Mission Concluding Statement 

June 20, 2016

Abenomics has made progress in revitalizing the Japanese economy but sustained higher growth and inflation remain elusive. Under current policies, the high nominal growth goal, the inflation target, and the primary budget surplus objective all remain out of reach within the timeframe set by the authorities. Recognizing the risk of falling short, the authorities have responded through easing of monetary and fiscal policies, but the outlook remains weak. Achieving Abenomics’ ambitious targets will therefore require a more substantial, coordinated policy upgrade. Income policies in combination with reforms to tackle labor market duality should move to the forefront, supported by additional monetary and fiscal stimulus in the near term and more credible policy frameworks. The fiscal strategy needs to commit to fiscal consolidation over the medium term and replace large discretionary consumption tax increases with a path of smaller, but sustained increases over a prolonged period. Such a package would make serious headway in achieving the authorities’ objectives, but if it is not forthcoming soon, the timeframe for achieving all targets should be pushed out and policies should be reset for steady but more gradual progress while building risk resilience. This would require embarking on prolonged and cumulatively larger fiscal adjustment and moving explicitly towards a more flexible time frame for achieving the inflation target, while reserving further monetary easing and fiscal stimulus for addressing large shocks.

After initial success, Japan is facing headwinds and policy challenges…

Abenomics has met with initial success. Strong coordination between the Bank of Japan’s (BoJ) unprecedented quantitative and qualitative easing program and fiscal stimulus combined with ambitious structural reforms helped narrow the large output gap, reversed the undue appreciation of the yen, eased financial conditions, boosted corporate profits, and lifted actual and expected inflation into positive territory. The first consumption tax hike locked in considerable fiscal savings. The economy reached full employment and modest, but historically significant, increases in base wages took hold.

But the recovery and progress with reflation stalled. Headline inflation fell back into deflationary territory, dampening base wage growth. Growth dropped towards potential, with consumption and investment remaining sluggish, amid declining sentiment. The yen appreciated in recent months, equity prices declined, and inflation expectations fell anew. Several factors explain the difficulties in achieving sustained lift off:

• Structural impediments: Low confidence in economic prospects, related to an aging and shrinking population, is holding back investment and credit demand, constraining portfolio rebalancing. Labor market duality and inflexibility are clogging the pass-through from a tightening labor market and high profits of large firms to wage increases. Weak demand and a lingering deflationary mindset are reducing the ability of firms to raise output prices. The financial sector does not sufficiently support risk taking, limiting access to risk-based capital, as suggested by high reliance of banks on fixed asset collateral and slow restructuring of non-viable SMEs.

• Policy shortcomings: The fiscal stance turned out to be too contractionary in 2014, over and above the anticipated consolidation due to the consumption tax hike. The stop-go nature of fiscal policy, with yearly supplementary budgets, discretionary changes in consumption tax hikes, and optimistic growth assumptions underlying medium-term budget projections have left fiscal policy without a credible medium-term anchor and are contributing to policy uncertainty. Weak monetary transmission, sluggish wage-price dynamics, and a falling natural rate of interest are preventing the needed rise in inflation expectations, creating a communication and credibility challenge for the BoJ. Structural reform efforts did not sufficiently address the above-mentioned structural impediments, notably in the labor market.

• Global weakness and volatility: Sluggish global growth and overcapacity in the traded goods sector, prevented the weaker yen from materially boosting exports. Concerns in emerging markets and revisions to the expected path of monetary policy in advanced economies led to heightened volatility in financial markets and safe haven appreciation pressures. Declining commodity prices did not boost activity as expected, but instead put downward pressure on headline inflation and forced the BoJ to repeatedly push out its timeline for hitting the inflation target.

Recent policy actions are aiming to put Abenomics back on track.

• Negative Interest Rate Policy: The adoption of the negative interest rate policy (NIRP) amid a weakening of the outlook and higher global uncertainty reinforced the BoJ’s commitment to its inflation target and added another tool to the policy framework, allowing it to be more open ended. So far the NIRP has been successful in lowering the entire yield curve and has not adversely impacted market functioning, beyond expected effects on JGB liquidity and bank profitability. More time is needed to see its full transmission to the real economy.

