakening of the exchange rate has dampened imports while raising Japan’s corporate competitiveness in global goods markets. While the 2014 external position and real effective exchange rate were broadly consistent with fundamentals, the real depreciation that took place during the second half of 2014 moved the real effective exchange rate to a somewhat weaker level. Since then the real effective exchange rate has remained broadly stable. Without bolder structural reforms and credible fiscal consolidation, domestic demand could remain sluggish, and any further monetary easing could lead to overreliance on depreciation of the yen.
The mission thanks the authorities and other interlocutors for their gracious hospitality and frank and open discussions.