## 1. National Accounts Revision and Reassessment of Economic Developments Under Abenomics

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### Recent developments: growth, labor, inflation, and policies
- Structural context and balance sheets
  - Rapidly aging population and shrinking labor force are hampering growth and productivity.
  - Low growth/low interest rate environment constrains monetary easing and fosters macro-financial challenges (sovereign-financial linkages, declining profitability of financial institutions, search for yield).
  - Corporates’ large cash reserves at almost 50 percent of GDP.

- Growth dynamics
  - Recent growth driven mainly by external demand and temporary fiscal stimulus; economy is growing above potential and narrowing the negative output gap.
  - Expansion is broader and more balanced than in 2015: private consumption growth turned positive; private investment strengthened on the back of residential investment.
  - Net exports picked up in H2 2016 as global demand rebounded and imports fell (lower energy costs).
  - Revised national accounts indicate more robust GDP growth during 2013–15 than originally estimated.

- Labor market and wages
  - Unemployment has fallen to a 25-year low; job-to-applicant ratio is at an all-time high.
  - Labor shortages evident, particularly in lower-paid non-regular work where wage pressure is mounting.
  - Overall wage growth remains weak due to limited labor mobility, preference for job security, and base pay negotiations guided by current inflation.
  - Female labor force participation has increased; gap between male and female employment rates remains high.
  - Authorities raised the minimum wage by 3 percent in FY2017.

- Inflation and expectations
  - Headline inflation fell in first three quarters of 2016 then began to rise in the last quarter on stabilizing energy prices and higher fresh food prices.
  - Inflation excluding fresh food and energy declined throughout 2016.
  - Medium- and long-term inflation expectations were depressed in 2016 and remain low; market-based indicators suggest they may be approaching an inflection point.
  - Average inflation would remain below one percent in 2017.

- Monetary and fiscal policy developments
  - BoJ adopted negative interest rate policy (NIRP) in February 2016 and introduced “QQE with yield curve control” (YCC) in September 2016.
  - Government postponed planned 2 percentage point increase in the consumption tax rate from April 2017 to October 2019.
  - A 1.5 percent of GDP supplementary fiscal package (August 2016) raised spending primarily in 2017:
    - $15 billion for infrastructure investment,
    - $24 billion for disaster alleviation and reconstruction,
    - $22 billion to improve welfare services (including support for child care),
    - $5 billion to support SMEs and revitalize local economies.
  - Fiscal policy characterized as stop-go; structural reforms have lagged relative to monetary easing.

- Structural reform and macro-financial developments
  - Progress in energy and agriculture, trade and investment promotion, and corporate governance.
  - Work Style Reform (WSR) agenda (March 2017) aims to address wage gaps, envisage caps on overtime, and expand childcare; implementation expected to be slow.
  - Financial intermediation: credit growth picked up to 3 percent in Q1 2017 versus a historical average of 2 percent during 2011–16.
  - Households: housing loans grew about 2 percent in 2016; portfolio rebalancing toward risky assets remained slow.
  - Corporates: retained earnings grew significantly; loan financing grew by nearly 3 percent in 2016 while issuance of equity and debt securities remained relatively low.
  - JGB market: 10-year yield hovered close to the zero percent target under YCC; BoJ’s JGB purchases continued to outpace government issuance.

### Outlook and risks
- Short-term outlook (2017–2018)
  - Growth momentum expected to carry through 2017 but would weaken in 2018 if fiscal stimulus fades as currently scheduled.
  - Expiration of fiscal stimulus in 2018 (a contraction of 0.6 percent of GDP in the structural primary balance) together with smaller expansion in foreign demand would reduce growth to less than half of that in 2017.
  - Exports expected to rise; net exports contribution would narrow in 2017 and turn negative in 2018 as imports pick up.
  - Inflation expected to rise only gradually; average inflation below one percent in 2017 and projected to decline slightly in 2018.

- Medium-term outlook
  - Without discretionary fiscal support, fiscal stance would be contractionary in 2018–20 due to expiry of 2017 stimulus measures and scheduled consumption tax hike; consumption likely to rise prior to the tax hike then contract, causing growth volatility in 2019–20.
  - Demographic headwinds will weigh on potential growth over the next 10–15 years as the most productive segment of the working age population starts to fall.
  - Current account surplus expected to rise gradually over the medium term under the current policy mix.

- Risks (tilted to the downside, especially medium term)
  - Near-term upside risks: possible supplementary budget for 2018; stronger exports.
  - Near-term downside risks: sharp yen appreciation; loss of confidence in domestic policies renewing deflationary risks; weakened JGB market functioning; market losses from equity or JGB yield moves affecting banks and life insurers.
  - Liquidity risk from regional banks expanding overseas.
  - Global risks: retreat from cross-border integration, disorderly rebalancing in China, regional geopolitical shocks.
  - Medium-term risks: doubts about fiscal sustainability leading to a jump in sovereign risk premium; low bank profitability and demographic headwinds posing solvency problems for regional banks; life insurers failing to meet interest guarantees; some real estate segments moderately overvalued.

### Key quantitative points and indicators cited
- Corporates’ cash reserves: almost 50 percent of GDP.
- Supplementary fiscal package: 1.5 percent of GDP.
  - $15 billion (infrastructure); $24 billion (disaster alleviation and reconstruction); $22 billion (welfare services including support for child care); $5 billion (SME support and local economy revitalization).
- Consumption tax increase: postponed from April 2017 to October 2019; planned increase was 2 percentage points.
- BoJ policy actions: NIRP adopted in February 2016; “QQE with yield curve control” introduced in September 2016.
- JGB market: 10-year yield hovered close to the zero percent target.
- Credit growth: 3 percent in Q1 2017; historical average 2 percent during 2011–16.
- Housing loans: grew about 2 percent in 2016.
- Corporates’ loan financing growth: nearly 3 percent in 2016.
- Minimum wage: raised by 3 percent in FY2017.
- Structural primary balance contraction if stimulus expires: 0.6 percent of GDP.
- Inflation: average inflation would remain below one percent in 2017.
- Output/demographics horizon: demographic headwinds intensify over the next 10–15 years.

### Authorities’ near-term outlook and priorities
- Authorities did not foresee a significant growth slowdown in 2018 and cited sustained external demand and investment.
- BoJ acknowledged weak inflation expectations but emphasized positive output gap and rising energy prices should gradually lift inflation towards the 2 percent target in FY2018.
- Authorities agreed risks are tilted to the downside and highlighted external risks—particularly spillovers from China’s rebalancing.
- Authorities noted reforms have been initiated to address declining profitability of financial institutions (see FSAP).

### Macro-structural reform goals and priorities
- Objective: exploit complementarities between macro-critical structural reforms and coordinated income and demand policies to lift potential growth and spur inflation while maintaining a broadly neutral near-term fiscal stance and credible medium-term fiscal consolidation.
- Priority 1 — Labor market reforms to boost wages and productivity:
  - Clarify legal framework for “intermediate” contracts; support worker mobility; accelerate “equal-pay for equal work”; introduce job descriptions.
- Priority 2 — Increase private investment and productivity:
  - Deregulate product and service sectors; further corporate governance reform; promote trade and FDI; expedite deregulation in Special Economic Zones.
- Priority 3 — Diversify and enhance labor supply:
  - Boost female and older-worker participation; allow more foreign workers; reduce excessive overtime; eliminate tax and social security disincentives to full-time work; increase childcare and nursing facilities; abolish firms’ right to set a mandatory retirement age; promote robotics and automation.
- SME and financial sector policies:
  - Improve credit allocation to SMEs (upgrade banks’ credit risk-assessment capacity; lower coverage of public credit guarantees; improve SMEs’ reporting standards); encourage internationalization of SMEs; promote alternative finance (asset-based lending, venture capital).

