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Public Information Notice (PIN) No. 04/88
August 11, 2004
International Monetary Fund
700 19th Street, NW
Washington, D.C. 20431 USA


IMF Concludes 2004 Article IV Consultation with Japan

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2004 Article IV consultation with Japan is also available.

On July 28, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.1


There are clear indications that Japan's longstanding economic problems have eased. Growth is rebounding, deflation is diminishing, and progress is being made in addressing corporate and financial sector problems. Looking ahead, near term growth prospects are favorable, although weaknesses remain that could restrain growth over the medium term.

Japan's economic recovery continued in 2003 and into the first part of 2004. For 2003, GDP growth reached 2½ percent, double the mid-year consensus forecast, and continued at about 6 percent on an annualized basis in the first quarter of 2004. The recovery was initially driven by business fixed investment and net exports, with the current account surplus widening to 3¼ percent of GDP. More recently, private consumption also contributed as labor market conditions improved. Following steady declines since 2001, employment, the labor force, and compensation stabilized, while the unemployment rate fell to 4.6 percent in May, from the record high of 5½ percent reached in early 2003. Meanwhile, deflationary pressures have eased; core CPI deflation (excluding fresh food) narrowed, in part reflecting temporary factors, but the GDP deflator continued to decline at a pace of about 2½ percent.

Monetary policy has maintained short term interest rates at zero under the Bank of Japan's (BoJ's) quantitative easing framework. Increases in the BoJ's target for current account balances have also supported base money growth and promoted financial stability by ensuring banks access to ample funding. Recent steps to clarify the monetary framework-by announcing that quantitative easing will be maintained at least until core CPI growth is nonnegative for a few months and positive inflation is expected-have helped reassure markets that short-term interest rates will be kept at zero as long as deflation persists.

During 2003 and early 2004, the yen came under periodic pressure to strengthen against the dollar, as markets focused on global current account imbalances. This pressure prompted the authorities to intervene in record levels to avoid an undue tightening of monetary conditions, with total intervention amounting to ¥20 trillion in 2003, and a further ¥15 trillion in the first quarter of 2004. Both upward pressure on the yen and intervention have since ceased. Since June 2003, the yen/dollar rate has appreciated by about 9 percent, but with the yen's appreciation against the euro more modest, on a multilateral basis the yen has appreciated only moderately in nominal and real effective terms.

The government recorded another large fiscal deficit in FY2003-7.9 percent of GDP-slightly lower than the previous year. On a structural basis (including social security but excluding bank support), the fiscal stance was around 6½ percent of GDP, unchanged from the previous year. Sustained fiscal deficits have fed a rapid increase in public debt, estimated to stand at 166 percent of GDP on a gross basis (80 percent on a net basis) at end-2003, by far the highest among advanced economies.

The financial condition of the banking system improved in FY2003, particularly among major banks, but some weaknesses persist and regional banks have lagged behind. Nonperforming loans at major banks declined to about 5 percent of loans, in line with the authorities' target to reduce the ratio to about 4 percent by end-FY2004. Major banks also increased their profits and capital adequacy ratios, aided in part by the economic recovery and gains on their equity holdings. However, core profits and the quality of capital remained weak, and regional banks (which account for 40 percent of bank lending) made less headway in reducing nonperforming loans and strengthening their capital bases.

In the corporate sector, restructuring activity has expanded from large export-oriented manufacturers to include small-and medium-sized enterprises (SMEs) and nonmanufacturers. Although debt levels remain high, profit indicators have improved, driven at first by labor cost reductions and strong external demand, and more recently by buoyant sales. The improvement in corporate profits has contributed to a rebound in stock prices, with the Nikkei Index gaining about 50 percent and ten-year JGB yields rising about 130 basis points to 1.8 percent since the lows achieved in 2003.