• Increased fiscal support: The authorities’ decisions to adopt and formulate additional stimulus packages and to postpone the scheduled 2017 consumption tax hike by two and a half years demonstrate the challenge of simultaneously stimulating the economy and moving towards fiscal sustainability in a short timeframe. While these decisions will reduce deflation risks and support near-term growth, they will likely affect the achievement of the authorities’ medium-term fiscal target, unless abrupt consolidation takes place, which would again undermine reflation prospects.

• Policies to boost wages and investment: The government has been rightly calling for higher wage increases through the tripartite dialogue and recently announced a floor of 3 percent on annual minimum wage increases. The government also cut the statutory corporate income tax rate below 30 percent in FY2016, one year earlier than scheduled, but so far no discernible impact on investment can be observed.

• New three arrows: Although specific and sufficiently ambitious measures remain to be largely identified, the new “three-arrows” strategy adopted by the government has commendable objectives: (i) a strong economy, with a target of raising nominal GDP to 600 trillion yen; (ii) childcare support to lift the fertility rate and labor force participation; and (iii) a social security system to allow people to continue employment while providing nursing care to family members.

Nonetheless, the growth outlook remains subdued. Japan’s economy is expected to grow at a moderate pace of about 0.5 percent in 2016, before slowing to 0.3 percent in 2017, excluding the possible effect of the yet to be adopted supplementary budget. Private consumption is projected to grow modestly, underpinned by lower commodity prices, targeted fiscal transfers, and rising labor force participation, while nominal wage growth is expected to remain sluggish in the near-term. Weakness in the global recovery and trade, higher uncertainty and the recent appreciation of the yen are expected to pose a drag on net exports and investment. The labor market is projected to remain tight with the unemployment rate remaining close to its structural level of about 3 percent. Over the medium-term, prospects are likely to be hamstrung by the demographics-induced decline in potential growth.

Inflation is expected to remain well below the BoJ’s 2 percent target under current policies. Core inflation is projected to decline in the near-term, reflecting exchange rate appreciation and weak demand. The declining trend in inflation expectations and the deceleration of base wage growth will also dampen inflation dynamics. Headline inflation is projected to remain at about 0.2 percent in 2016 and rise to 0.6 percent in 2017, supported by energy price developments. Inflation is expected to rise gradually in the medium-term with the narrowing of the output gap and slowly strengthening wage-price dynamics.

Downside risks dominate in the medium-term. Risks to the near-term outlook are tilted to the upside—a likely large fiscal stimulus package in 2016-17 provides upside, while external factors including a sharper-than-expected moderation of growth in China, weaker growth in advanced economies and Brexit could have adverse effects. However, the medium-term is subject to important downside risks related to weak domestic demand, uncertainty about the sustainability of low interest rates in a high public debt environment and financial stability risks in the context of unprecedented unconventional monetary policies. These risks can result in stagnation, where doubts about long-term fiscal sustainability could lead to higher sovereign risk premiums, forcing abrupt further fiscal adjustment with adverse feedback loops to the financial system and the real economy.

Abenomics needs to be reloaded…

Income policies combined with labor market reforms should move to the forefront. Monetary and fiscal policies in isolation cannot achieve the inflation target in the envisaged timeframe. Reinvigorating wage-price dynamics can generate sustained cost-push inflation, a powerful tool to first raise actual and then expected inflation. A deflationary mindset, the absence of a mechanism to coordinate wage and price increases (a role usually played by well-anchored inflation expectations), and a secular decline in the bargaining power of labor have led to base wage inflexibility. Meanwhile a rising share of non-regular workers with lower wages has lowered average wage growth. This highlights the need for bolder policies to directly target the wage bargaining process and reforms to reduce labor market duality:

• Income policies: The government can introduce a “comply or explain” mechanism for profitable companies to ensure that they raise base wages by at least three percent (the inflation target plus average productivity growth) and back this up by stronger tax incentives or—as a last resort— penalties, given that the latter would be contractionary if they failed to trigger higher wages. In addition, the government can commit to raising all administratively controlled wages annually and ensure this is followed at the prefectural level. These measures can be supported by calling for supplementary wage rounds and conversion of bonuses to base pay.