### Coordinated demand and income policies (staff recommendations)
- Monetary policy
  - Maintain a sustained accommodative stance; keep long-term benchmark yield stable; consider additional monetary easing in coordination with fiscal stimulus if deflationary pressures increase.
  - BoJ could strengthen communication by publishing staff forecasts of inflation and gradually phasing out references to quantitative JGB targets (authorities currently do not plan to publish staff inflation forecasts).

- Fiscal policy near term
  - Near-term fiscal policy should support demand despite high public debt, given limited funding risks and low borrowing costs—provided medium-term debt trajectory is anchored by a credible consolidation plan.
  - Fiscal stance recommendation: be at least broadly neutral in 2018—avoiding the scheduled withdrawal of fiscal stimulus—followed by gradual consolidation.
  - A neutral fiscal stance in 2018 (an additional 0.6 percent of GDP) could accommodate discretionary fiscal measures to accelerate structural reforms and income policies.
  - Prioritization for fiscal incentives: intermediate labor contracts, active labor market policies, increased provision of childcare.
  - Staff model simulations suggest near-term fiscal support within a comprehensive coordinated package would boost growth and inflation without aggravating fiscal sustainability.

- Income policies to reflate the economy
  - Incentivize profitable companies to raise wages by at least three percent (the inflation target plus average productivity growth).
  - Options: more effective tax incentives or penalties as a last resort; government commitment to raising administratively controlled wages annually in line with the inflation target; combine income policies with near-term monetary and fiscal support.

- Coordination and sequencing
  - Demand policies should be coordinated in size, sequence, and communication via existing fora (Council on Economic and Fiscal Policy).
  - Avoid premature fiscal tightening; unorthodox monetized or unbacked fiscal expansions are not recommended under current circumstances.

### Stronger macroeconomic policy frameworks and fiscal consolidation
- A credible fiscal policy framework is essential; interim fiscal review scheduled for FY2018 provides an opportunity to strengthen the framework.
- Medium-term consolidation pace:
  - Average annual consolidation of 0.5 percent of GDP in the structural primary balance is recommended to balance growth protection and debt stabilization.
- Revenue and spending options:
  - Consumption tax remains preferred source: replace planned 2 percentage point 2019 hike with a pre-announced schedule of gradual increases of 0.5–1.0 percentage points over regular intervals until rate reaches at least 15 percent, preserving the unitary structure.
  - Consider mitigating measures with high multipliers (cash transfers to low income households) and other tax measures (asset tax, property tax reform, strengthened personal income tax).
  - On the spending side, curb social security outlays growth.

### Enhanced financial sector policies and crisis preparedness
- Move to full risk-based prudential supervision; strengthen corporate governance across banking and insurance sectors; encourage regional institutions to improve risk management; tailor capital requirements to bank risk profiles.
- Strengthen macroprudential framework: clarify mandate of Council for Cooperation on Financial Stability; broaden systemic risk assessments; develop housing-sector tools; require internationally active financial institutions to hold sufficient liquidity buffers in significant foreign currencies.
- Bank viability: engage with boards and management on population dynamics; facilitate transition to fee-based income; support consolidation among regional and Shinkin banks.
- Crisis management and resolution: tighten preconditions for emergency liquidity assistance; consider loss-absorbing capacity requirements for domestic systemically important banks; expand resolution toolkit and clarify legal framework.
- JGB market risks: monitor scarcity and liquidity; consider offsetting measures to provide JGBs in short supply; MoF to tailor Auction for Enhanced-Liquidity and re-opening scheme and coordinate with BoJ.

### External position, spillovers, and staff assessment
- Current account strengthened in 2016: surplus increased from 3.1 percent of GDP in 2015 to 3.8 percent in 2016; projected to increase to 3.9 percent of GDP in 2017.
- IMF EBA results and staff analysis:
  - 2016 external position assessed as moderately stronger than level consistent with medium-term fundamentals and desirable policies.
  - 2016 current account norm estimated at 1.3-3.3 percent of GDP after adjustments (EBA estimates the norm at 3.4 percent).
  - 2016 cyclically-adjusted current account estimated at 3.3 percent after adjustments (EBA estimates it at 3.1 percent).
  - 2016 current account gap midpoint: 1.0 percent of GDP.
- Policy implication: coordinated domestic policy package—including bolder structural reforms and a credible medium-term consolidation plan—is needed to support growth, domestic demand, imports and prices, and help align the external position with fundamentals.

### Debt sustainability, stress tests, and scenario outcomes
- Principal finding: Japan’s public debt is unsustainable under current policies, amounting to 239 percent of GDP in 2016.
- Baseline projections and key indicators (selected exact figures)
  - Nominal gross public debt (percent of GDP): 214.8 (2015), 238.2 (2016), 239.4 (2017), 240.7 (2018), 240.3 (2019), 238.7 (2020), 237.1 (2021), 235.5 (2022).
  - Public gross financing needs (percent of GDP): 57.5 (2015), 54.5 (2016), 50.2 (2017), 50.1 (2018), 49.5 (2019), 48.7 (2020), 46.7 (2021), 46.6 (2022).
  - Net public debt (percent of GDP): 100.0 (2015), 118.5 (2016), 119.9 (2017), 121.3 (2018), 120.9 (2019), 119.3 (2020), 117.7 (2021), 116.1 (2022).
  - Real GDP growth (in percent): 0.5 (2015), 1.1 (2016), 1.0 (2017), 1.3 (2018), 0.6 (2019), 0.8 (2020), 0.2 (2021), 0.7 (2022).
  - Inflation (GDP deflator, in percent): -0.7 (2015), 2.1 (2016), 0.3 (2017), -0.1 (2018), 0.9 (2019), 1.1 (2020), 1.4 (2021), 0.9 (2022).
  - Effective interest rate (in percent): 0.9 (2015), 0.8 (2016), 0.7 (2017), 0.6 (2018), 0.5 (2019), 0.5 (2020), 0.5 (2021), 0.5 (2022).
  - Gross financing needs: around 54 percent of GDP in 2016; projected to remain around 50 percent of GDP over near term.
  - Average maturity: about 7.7 years.

- Stress-test scenarios (selected quantified outcomes)
  - Real GDP growth shock ("0.25 percentage point per 1-point decrease in growth"):
    - Brings debt ratio to about 248 percent of GDP at the peak (around 9 percentage points higher relative to baseline).
  - Interest rate shock:
    - Effective interest rate higher by more than 1 percentage point in 2022 than the baseline.
    - Debt ratio higher by around 8 percentage points relative to the baseline.
  - Combined interest rate and contingent liability shock:
    - One-time capital injection equivalent to about 3.6 percent of banking sector assets (approximately 10 percent of regional banks assets).
    - Capital injection will increase government spending by around 5.8 percent of GDP.
    - Debt ratio will increase to around 264 percent of GDP in 2019 (about 26 percentage points higher than baseline).
  - Longer-term projection: debt-to-GDP ratios projected to start increasing after 2023 and reach around 250 percent of GDP by 2030 under baseline assumptions.
  - Public health spending risk: a larger-than-assumed increase would imply a debt ratio of 255 percent of GDP by 2030.

### Annex IV risk assessment highlights (selected likelihood/impact)
- Successful reflation following comprehensive reforms: Likelihood (Over next 1–3 years): Low; Impact: High.
- Retreat from cross-border integration: Likelihood: High; Impact: High.
- Weaker than expected global growth (including China slowdown): Likelihood: High/Medium (general) and Low/Medium (China); Impact: Medium to High.
- Bond market stress from a reassessment of sovereign risk: Likelihood: Medium; Impact: High.
- Severe earthquake: Likelihood: Medium; Impact: High.