The near-term economic outlook has improved over the past year. As the economic recovery broadens further, real GDP is projected to expand by 4½ percent in 2004 and 2½ percent in 2005, with CPI deflation ebbing to zero by the end of this period. However, this outlook could be threatened by external factors, including a potential sharp rise in global interest rates or a slowdown in key trading partners. Beyond the near term, growth is envisaged to slow to around potential, estimated by staff at around 1.7 percent per year. However, additional structural economic reforms and continued progress in financial and corporate sector restructuring could raise Japan's economic potential.

Executive Board Assessment

Directors welcomed signs that the Japanese economy is emerging from its long period of slump, with support from a range of policy measures. In particular, the recovery has strengthened and become more broadly based, while labor market conditions have improved. Meanwhile, deflationary pressures have eased, against the backdrop of a narrowing output gap and supportive monetary policy. Also, restructuring has continued in the financial and corporate sectors, encouraged by enhancements to bank regulation and the framework for corporate revitalization.

At the same time, Directors noted that financial and corporate sector weaknesses remain, mild deflation persists, and the public debt is very high, which could restrain growth over the medium term. In addition, several Directors acknowledged the existence of risks related to the external environment. Against this background, Directors considered that policies should build on the existing reform program in order to resolve remaining weaknesses promptly, boost Japan's economic potential and thereby sustain the expansion over the longer term. Key priorities include broader financial and corporate sector restructuring, medium-term fiscal consolidation, and continued structural reforms.

On monetary policy, Directors welcomed recent steps by the Bank of Japan to clarify and demonstrate its commitment to counter deflation by maintaining zero interest rates until both actual and expected inflation rates turned positive. Directors saw the current accommodative policy stance as appropriate and considered that further increases in the current account operating target could be used if needed to reinforce the policy commitment. Also, as the end of deflation draws nearer, enhancements to the Bank of Japan's communication strategy to provide a clear signal to markets about the future direction of monetary policy could help stabilize inflation expectations. While some Directors supported quantification of a medium-term inflation objective and an eventual shift to inflation targeting, a number of others considered such an objective premature at this point in time in light of the uncertainty in the monetary policy transmission mechanism.

Nearly all Directors observed that sizeable past interventions had kept upward pressure on the yen from resulting in an undue tightening of monetary conditions. With exchange rate risks now more balanced, such interventions were not seen as desirable. Many Directors considered that additional intervention could be warranted if significant upward pressures on the yen reemerged to the extent that they threatened to stall the recovery. Many other Directors, however, expressed concern that such actions could exacerbate global imbalances, and urged that the exchange rate be fully market-determined. Some Directors also asked for more analysis of exchange rate policies in future Article IV reports as called for in the conclusions to the last review of surveillance.

Directors noted that the economic recovery and enhanced financial regulation have fostered progress in resolving banks' balance-sheet problems. Major banks have cut nonperforming loans (NPLs) and are on track to attain the target of reducing NPLs as a share of loans to about 4 percent by end-March 2005. At the same time, deferred tax assets have fallen as a share of regulatory capital. In light of the progress in strengthening the banking system, Directors welcomed the planned reduction in deposit insurance coverage by the end of the fiscal year.

Nevertheless, weaknesses remain in the banking system, as reflected in low core profits and less progress in restructuring by regional banks. Directors thus welcomed the authorities' commitment to press ahead with bank reforms, and encouraged the authorities to expand on existing reforms to expeditiously resolve these weaknesses so that lending growth could resume and help support the recovery. For major banks, measures to improve further the recognition of, and provisioning for, problem loans, to strengthen bank capital, and to bolster bank governance would be key. Also, to improve prospects for bank profitability, competition of government financial institutions with private institutions should be scaled back. Regarding regional banks, Directors observed that measures similar to those employed for major banks could encourage more rapid restructuring. Also, the new capital injection facility could be used, with appropriate conditionality, to facilitate consolidation among regional banks. Directors commended the Japanese authorities' high level of compliance with international standards to combat money laundering and terrorism financing, and encouraged them to address the remaining weaknesses identified.