• Labor market reforms: Promoting “intermediate” contracts that balance job security and wage increases, including by clarifying the legal framework and providing subsidies for converting non-regulator workers to such contracts, would reduce labor market duality and reinforce income policies provided new hiring is done under these contracts. It would also stimulate productivity growth through greater incentives for skill formation. Eliminating disincentives to full-time or regular work due to the tax and social security system such as the spousal deduction and spouse allowance, as well as raising the availability of child-care facilities through deregulation remain critical.

Income policies and structural reforms should be reinforced by coordinated demand support. To facilitate the pass-through of higher wages to prices and the implementation of labor market reforms, it is imperative that monetary and fiscal policy give a balanced and sustained growth impulse in the near term, warranting a modest near-term fiscal expansion, calibrated on the need to accelerate the closing of the output gap. Fiscal stimulus should be coordinated with further monetary easing, where all policy tools should remain on the table.

A credible fiscal consolidation course needs to be charted now, including a pre-announced path of gradual consumption tax hikes. Such an approach can address Japan’s looming fiscal sustainability problem, reduce policy uncertainty, and create policy space. Given low potential growth, and the need to avoid leaning excessively against the BoJ’s easing policies, a gradual increase in the consumption tax towards at least 15 percent, e.g. by 0.5 or 1 percent per year over regular intervals, would strike the right balance between supporting growth and achieving fiscal sustainability in the long run. The precise path should be determined mindful of the need to secure political buy-in, compliance costs for firms, and the administrative burden for the tax authorities. Starting the increases soon and replacing the currently planned 2019 hike with such a pre-announced, gradual path would enhance the credibility of the long-run fiscal adjustment, reduce uncertainty for consumers, and avoid large intertemporal shifts in spending around the time of the tax hikes. The single rate structure should be maintained as much as possible and concerns for the tax impact on low income households addressed by targeted cash transfers.

More structural reforms especially in the labor market are the only viable option to significantly raise growth prospects. Without high-impact reforms, potential growth is projected to decline from about 0.5 percent in 2015 to close to zero by 2030, given the demographic overhang. In addition to measures to boost domestic labor supply of women and older workers, increased reliance on foreign labor should be considered. Full implementation and possible expansion of TPP as well as proceeding with other trade and bilateral investment agreements and further deregulation would help increase productivity over time and can also support demand in the near-term. Finally, the financial sector’s role in promoting innovation and new growth areas could be enhanced through (i) further developing domestic capital markets by encouraging securitization and development of private-equity funds to further ease SME financing conditions, (ii) reducing government support for SMEs to promote restructuring of viable firms and exit of nonviable ones, and (iii) fostering business succession.

Policy frameworks should be strengthened to enhance policy credibility. The authorities’ medium-term consolidation plan of achieving primary surplus by FY2020 should avoid relying on optimistic growth assumptions, which undermines confidence by masking the required amount of structural adjustment, leaving fiscal policy without a medium-term anchor. Strengthening the fiscal framework requires adopting rules to curb expenditure, especially on social security, limits on the use of supplementary budgets, and publication of more independent assessments of the outlook and budget projections. Social expenditure reform, especially of medical expenses, has taken on added importance as fiscal revenues are being delayed. Clearer communication and better use of forward guidance by the BoJ—including by publishing the staff forecast, communicating willingness to overshoot the inflation target and committing to maintain a large balance sheet—can help strengthen monetary policy credibility and raise inflation expectations.