### Work Style Reform (Annex I) — measures, limitations, and recommendations
- WSR main measures that could affect productivity, wages, and labor supply:
  - Overtime caps: Maximum 45 hours per month and 360 hours per year, or maximum 720 hours per year (60 hours per month) during busy times with limits (including a 100-hour monthly limit).
  - Minimum wage aim: rise of about 3% per year toward an hourly wage of 1,000 yen nationwide weighted average.
  - Equal Pay for Equal Work: draft guidelines and legal revisions; subsidies for converting non-regular to regular positions; five-year rule effective April 2018.
  - Measures to increase labor supply: support integration of women, consider accepting foreign human resources (mostly for skilled labor).
- Assessment: implementation will be slow; many measures may take years to be effective; lack of concrete measures to increase medium and low-skilled foreign labor.
- Policy recommendations to maximize WSR impact:
  - Accelerate key measures and introduce job descriptions to facilitate equal pay for equal work.
  - Widen income policy toolkit to encourage wage growth (expand/target tax incentives; increase public wages).
  - Implement labor contract reform to reduce duality (higher employment security for non-regular workers; lower protection for regular workers).
  - Encourage managerial practice changes, complement with corporate governance reforms requiring action plans on a comply-or-explain basis.
  - Further encourage female labor force participation by enhancing childcare provision and eliminating the income tax spousal deduction.
  - Relax entry requirements for low-medium skilled foreign workers in sectors with shortages.
  - Phase out WSR subsidies that create market distortions once exit from deflation is consolidated.

### Staff appraisal and high-level recommendations
- Economic conditions improved but inflation remains low and risks are tilted to the downside.
- Absent continued demand stimulus and further reform, momentum would fade; domestic consumption and investment have yet to build sufficient steam; wage growth remains subdued despite labor shortages.
- Policy recommendation: accelerate reforms via a comprehensive and coordinated policy package—bolder structural reforms and a credible and specific medium-term consolidation plan are needed to support growth, domestic demand, imports and prices, and reduce deflation risks and external imbalances.
- Timing: recommend next Article IV consultation on the standard 12-month cycle.

*Source: IMF staff report chapter "1. National Accounts Revision and Reassessment of Economic Developments Under Abenomics" (cr17242).*

### 1. National Accounts Revision and Reassessment of Economic Developments

### 1. National Accounts Revision and Reassessment of Economic Developments Under Abenomics

### Recent developments: growth, labor, inflation, and policies
- Structural context
  - Rapidly aging population and shrinking labor force are hampering growth and productivity.
  - Low growth/low interest rate environment constrains monetary easing and fosters macro-financial challenges (sovereign-financial linkages, declining profitability of financial institutions, search for yield).
  - Household and corporate balance sheet features: corporates’ large cash reserves at almost 50 percent of GDP.

- Growth dynamics
  - Recent growth driven mainly by external demand and temporary fiscal stimulus; economy is growing above potential and narrowing the negative output gap.
  - Expansion broader and more balanced than in 2015: private consumption growth turned positive; private investment strengthened on the back of residential investment.
  - Net exports picked up in H2 2016 as global demand rebounded and imports fell (lower energy costs).
  - Revised national accounts indicate more robust GDP growth during 2013–15 than originally estimated, reflecting stronger private investment and consumption.

- Labor market and wages
  - Unemployment has fallen to a 25-year low; job-to-applicant ratio is at an all-time high.
  - Labor shortages are evident, particularly in lower-paid non-regular work where wage pressure is mounting.
  - Overall wage growth remains weak; reasons include limited labor mobility, preference for job security, and base pay negotiations guided by current inflation.
  - Female labor force participation has increased, but the gap between male and female employment rates remains high.
  - Authorities raised the minimum wage by 3 percent in FY2017.

- Inflation and expectations
  - Inflation is stubbornly low: headline inflation fell in first three quarters of 2016 then began to rise in the last quarter on stabilizing energy prices and higher fresh food prices.
  - Inflation excluding fresh food and energy declined throughout 2016.
  - Medium- and long-term inflation expectations were depressed in 2016 and remain low; market-based indicators suggest they may be approaching an inflection point.
  - Average inflation would remain below one percent in 2017.

- Monetary and fiscal policy developments
  - BoJ adopted negative interest rate policy (NIRP) in February 2016 and introduced “QQE with yield curve control” (YCC) in September, including a long-term interest rate target and a commitment to overshoot the 2 percent inflation target.
  - YCC aimed at raising inflation expectations and strengthening commitment to sustained monetary easing; communication about timing of achieving the inflation target was deemphasized.
  - In June 2016, the government postponed the planned 2 percentage point increase in the consumption tax rate from April 2017 to October 2019.
  - In August 2016, a 1.5 percent of GDP supplementary fiscal package raised spending primarily in 2017. The package included $15 billion for infrastructure investment, $24 billion for disaster alleviation and reconstruction of quake-hit areas, $22 billion to improve welfare services (including support for child care), and $5 billion to support SMEs and revitalize local economies.
  - Fiscal policy characterized as stop-go; structural reforms have lagged relative to monetary easing.

- Structural reform
  - Progress in energy and agriculture, trade and investment promotion, and corporate governance.
  - Work Style Reform (WSR) agenda (March 2017) seeks to address wage gaps between regular and non-regular workers, envisage a cap on overtime, and expand childcare facilities (Annex I). Implementation expected to be slow; reforms to remove labor market duality and disincentives embedded in tax and social security systems have fallen short.
  - Corporate tax cuts and governance reforms have not yet mobilized large corporate cash holdings for private investment and wage increases.

- Macro-financial developments and vulnerabilities
  - Sovereign debt market: shorter end of yield curve stabilized under YCC; 10-year yield has hovered close to the zero percent target. Super-long yields rose amid higher global interest rates. BoJ’s JGB purchases continued to outpace government issuance; financial institutions’ JGB holdings fell in 2016, though pace of purchases slowed and some market liquidity improved.
  - Financial intermediation: financial institutions increased risk-taking—expanding real-estate and overseas lending. Credit growth picked up to 3 percent in Q1 2017 versus a historical average of 2 percent during 2011–16, suggesting an expansionary credit cycle.
  - FX and equity markets: sharp yen appreciation in H1 2016 was partly reversed by end-year; equity prices rose with a more favorable global outlook. U.S. dollar funding costs increased in 2016 but lessened somewhat in 2017.
  - Households: housing loans grew about 2 percent in 2016; household portfolio rebalancing toward risky assets remained slow.
  - Corporates: retained earnings grew significantly; loan financing grew by nearly 3 percent in 2016 while issuance of equity and debt securities remained relatively low.

### Outlook and risks
- Short-term outlook (2017–2018)
  - Growth momentum expected to carry through 2017 but would weaken in 2018 if fiscal stimulus fades as currently scheduled.
  - Fiscal stimulus supports 2017 growth through higher consumption and investment; monetary policy under YCC expected to remain accommodative and facilitate credit-economic growth dynamics.
  - Expiration of fiscal stimulus in 2018 (a contraction of 0.6 percent of GDP in the structural primary balance) together with smaller expansion in foreign demand would reduce growth to less than half of that in 2017, despite an anticipated Olympics-related boost in private investment.
  - Exports expected to rise; contribution from net exports would narrow in 2017 and turn negative in 2018 as stronger investment and consumption boost imports.
  - Inflation is expected to rise only gradually; average inflation below one percent in 2017 and projected to decline slightly in 2018 as growth slows. Modest wage increases mean wage-push inflation unlikely to contribute significantly.

- Medium-term outlook
  - Without discretionary fiscal support, fiscal stance would be contractionary in 2018–20 due to expiry of 2017 stimulus measures and scheduled consumption tax hike; consumption likely to rise prior to the tax hike then contract, causing growth volatility in 2019–20 and delaying closing of the output gap.
  - Demographic headwinds will weigh on potential growth over the next 10–15 years as the most productive segment of the working age population starts to fall.
  - Current account surplus expected to rise gradually over the medium term under the current policy mix.