Directors welcomed the notable headway in corporate restructuring, but also noted that corporate debt remains high and aggregate returns on assets are still low by historical standards. They considered that strengthening the banking system would facilitate additional corporate restructuring, and they agreed that the Industrial Revitalization Corporation of Japan could continue to coordinate creditors and facilitate market-based restructuring.

Regarding fiscal policy, Directors welcomed the authorities' strategy for achieving medium-term consolidation. They noted that the better-than-anticipated economic environment could facilitate an early start toward the authorities' goal to reach a primary surplus early in the next decade. In particular, it would be desirable to achieve savings relative to the budget in fiscal year 2004, if the recovery remains robust, by saving any stronger-than-expected revenues and seeking expenditure reductions.

Directors observed that a substantial medium-term fiscal adjustment will be needed to put the public debt on a sustainable trajectory. Accordingly, they welcomed the recently adopted pension reforms, while noting that further social security reforms will be needed in the medical and long-term care systems. In addition, most Directors saw scope to broaden the personal income tax base, increase the consumption tax rate over time, and further reduce public investment. Many Directors also considered that the credibility of the medium-term consolidation plan could be strengthened by defining a more specific goal for the primary balance and supporting measures to achieve it, while retaining due flexibility to adapt to short-term economic fluctuations. Some Directors called for further reform of local finances, including a reduction in transfers from the central government and greater tax autonomy, to encourage a more efficient allocation of resources and help improve the fiscal position at the subnational level.

Directors noted that Japan has embarked on a broad-based program of structural reforms. They considered that accelerated implementation of the reform program would help to raise Japan's long-term economic potential. In particular, front-loaded measures to improve labor market flexibility, relax business regulation and strengthen competition policy, and reform public enterprises could foster a more rapid and efficient reallocation of economic resources and thereby bolster medium-term productivity and growth.

On trade policy, Directors viewed the Japan-Mexico Economic Partnership Agreement as a step forward in further opening Japan's market, but stressed that multilateral liberalization should remain the centerpiece of Japan's trade policy regime. In this connection, they encouraged Japan to work with other major industrial countries towards implementation of the Doha Round's development objectives, especially in agriculture. Directors welcomed the expansion of coverage for LDC exports under Japan's generalized system of preferences, and encouraged the authorities to take additional steps in that direction.

Directors noted that Japan's official development assistance (ODA) was presently about the same as the G-7 average in percent of GNI. While recognizing that Japan remained the second largest provider of such assistance, they encouraged the authorities to raise ODA toward the UN target of 0.7 percent of GNI.

Directors welcomed the review of the methodology for compiling national accounts statistics, which aims at improving the accuracy of price and volume measures. Also, they noted the authorities' intention to conduct a data ROSC starting in mid-2005.

Japan: Selected Economic Indicators







GDP 1/






Private consumption






Nonresidential investment






Residential investment






Public investment






Public consumption






Stockbuilding (contribution to growth)






Foreign balance (contribution to growth)






Exports of goods and services






Imports of goods and services









GDP deflator













Unemployment rate (period average, percent)







Current account balance


Billions of U.S. dollars






Percent of GDP







General government balances (percent of GDP, FY)


Balance including social security






Balance excluding social security






Structural balance 2/







Money and credit (12-month growth rate; end period)






Base money







M2 + CDs (period average) 4/







Bank lending 4/








Exchange and interest rates (period average)


Yen/dollar rate







Real effective exchange rate 6/







3-month CD rate







10-year government bond yield







Sources: Global Insight, Nomura database and IMF staff estimates and projections.

1/ Annual growth rates and contributions are calculated from seasonally adjusted data.
2/ Including social security, excluding bank support.
3/ July 2004.
4/ From April 1998 onward, data reflect the inclusion of foreign banks, foreign trust banks and Shinkin banks in the monetary survey.
5/ July 30, 2004.
6/ Based on normalized unit labor costs; 1990 = 100.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the July 28, 2004 Executive Board discussion based on the staff report.


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