Economic Health Check
Japan’s Bumpy Growth Path Puts Premium on Structural Reforms
July 31, 2014
- “Abenomics” gaining traction, but self-sustaining growth not assured
- Growth set to resume following recent contraction
- Ambitious structural reforms and concrete fiscal measures urgently needed
In its latest assessment of the Japanese economy, the IMF said the recent economic reforms are taking hold, but they need to be more comprehensive and sustained for an extended period. This would help achieve the new inflation target and guard against headwinds from a shrinking labor force and a large fiscal adjustment need.
The IMF report found that “Abenomics”—a three-pronged approach to reflate the economy through monetary, fiscal, and structural policies—is progressing well, but unevenly across the three arrows, with medium-term risks remaining substantial. Aggressive monetary easing by the Bank of Japan has contributed to a pickup in actual and expected inflation. Growth has been well above potential, labor markets continue to tighten, and credit growth has turned positive, including to small- and medium-sized enterprises.
“We expect Japan’s economy to grow by about 1.6 percent this year, before slowing to 1.1 percent in 2015 as a result of fiscal adjustment,” said Jerry Schiff, Deputy Director in the IMF’s Asia and Pacific Department and head of the mission that conducted the assessment. “Inflation is expected to rise temporarily to 2.8 percent on average for 2014 due to recent increase in consumption tax rate, and we expect the Bank of Japan’s 2 percent target will be achieved over the medium term.”
Growth path to be bumpy
After strong first-quarter growth driven by rush demand ahead of the consumption tax increase, the economy is expected to contract in the second quarter. Nonetheless, conditions are in place for the economy to weather well the effects of the consumption tax rise and see a return to a moderate pace of recovery in the second half of the year. Private consumption already rebounded in May after a large drop in April.
However, the report notes that the recovery has so far relied on fiscal and monetary stimulus, with still tentative investment and export growth. The rise in inflation too has depended to a large extent on the weakening of the yen. These factors raise questions about the sustainability of the recovery over the medium term. “Implementing high-impact structural reforms will be essential to maintain confidence and competitiveness and avoid a scenario where monetary policy would be overburdened, which would be detrimental for Japan, as well as other countries in the region,” said Schiff.
Structural reforms vital
Since the introduction of the new growth strategy in June 2013, reforms are progressing in several areas and the government recently adopted an updated strategy. These reforms will take time given the range of economic interests involved. The IMF report, however, says more forceful reforms are needed going forward to overcome structural impediments to raising growth and ending deflation.
“We recommend in particular, raising the employment of women, older workers, and foreign labor, which would help to offset the aging-related decline in the labor force,” said Schiff. “At the same time, deregulating agriculture and domestic services sectors, as well as reforming corporate governance, would help raise productivity and encourage investment.”
Maintaining focus on fiscal sustainability
Although Japan’s fiscal balance is projected to improve over the near term, the debt-to-GDP ratio would continue to rise in the medium term, according to the IMF’s debt sustainability analysis. The report recommends a concrete set of measures that includes further revenue and entitlement reforms to achieve debt sustainability over the medium term, which would allow greater fiscal flexibility to respond to downside risks.
The report is supportive of the second consumption tax rate increase in 2015 to 10 percent. Concerns that the higher tax rate might harm low-income households could be addressed through targeted subsidies. Yet on the recent decision to reduce the corporate income tax rate, the IMF noted that while a cut could raise investment and growth, it would likely not do so sufficiently to make the reform pay for itself. Hence, it recommends offsetting measures to limit revenue losses and suggests to phase in the reduction gradually.
Monetary policy to stay the course
The report says monetary policy is appropriately accommodative and that no further easing is needed at this point with actual and expected inflation steadily progressing toward the 2-percent target. The report, however, suggests the Bank of Japan act quickly if actual or expected inflation stagnates or growth disappoints.
“While the Bank of Japan’s communications have been very effective, the Bank needs to remain flexible in the use of its communication toolkit as actual inflation approaches the 2 percent target,” said Schiff.