- Risks (tilted to the downside, especially medium term)
  - Near-term upside risks: possible supplementary budget for 2018; further strengthening of exports due to higher global demand.
  - Near-term downside risks: sharp yen appreciation from geopolitical instability and safe-haven flows; loss of confidence in domestic policies renewing deflationary risks; weakened functioning of JGB markets constraining BoJ operations; market losses from declines in equity prices or increases in JGB yields leading to substantial losses for banks and life insurers.
  - Liquidity risk: regional banks expanding overseas could face negative funding gaps in foreign currencies under adverse liquidity scenarios.
  - Global risks: retreat from cross-border integration, disorderly rebalancing in China, and regional geopolitical shocks could generate significant spillovers.
  - Medium-term risks: doubts about fiscal sustainability could lead to a jump in the sovereign risk premium, forcing abrupt fiscal adjustment with adverse feedback effects to the financial system and real economy; low bank profitability and demographic headwinds could pose solvency problems for regional banks; life insurers could fail to meet interest guarantees if low interest rates persist; segments of the real estate market appear moderately overvalued amid rapid expansion of real estate lending.

### Key quantitative points and indicators cited
- Corporates’ cash reserves: almost 50 percent of GDP.
- Supplementary fiscal package: 1.5 percent of GDP.
  - Composition cited: $15 billion (infrastructure), $24 billion (disaster alleviation and reconstruction), $22 billion (welfare services including support for child care), $5 billion (SME support and local economy revitalization).
- Consumption tax increase: postponed from April 2017 to October 2019; planned increase was 2 percentage points.
- BoJ policy actions: NIRP adopted in February 2016; “QQE with yield curve control” introduced in September.
- JGB market: 10-year yield hovered close to the zero percent target.
- Credit growth: reached 3 percent in Q1 2017 versus historical average of 2 percent during 2011–16.
- Housing loans: grew about 2 percent in 2016.
- Corporates’ loan financing growth: nearly 3 percent in 2016.
- Minimum wage: raised by 3 percent in FY2017.
- Structural primary balance contraction if stimulus expires: 0.6 percent of GDP.
- Inflation: average inflation would remain below one percent in 2017.
- Output and demographic horizon: demographic headwinds intensify over the next 10–15 years as the most productive segment of the working age population starts to fall.

*Source: IMF staff report chapter "1. National Accounts Revision and Reassessment of Economic Developments Under Abenomics" (excerpts).*

### 14. The authorities were more optimistic about near-term growth while pointing to

### 14. The authorities were more optimistic about near-term growth while pointing to

### Authorities’ near-term outlook and risks
- Authorities did not foresee a significant growth slowdown in 2018, citing sustained external demand and investment.
- Consumption is likely to strengthen gradually due to rising base wage dynamics.
- The BoJ acknowledged that weak inflation expectations remain a major obstacle to reflation, but emphasized that a positive output gap and rising energy prices should gradually lift actual and expected inflation towards the 2 percent target in FY2018.
- Authorities agreed that risks are tilted to the downside and identified external risks—particularly spillovers from China’s rebalancing—as the main threat to the outlook.
- Financial risks assessment: authorities broadly agreed with staff on financial risks and highlighted recent efforts to curb FX risks through bilateral dialogue with financial institutions.
- Authorities noted that the low interest rate environment and adverse demographic trends are contributing to declining profitability of financial institutions, could spur excessive risk taking, impair financial intermediation, and potentially lead to solvency risk for regional financial institutions; they noted reforms have already been initiated (see FSAP).

### A. Macro-Structural Reforms — goals and priorities
- Objective: exploit complementarities between macro-critical structural reforms and coordinated income and demand policies to lift potential growth and spur inflation; maintain a broadly neutral near-term fiscal stance while implementing a credible medium-term fiscal consolidation plan.
- Strategy: prioritize measures aimed at reflating the economy, followed by measures to lift potential growth; provide appropriate demand support where reforms (e.g., boosting labor supply) may generate near-term deflationary pressure.

Priority 1 — Labor market reforms to boost wages and productivity
- Clarify legal framework for “intermediate” contracts to promote use, balance job security and wage increases, and reduce labor market duality.
- Support worker mobility across firms via contract reform, portability of pensions, and government programs.
- Accelerate the “equal-pay for equal work” initiative and introduce job descriptions to help close the wage gap between regular and non-regular workers (Annex I).

Priority 2 — Increase private investment and productivity
- Deregulate product and service sectors (reduce barriers to entry; remove protections to incumbents in some industries, e.g., telecoms and gas; deregulate professional services).
- Further corporate governance reform: more ambitious requirements for outside directors, enhanced transparency of beneficial ownership, explicit limits on cross-shareholdings.
- Provide greater clarity on macroeconomic policy frameworks, promote trade and FDI, and expedite deregulation in Special Economic Zones.

Priority 3 — Diversify and enhance labor supply
- Boost female and older-worker labor force participation; allow more use of foreign workers and integrate them into the economy.
- Reduce excessive overtime; encourage managerial practices that reward productivity rather than long hours.
- Eliminate disincentives to full-time and regular work stemming from the tax and social security system.
- Increase availability of childcare and nursing facilities (including via deregulation); abolish firms’ right to set a mandatory retirement age.
- Promote robotics and automation to boost productivity and potential growth.

SME and financial sector policies to support reform
- Improve credit allocation to SMEs by upgrading banks’ credit risk-assessment capacity, lowering coverage of public credit guarantees, and improving SMEs’ reporting standards (consistent with FSAP recommendations).
- Encourage internationalization of SMEs and provision of financial services for an aging society.
- Promote alternative finance to SMEs and startups (asset-based lending, venture capital).

### Authorities’ views on reforms and implementation
- Authorities emphasized the importance of a comprehensive reform agenda and agreed labor market reforms are key to revitalizing the economy and increasing inflation.
- Planned new legislation based on the Council for the Realization of Work Style Reform will be submitted to the Diet promptly.
- Recent measures highlighted: revision of the spousal tax deduction encouraging private companies to review family allowance requirements; corporate governance code (2015) increased companies with independent directors and reduced cross-shareholdings; revisions to the Stewardship Code finalized; full liberalization of the gas retail market in April; progress on TPP-11 considerations and Japan-EU EPA negotiations; measures to promote FDI (one-stop center for start-ups in 2015; streamlining procedures); SME Credit Guarantee Scheme reforms (relevant bills passed in June); 2017 growth agenda initiatives on healthcare efficiency and driverless transportation to address labor shortages.

### B. Coordinated Demand and Income Policies
Monetary policy
- Recommendation: maintain a sustained accommodative stance.
- BoJ faces an uphill battle due to backward-looking inflation expectations and a shrinking gap between short-term actual and natural real interest rate.
- Combine income policies and labor market reform with sustained monetary accommodation.
- Keep long-term benchmark yield stable to amplify spillovers from favorable external conditions.
- BoJ should maintain current accommodative stance even if stronger than expected global demand puts upward pressure on interest rates.
- Consider additional monetary easing (lowering the yield curve) in coordination with fiscal stimulus and with due consideration to profitability of financial institutions and JGB market functioning if deflationary pressures increase.

Fiscal policy near term
- Near-term fiscal policy should support demand and provide a buffer against adverse shocks despite Japan’s unprecedented high public debt level.
- Some fiscal space exists in the near term given limited funding risks and low borrowing costs, underpinned by JGB purchases by the BoJ and domestic investors’ home bias—provided the medium-term debt trajectory is anchored by a credible fiscal consolidation plan.
- Fiscal stance recommendation: be at least broadly neutral in 2018—avoiding the scheduled withdrawal of fiscal stimulus—followed by gradual consolidation in subsequent years.
- With constrained scope for additional monetary easing, fiscal policy should take a leading role if adverse shocks materialize.