…or should be reset for the long-haul of gradual achievement of its objectives…

In the absence of a significant policy upgrade, policy space will be very limited and should be used sparingly. Without ambitious income policies and the associated comprehensive reforms, an expansionary fiscal policy stance would have limited impact, unless stimulus was very large, which could be counterproductive by raising risk premiums. Nonetheless, the weak outlook suggests that the fiscal stance will need to be broadly neutral in the near term. Similarly, since achieving the inflation target will take longer, loose financial conditions will have to be maintained for an extended period. Hence, monetary policy would have to be reset for the long haul and carefully balance the benefits of providing further easing with the potential risks to medium-term financial stability, including JGB market liquidity, the profitability of financial institutions, disintermediation, and reduced market functioning, and limits to JGB purchases and negative interest rates.

The resulting weak inflation and low growth imply a prolonged adjustment process. Absent higher nominal growth, the required fiscal adjustment would be larger and take place over a longer time horizon, implying greater vulnerability to shocks. A gradual fiscal consolidation by about ¼ to ½ percent of GDP per year in structural terms would need to be maintained for as long as needed to turn debt dynamics around. The monetary policy framework would need to become more flexible, with the BoJ abandoning the use of a specific calendar date for achieving its inflation target. While such a shift should raise BoJ credibility by setting a more realistic goal, the transition will need to be well communicated to avoid perceptions that the BoJ is reducing its commitment to achieving its inflation target and to limit the potential for adverse market reactions, including yen appreciation.

While safeguarding financial stability…

Financial stability risks could emerge from prolonged unconventional monetary policies or the failure to achieve reflation and fiscal sustainability. The financial sector remains stable overall but risks are rising in some areas. With returns on assets already very low, profitability of financial institutions may continue to fall in the negative interest rate environment. While interest rate risk on domestic bond holdings and the ratio of non-performing loans have declined, market risks associated with the volatility of stock prices have increased markedly, and FX risks remain elevated. JGB market liquidity appears to have decreased, with limited spillovers to other markets so far. The authorities have appropriately responded to some of these risks, including by (i) encouraging the change in business models among regional banks, (ii) supporting banks to reduce strategic stockholdings and secure stable funding sources in major foreign currencies, and (iii) expanding the Security Lending Facility. In addition, they should ensure a sufficiently high liquidity coverage for the major foreign currencies if FX loans keep growing more rapidly than corresponding FX deposits. The authorities should regularly assess the impact of the reduced inventories of primary dealers on their market-making ability. The ongoing strengthening of the existing macroprudential policy framework should continue, through enhanced sharing of information and findings from supervisory activities and ensuring that the respective roles of the BoJ and Financial Services Agency in managing the relevant policy tools remain clear. Internationally active banks are on track to meet regulatory changes, but any regulatory changes affecting regional banks should be clarified as soon as possible. A reduction in the provision of cross-border financial services by Japanese banks, especially correspondent banking, in response to reduced risk-taking or regulatory changes has not yet been observed, but the repercussions of the forthcoming alignment of the AML/CFT framework with FATF should be assessed.

…and addressing risks and spillovers.

Available buffers and policy responses to downside risks depend on the size and origin of the shock. A coordinated response, making use of fiscal and monetary policies should be the first line of defense to counter downside growth shocks. The fiscal response will need to be contingent on the behavior of the sovereign risk premium and its impact on financial stability. Substantial downward shocks with a large adverse impact on growth, inflation, and debt dynamics or the failure of policies to make progress toward fiscal sustainability over the medium term could exhaust the effectiveness of conventional buffers. However, shifting to even more unorthodox policy packages, such as explicit monetization of public debt, would entail high potential stability risks that could arise from adverse confidence reactions to such policy packages.

Strengthening domestic policies is important to mitigate inward spillovers and secure external balance over the medium term. Inward spillovers from the slowdown in emerging markets, bouts of global financial volatility, and lower oil prices are posing a challenge for Japan’s efforts to raise growth and reduce deflation risks. While the 2015 external position was moderately stronger than the level consistent with medium-term fundamentals and desired policies, the appreciation of the real effective exchange rate since the beginning of 2016 has moved it towards a level broadly consistent with medium-term fundamentals suggested by the 2015 assessment, while it may undermine the effort to lower deflation risks. Strengthening domestic policies remains the most effective tool to reduce deflation risks and increase resilience. 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.