Fiscal support and composition
- A neutral fiscal stance in 2018 (an additional 0.6 percent of GDP) could accommodate discretionary fiscal measures to accelerate structural reforms and income policies.
- Prioritization for fiscal incentives: intermediate labor contracts, active labor market policies to support worker mobility, and increased provision of childcare.
- Fiscal savings from removing distortionary measures (e.g., disincentives for dual earner households, unemployment insurance payments for elderly) could be redistributed to growth-friendly initiatives.
- Staff model simulations suggest near term fiscal support, if provided in the context of a comprehensive and coordinated policy package including a credible medium-term fiscal consolidation strategy, would boost growth and inflation without aggravating fiscal sustainability.

Income policies to reflate the economy
- Incentivize profitable companies to raise wages by at least three percent (the inflation target plus average productivity growth) to address the deflationary mindset.
- Options include more effective tax incentives or penalties as a last resort to increase the share of base wages (as opposed to bonuses) in overall compensation.
- Government could commit to raising administratively controlled wages annually in line with the inflation target and ensure similar policies are adopted at the prefectural level.
- Combine income policies with near-term monetary and fiscal support to raise inflation expectations and facilitate pass-through of higher wages to prices.

Coordination and sequencing
- Demand policies should be coordinated in size, sequence, and communication.
- Use existing fora (Council on Economic and Fiscal Policy) for deeper consultations between government and BoJ on macroeconomic conditions and effective demand support.
- Coordination should aim to prevent premature fiscal tightening.
- Unorthodox policies such as a monetized fiscal expansion or an unbacked fiscal expansion conditioned on reaching the inflation target are not recommended under current circumstances.

Authorities’ views on demand/income policy
- Authorities noted policy coordination is already built into the current framework and that some income policies exist.
- Authorities agreed fiscal policy is important to mitigate downside risks but stressed available fiscal space is limited given high public debt and adjustment needs.
- BoJ acknowledged further room for monetary easing if called for (cutting short-term policy rate, lowering target long-term interest rate for YCC, or expanding asset purchases).
- Authorities agreed on the importance of fiscal support to growth-friendly reform initiatives; recent fiscal stimulus package already promotes macro-critical structural reforms; current income policies (e.g., subsidies for wage increases) may be fine-tuned after evaluation.

### C. Stronger Macroeconomic Policy Frameworks
- A credible fiscal policy framework is essential to enhance effectiveness of near-term demand support and minimize longer-term risks.
- Recent approach of medium-term consolidation plans based on optimistic growth assumptions and stop-go yearly stimulus packages has increased policy uncertainty.
- An interim fiscal review scheduled for FY2018 provides an opportunity to strengthen the fiscal framework: limit use of supplementary budgets, rely on more independent and realistic assessments of the outlook and budget projections, and define specific fiscal measures to deliver consolidation.

Medium-term consolidation pace
- To balance protecting growth and putting debt on a stable path, medium-term fiscal consolidation should embed a gradual approach with an average annual consolidation of 0.5 percent of GDP in the structural primary balance.
- Faster consolidation could achieve sharper debt reduction but could potentially undermine reflation prospects; flexibility should be allowed year-to-year to account for economic conditions.

Revenue and spending options
- The consumption tax remains the preferred source for raising additional revenue given its low rate, broad base, and applicability across age groups.
- The planned 2 percentage point consumption tax rate hike in 2019 would pose cyclical challenges and should be replaced with a pre-announced schedule of gradual increases of 0.5–1.0 percentage points over regular intervals until the rate reaches at least 15 percent, while preserving the unitary structure of the tax.
- Mitigating measures with high multipliers (such as cash transfers to low income households) could be used to address business cycle fluctuations.
- Other tax measures to explore: an asset tax, property tax reform, or a strengthened personal income tax to supplement the consumption tax in a growth-friendly manner.
- On the spending side, the consolidation plan should curb social security outlays given their rapid increase is putting pressure on fiscal sustainability and private consumption through further increases in premium contributions (Annex II).

*cr17242 - 14. The authorities were more optimistic about near-term growth while pointing to*

### 29. Maintaining credibility of the monetary policy framework is crucial to underpin the

### 29. Maintaining credibility of the monetary policy framework is crucial to underpin the

### Monetary policy credibility and BoJ framework
- The BoJ has shown a strong commitment to its new framework (Box 2).
- Care should be taken to maintain an accommodative stance until significant progress has been made on reflation.
- To bolster credibility and lift inflation expectations, the BoJ could further strengthen its communication framework by publishing staff forecasts of inflation and gradually phasing out references to quantitative JGB targets.
- Over the medium term, the costs of maintaining the current policy stance are likely to rise if inflation remains below target and the BoJ is unable to reduce JGB purchases (e.g., low profitability of financial institutions and deterioration in JGB market functioning).
- The authorities noted they do not currently have plans to publish staff’s inflation forecasts (which they see as an internal exercise), but agreed effective communication is important to reduce market uncertainty and ensure policy credibility.

### Fiscal policy adjustment and consolidation options
- Annual consolidation of 0.5 percent of GDP would be consistent with a stabilization of the public debt ratio by 2030.
- Revenue measures (percentage point of GDP or amounts as presented):
  - Revenue 3.5
  - Broaden personal income tax base (including a reduction of the wage deduction)
  - 0.5 to 1.0 Eliminate preferential tax treatment for pension benefit income 1/1/4
  - Targeted tax credits [Offsetting measures]...
  - ... 1.0
- Expenditure measures:
  - Expenditure Curb growth rate of health spending 1/1.0
  - Raise pension eligiblity age to 67 or higher1/4
- Total savings6.5 to 7.0
- Options for Fiscal Policy Adjustment (in percentage point of GDP) listed in the text include:
  - Increase consumption tax rate from 8 to 15 percent
  - Personal income tax adjustments
  - Increase property tax
  - Increase healthcare copayments and premium contributions 1/
- Authorities’ stated fiscal objectives:
  - Remain committed to achieving a primary budget surplus by FY2020.
  - Reducing the public debt-to-GDP ratio.
  - Implementing the 2019 consumption tax hike; noted the 2019 tax hike is written into law.
  - The FY2018 interim fiscal review will assess progress and consider additional expenditure and revenue measures if necessary.

### External position and spillovers
- The current account strengthened in 2016 due to an improved goods trade balance.
  - Overall current account surplus increased from 3.1 percent of GDP in 2015 to 3.8 percent in 2016, and is projected to increase to 3.9 percent of GDP in 2017.
- Drivers and composition:
  - Goods exports (share of GDP) decreased but goods imports decreased by more, with value and volume of energy and consumption goods imports falling.
  - The income balance continued to account for most of the current account surplus, though it declined in 2016 in line with yen appreciation.
  - High income balance driven by Japan’s large net foreign asset position and high rates of return on net foreign assets.
- Capital flows and spillovers:
  - Capital outflows continued during most of 2016 as institutional investors’ overseas diversification and FDI outflows persisted.
  - Bulk of FDI outflows in 2016 went to Europe and Central/South America; portfolio outflows driven largely by insurance companies and channeled to U.S. bonds and foreign equities.
  - Outflows to emerging markets remained very low and concentrated in the region.
  - Outward spillovers from YCC have been limited; portfolio and FDI outflows and expansion of Japanese banks abroad have been associated with positive spillovers.
  - If capital outflows were to accelerate, they could offset tighter domestic financial conditions in the region due to expected normalization of policy interest rates in other advanced economies.
- Global architecture risks:
  - A global retreat from cross-border integration would likely decrease Japan’s goods trade surplus and negatively impact growth, at least initially.
  - Potential unwinding of U.S. financial regulations would likely reduce U.S. dollar funding cost for Japan’s financial institutions and facilitate rebalancing to overseas investments.
- IMF external balance assessment (EBA) results and staff analysis:
  - The 2016 external position was assessed as moderately stronger than the level consistent with medium-term fundamentals and desirable policies.
  - The 2016 current account norm is estimated at 1.3-3.3 percent of GDP after adjustments (EBA estimates the norm at 3.4 percent).
  - The 2016 cyclically-adjusted current account is estimated at 3.3 percent after adjustments (EBA estimates it at 3.1 percent).
  - Delivering a 2016 current account gap midpoint of 1.0 percent.
  - The assessment reflects adjustments for (i) anticipated effect from structural reforms and removal of domestic distortions holding back demand and imports, and structurally lower exports reflecting production offshoring; and (ii) elevated energy imports associated with the nuclear power plant shutdown.
- Policy implication:
  - A coordinated domestic policy package, including bolder structural reforms and a credible and specific medium-term consolidation plan, is needed to support growth, domestic demand, imports and prices, and help bring the external position in line with fundamentals over the medium term.

### Enhanced financial sector policies
- Financial oversight has improved but further progress is needed:
  - Move to full risk-based prudential supervision.
  - Strengthen corporate governance across the banking and insurance sectors.
  - Encourage regional financial institutions to improve risk management capacity.
  - Capital requirements need to be better tailored to individual bank risk profiles.
  - Adopt a stronger principles-based approach to related party exposures.
  - Implement an economic-value-based solvency regulation for the insurance sector.
- Strengthen macroprudential framework by:
  - Clarifying the mandate of the Council for Cooperation on Financial Stability.
  - Broadening systemic risk assessments to non-systemically important banks and non-banks.
  - Developing tools for the housing sector.
  - Require internationally active financial institutions to hold sufficient liquidity buffers in significant foreign currencies.
- Bank viability and business model transition:
  - Authorities should engage with bank boards and senior management on population dynamics and act promptly to resolve unviable firms.
  - Facilitate transition of regional banks to higher fee-based income by charging routine banking transactions.
  - Consolidation among regional and Shinkin banks may bring economies of scale and scope but is unlikely to be sufficient alone.
- Crisis management and resolution framework:
  - Need to strengthen the framework given complexity and ambiguities that could fuel expectations of public support.
  - Preconditions for emergency liquidity assistance should be tightened to anchor solvency and collateralization requirements.
  - Consider extending loss absorbing capacity requirements to domestic systemically important banks.
  - Ensure supervisory powers can be deployed quickly and embed early intervention measures.
  - Expand the resolution toolkit, enhance and clarify legal framework (including extension to central counterparties), and improve operational readiness.
- JGB market risks:
  - Continue to monitor scarcity of JGBs in the market and consider negative effects on market liquidity when conducting outright purchases.
  - Monitor impact of JGB scarcity on repurchase markets.
  - In situations of stress, consider offsetting measures to provide JGBs in short supply to the market.
  - The Ministry of Finance could continue to tailor its Auction for Enhanced-Liquidity and re-opening scheme to reduce demand-supply imbalances in certain JGBs and coordinate with the BoJ to avoid potential liquidity stress ex ante.

### Authorities’ views (selected)
- Authorities remain committed to primary surplus by FY2020, reducing public debt-to-GDP ratio, and implementing 2019 consumption tax hike.
- Authorities stressed gradual approach merits but noted administrative burden and that 2019 tax hike is written into law.
- Authorities had reservations about the EBA methodology and its application to Japan, arguing the model does not properly capture drivers of Japan’s current account and questioned staff adjustors and judgement.
- BoJ emphasized the new policy framework increased policy sustainability and flexibility; saw market participants as understanding that JGB purchases will fluctuate with market developments and the need to keep long-term interest rate close to target.
- On financial sector reforms, authorities broadly agreed with recommendations but differed on crisis management and resolution framework specifics; they stressed the effectiveness of the CCFS and the role of ELA as lender of last resort.

### Staff appraisal and recommendations
- Economic conditions have improved but inflation remains low and risks to the outlook are tilted to the downside.
  - A pick-up in external demand, short-term fiscal stimulus, and accommodative monetary policy have strengthened the economy and narrowed the output gap.
  - Absent continued demand stimulus and further reform, momentum would fade.
  - Domestic consumption and investment have yet to build sufficient steam; wage growth remains subdued despite labor shortages.
  - A slip in external demand or a sharp increase in global interest rates could stall growth momentum and complicate reflation efforts.
  - Low interest rate environment and demographic headwinds pose risks to the financial sector.
- Policy recommendation:
  - Seize the opportunity to accelerate reforms via a comprehensive and coordinated policy package to support near-term growth and bring ambitious targets within reach.
  - Bolder structural reforms and a credible and specific medium-term consolidation plan are needed to support growth, domestic demand, imports and prices, and to reduce deflation risks and external imbalances.

*IMF staff summary based on the provided chapter content.*

### 47. A more determined structural reform effort is needed. The government should prioritize

### 47. A more determined structural reform effort is needed. The government should prioritize

### Structural reform priorities to reflate and lift potential growth
- First priority: strengthen productivity and wage pressures by reducing labor market duality and increasing mobility.
- Second priority: promote investment and potential growth by:
  - deregulating product and services markets,
  - strengthening corporate governance,
  - boosting trade and FDI,
  - improving credit allocation to SMEs.
- Diversify and enhance labor supply by removing disincentives to full-time work and supporting female and older labor market participation, and increased use of foreign labor.
- The government’s Work Style Reform plan is welcome and should be accelerated and broadened.

### Macro policy mix and income policies
- Renewed macro-critical structural reforms should go hand in hand with demand support and income policies to reflate the economy.
- Maintain sustained accommodative monetary policy and a fiscal stance that is at least neutral in the near-term, complemented by income policies including stronger incentives for profitable firms to raise wages.
- An expansionary fiscal stance may be considered if there is substantial progress on structural reforms and if macroeconomic conditions warrant additional near-term support.
- Complementary growth-enhancing reforms would raise the neutral real interest rate and support credit demand, making monetary policy more effective.
- Strengthen monetary policy communication to improve policy predictability, maintain credibility in the new monetary policy framework, and lift inflation expectations.

### Fiscal consolidation and medium-term plan
- Move to address Japan’s unsustainable level of public debt through an annual consolidation in the structural primary balance of 0.5 percent of GDP on average.
- Plan should emphasize gradual and pre-announced consumption tax hikes of 0.5–1.0 percentage points in regular intervals, starting as soon as possible.
- Social security spending will need to be curbed through fundamental reforms.
- Use the FY2018 interim fiscal review to:
  - limit reliance on supplementary budgets,
  - use more independent and realistic macroeconomic assumptions,
  - specify fiscal measures.

### Financial sector policies and risks
- Move to full forward-looking risk-based supervision and continue to enhance corporate governance.
- Strengthen the macroprudential framework further.
- Authorities should engage with financial institutions on the future of their business models and take timely actions if viability concerns are identified.
- Strengthen the financial sector crisis management and resolution framework.
- Address solvency concerns of regional financial institutions and contain emerging risks.

### External position and spillovers
- The 2016 external position was assessed as moderately stronger than consistent with medium-term fundamentals and desirable policies.
- The substantial appreciation of the real effective exchange rate in 2016 moved it to a level consistent with medium-term fundamentals.
- Bolder structural reforms and a credible and specific medium-term consolidation plan—in line with staff’s recommended policy package—would help mitigate inward spillovers and bring the external position in line with fundamentals over the medium term.

### Timing of Article IV consultation
- It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

### Box 1 — National Accounts Revision and Reassessment of Economic Developments Under Abenomics
- A comprehensive revision of the national accounts published in December 2016 reflects:
  - switch to System of National Accounts 2008 (SNA2008),
  - updating the benchmark year from 2005 to 2011,
  - incorporation of detailed source statistics and other methodological changes.
- Under the revision:
  - nominal GDP 2015 rose by 6.2 percent, with 61 percent of the upward revision reflecting capitalization of R&D under SNA2008.
  - With higher GDP, the 2015 fiscal balance improved by 0.4 percentage points while the public debt to GDP ratio decreased by 15 percentage points.
- Revised real GDP growth:
  - real GDP growth in 2013–15 now averages 1.2 percent compared to 0.6 percent pre-revision.
  - Contributions to real GDP growth over 2013–15:
    - private consumption: 0.2 percentage points per year versus -0.1 pre-revision,
    - private non-residential investment: 0.5 percentage points per year versus 0.2 pre-revision.
- Japan: Revisions to Nominal GDP and Real GDP Growth (In billion yen or percent)
  - 2013 2014 2015
    - Nominal GDP (new) 503,176 513,698 530,545
    - Nominal GDP (old) 479,084 486,871 499,281
    - Real GDP growth (new) 2.0 0.3 1.2
    - Real GDP growth (old) 1.4 0.0 0.6
- The revision improved Japan’s standing among G7 peers: Japan’s average real GDP growth since 2013 ranks 5th among the G7 economies, compared to 6th before the revision.
- While private consumption’s contribution improved, it still looks low in a G7 context; the revision places Japan in a relatively strong position on private investment among G7 peers.

### Box 2 — Yield Curve Control (YCC): The Road Less Traveled
- Background:
  - BoJ adopted negative interest rate policy (NIRP) in February 2016.
  - In September 2016 BoJ adjusted framework by deemphasizing quantitative JGB purchases in favor of a long-term interest rate target and an inflation overshooting commitment.
- QQE with Yield Curve Control combined with an inflation overshooting commitment:
  - BoJ deemphasized its annual 80 trillion yen JGB purchase target in favor of targeting the 10-year JGB yield at “around zero”.
  - BoJ committed to expanding the monetary base until inflation exceeded 2 percent.
  - In February 2017 BoJ increased transparency on timing and quantities of planned monthly JGB purchases.
- Effects and indicators:
  - Pace of annual JGB purchases by BoJ has dropped to about 60 trillion yen.
  - Volatility in yields up to the 10-year benchmark has fallen; yield curve has remained stable except for an increase in super long-term yields.
  - Some aspects of JGB market liquidity (e.g., price dispersion and bid-ask spreads) appear to have improved, despite continued weakening in market functioning and increased scarcity of JGBs in the market.
  - Limited spillovers from rise in global interest rates to JGB yields contributed to higher interest spreads and some reversal of the yen appreciation seen in the first half of 2016.
  - Credit growth has risen since the advent of YCC.
- Risks and concerns:
  - Emerging signs of scarcity in the JGB market; too early to properly evaluate overall impact on the economy.
  - Potential side effects on financial sector profitability and JGB market functioning, including reduced JGB market trading and difficulties executing large transactions.
  - A loss of credibility could trigger accelerated sell-off of JGBs; highlights need to complement monetary policy with near-term fiscal support and accelerated structural reform.
- Signs of JGB scarcity in the market include:
  - intensified use of BoJ’s Securities Lending Facility;
  - rapidly rising spread between the General Collateral and Special Collateral repo rates since late 2016;
  - increasing number of fails in the repo market.

### Box 3 — Japan’s Lifetime Employment System and Gender Inequality
- Lifetime employment and gender differences:
  - Nearly 30 percent of men work at the same firm where they started—virtually unchanged since 1990.
  - Only 19 percent of women stay at the same firm, and the ratio has been declining.
- Women overrepresented in non-regular jobs:
  - More than 50 percent of women in the labor force are non-regular workers, compared to 20 percent of men.
  - The proportion of non-regular workers rose from 20.3 percent in 2004 to 37.5 percent in 2016.
  - Part-time non-regular workers’ wage (per hour) is about half of full-time regular workers.
  - This has suppressed the overall wage bill despite a labor shortage, putting downward pressure on wage-price dynamics.
- Dual-track system and impacts on women:
  - Dual-track system: career track (management stream) versus non-career track (routine, clerical work); men dominate the career track.
  - Companies require track commitment before hiring and limit track switching; some require relocation for career track—discouraging applicants with family responsibilities (mostly women).
  - Women in non-career track are deprived of training opportunities and have limited promotion prospects, resulting in lower wages compared to male peers.
- Childcare and eldercare capacity:
  - Childcare capacity rose by 500,000 in 2009-16, but waitlisted children remained above 20,000 for the same period.

*Prepared from IMF staff analysis in the supplied chapter content.*

### Box 3. Japan’s Lifetime Employment System and Gender Inequality (concluded)

### Box 3. Japan’s Lifetime Employment System and Gender Inequality (concluded)

### Tax and social security disincentives to female labor
- Many non-regular workers intentionally choose fewer hours or lower wages because:
  - they are exempted from income and residential tax if they earn less than JPY 1.03 million per year,
  - they are exempted from social security premiums if they earn less than JPY 1.3 million per year.
- Household heads can receive a spousal allowance if the second-earner (typically the woman) earns less than the threshold, which is usually set below the tax or social security premium threshold.
- The government raised the threshold for spousal deduction from JPY 1.03 million to JPY 1.5 million, effective January 2018.
- Wage-difference indicators shown in the source include the values: 60.2, 73.0, 75.1 (presented in the “Wage Difference by Gender” figure, Female wage as percent of men).

### Limits of contract and entitlement reforms; need for broader measures
- Reform of employment contracts, and tax and social security systems is a prerequisite to:
  - raise female labor force participation,
  - create upward pressure on wage-price dynamics.
- These reforms alone are not sufficient; success in equalizing opportunities within the labor market hinges on comprehensive policy action.

### Public investment and financing
- More public investment in family support is required to equalize opportunities.
- Finding stable financing for increased public investment in family support is identified as an urgent issue.

*Source: Box 3. Japan’s Lifetime Employment System and Gender Inequality (concluded), cr17242 (IMF).*

### Annex I. Japan’s Labor Market Bottlenecks and the Work Style

### Annex I. Japan’s Labor Market Bottlenecks and the Work Style Reform Plan

### Key findings: structure and effects
- The structure of Japan’s labor market hinders labor supply, productivity, and growth.
- Labor market duality reduces productivity by lowering motivation and access to training of non-regular workers.
- A working culture based on long hours prevents the economy from fully benefiting from the contribution of Japan’s highly-educated women.
- The lack of a clear framework for admission of medium and low-skilled foreign workers implies virtually zero foreign labor supply in sectors with acute labor shortages.

### Reasons wage growth remains moderate despite a tight labor market
- Reduced bargaining power and low wages of non-regular workers.
- Aspects of the lifetime employment system for regular workers which reduce incentives to increase wages to attract workers from competitors:
  - low horizontal mobility;
  - emphasis on employment stability rather than wage increases;
  - intra-firm job rotation;
  - seniority-based wages.
- Japan’s long history of deflation and entrenched deflation expectations, magnifying the impact of the two factors above by reducing the need for nominal wage increases.

### Work Style Reform (WSR) plan: main measures that could positively affect productivity, consumption, wage-price dynamics, and labor supply
- A cap on excessive overtime
  - Maximum 45 hours per month and 360 hours per year, or
  - Maximum 720 hours per year (60 hours per month) during busy times with a labor-management agreement (subject to limitations, including a 100-hour monthly limit)
- Income and productivity policies
  - Increasing the minimum wage
    - Aim at minimum wage rise of about 3% per year
    - Toward an hourly wage of 1,000 yen in nationwide weighted average
  - Tax exemptions and subsidies for companies to increase wages and productivity
  - Improving price negotiating power of SMEs when subcontracting with large companies
- Addressing labor market duality
  - Equal Pay for Equal Work:
    - Draft guidelines showing unreasonable differences in treatment between regular and non-regular workers
    - Legal revisions based on the draft guidelines
  - Providing subsidies for companies which convert non-regular workers to regular position
  - Increasing awareness of the five-year rule (effective April 2018) under which firms must convert non-regular workers in the same job for more than five years to regular positions
- Horizontal mobility of workers across firms
  - Subsidies and provision of information to workers and SMEs
  - Subsidies for companies introducing the capacity-based worker evaluation rather than the seniority-based one
  - Guidelines for companies to accept workers changing their jobs
- Measures which could increase labor supply
  - Support integration of women in the labor market
  - Consider ways of accepting foreign human resources (mostly for skilled labor)

### Assessment: limitations and implementation risks
- WSR implementation will be slow, and its overall impact on productivity, wages, and labor supply remains to be seen.
- Several measures (e.g., on overtime and equal pay for equal work) may take several years to become effective, depending on the speed of the legislative process and its implementation.
- Measures to shift managerial practices (e.g., promoting telework and discouraging seniority-based wages) are mostly piecemeal.
- Limiting excessive overtime, while desirable, is unlikely by itself to change working styles and increase productivity.
- Guidelines on equal pay for equal work could be circumvented given the lack of a job description framework in Japan, and may not result in higher pay for non-regular workers.
- Subsidies to encourage conversion of non-regular to regular positions are unlikely to be effective without contract reform to reduce differences in employment protection between regular and non-regular workers; the 5-year rule can be circumvented.
- The plan lacks concrete measures to increase use of medium and low-skilled foreign labor, which is needed most in sectors with labor shortages.

### Policy recommendations to maximize WSR impact (concrete measures)
- Accelerate the timeframe for key measures of the current WSR plan, and make them more effective (for example by introducing job descriptions to facilitate equal pay for equal work).
- Widen the income policies toolkit to encourage wage growth:
  - In addition to the recent minimum wage increase, possible options include expanding and better targeting tax incentives for wage growth and increasing public wages.
- Implement labor contract reform to reduce duality (see Aoyagi and Ganelli, IMF WP 13/202):
  - This would imply a higher level of employment security and career prospects for non-regular workers, but lower employment protection for regular workers.
- Introduce a comprehensive framework to encourage change in firms’ managerial practices to focus more on productivity than on working hours:
  - Reliance only on subsidies is unlikely to be sufficient given previous experience;
  - Coordination with efforts to reduce overtime and increase flexible-work arrangements will help enhance impact;
  - Complement with corporate governance reforms that require action plans reported to shareholders on a comply-or-explain basis.
- Further encourage female labor force participation, especially in regular jobs, by:
  - Enhancing public and private childcare provision;
  - Eliminating the income tax spousal deduction.
- Relax entry requirements for low-medium skilled foreign workers, especially in sectors facing labor shortages:
  - This could include the introduction of guest worker programs, following the experience of other countries (see Ganelli and Miake, IMF WP 15/181).
- Phase out WSR planned subsidies and measures that create market distortions (e.g., subsidies to increase firm productivity, improving the pricing power of SMEs) once the exit from deflation is consolidated.

*Prepared by Chie Aoyagi and Giovanni Ganelli (APD).*

### Annex IV. Risk Assessment Matrix

### Annex IV. Risk Assessment Matrix

### Overall Level of Concern — Key Risks, Likelihood, Impact and Policy Responses
- Successful reflation following comprehensive reforms  
  - Likelihood (Over next 1–3 years): Low  
  - Impact: High. Credible policy frameworks with incomes policies and short-term demand stimulus would raise inflation and growth and restore confidence in fiscal sustainability and medium-term growth prospects.  
  - Policy response: The BoJ should prepare a credible exit strategy.  
- Retreat from cross-border integration  
  - Likelihood: High  
  - Impact: High. A backlash against global trade will have a significant growth impact and will increase market volatility.  
  - Policy response: Flexible policy responses should be considered, including multilateral efforts to restore global trade and bilateral trade agreements.  
- Weaker than expected global growth (structurally weak growth in key advanced and emerging economies)  
  - Likelihood: High/Medium  
  - Impact: Medium. The output gap would widen and growth potential could be adversely affected complicating efforts to restore public debt sustainability.  
  - Policy response: Despite limited policy space, the government should deploy additional measures on all policy fronts (including incomes policies) in order to restore growth and inflation momentum and maintain confidence in Abenomics.  
- Weaker than expected global growth (significant China slowdown and its spillovers)  
  - Likelihood: Low/Medium  
  - Impact: High. The recovery of exports would stall not only due to close trade links with China but also because of safe-haven appreciation causing a sharp correction in the stock market and sentiment.  
  - Policy response: Fiscal policy should provide a buffer against the external shock. If the authorities commit to a credible fiscal consolidation plan by passing concrete measures, the near-term fiscal withdrawal could be made more gradual. Ambitious structural reforms are important to boost domestic demand.  
- Bond market stress from a reassessment of sovereign risk in Japan  
  - Likelihood: Medium  
  - Impact: High. Staff’s DSA analysis shows that an increase in the sovereign risk premium would worsen public debt dynamics gradually as the average maturity is about 7.7 years. But such a shock could cause distress in the financial sector with possible knock-on effects on debt.  
  - Policy response: Fiscal policy would have to become more contractionary and the fiscal framework needs to be strengthened, which together with additional JGB purchases by the BoJ should contain the immediate rise in bond yields.  
- A severe earthquake hits Japan  
  - Likelihood: Medium  
  - Impact: High. Growth and confidence would decline, together with safe-haven appreciation, and equity price adjustments could hamper domestic demand. Firms may increase production offshoring. Fiscal position could deteriorate significantly, increasing future adjustment needs and the risk of a jump in the risk premium.  
  - Policy response: The government should deploy additional fiscal and monetary stimulus to restore growth and inflation momentum and maintain confidence.

### External Position — NIIP, Current Account, REER, Capital Flows, FX Reserves
- Net International Investment Position (NIIP) and trajectory  
  - Background: NIIP increased from 55 to 61 percent of GDP between 2011 and 2016 (assets: 164 percent; liabilities: 103 percent). In the medium term it is projected to rise to about 85 percent with current account (CA) surpluses, before gradually stabilizing due to population aging.  
  - Assessment: Vulnerabilities are limited (equity and direct investment comprise a rising share of liabilities, now at 32 percent of total). Assets are diversified geographically and by risk classes. The NIIP generated net annual investment income of 3.4 percent of GDP in 2016.  
- Overall external position assessment  
  - 2016 external position: Moderately stronger than the level consistent with medium-term fundamentals and desirable policies.  
  - Drivers: Strengthened current account due to reduced energy import bill and decline in consumption goods imports; REER appreciated substantially between 2015 and 2016.  
  - Policy message: Continued accommodative BoJ stance is consistent with reflation objective but needs to be accompanied by bold structural reforms and a credible and specific medium-term fiscal consolidation plan to deliver an external position consistent with medium-term fundamentals.  
  - Potential policy responses:  
    - Raise growth and inflation via measures to boost wages and labor supply, reduce labor market duality, enhance risk capital provision, and accelerate agricultural and services sector deregulation.  
    - Fiscal consolidation should proceed in a gradual manner anchored by a concrete plan to achieve the medium-term target, and be attuned to economic conditions and prospects. These policies are expected to support growth, imports and prices, and help bring back the external position in line with fundamentals over the medium term.
- Current account (CA)  
  - Background: The CA surplus was about 2 percent of GDP in 2011 and about 1 percent in 2012-14. In 2016, the CA increased to 3.8 percent of GDP - from 3.1 percent in 2015 - due to an improvement in the goods trade balance (by about 1.2 percent of GDP). Exports of goods as a share of GDP decreased in 2016 (to 12.9 percent) but imports of goods decreased by more (to 11.8 percent of GDP) with value and volume of energy imports declining and imports of consumption goods also decreasing. The income balance continues to account for most of the current account surplus (89 percent in 2016).  
  - Assessment and adjustments to EBA:  
    - EBA estimate of 2016 cyclically-adjusted CA: 3.1 percent of GDP, adjusted by staff to compute an underlying, cyclically-adjusted CA of 3.3 percent of GDP (to reflect temporary factors, including elevated energy imports and adjusted for the decline in energy prices).  
    - EBA estimate of 2016 CA norm: 3.4 percent of GDP (standard deviation 1.8 percent). Staff adjusts to compute a norm range of 1.3-3.3 percent of GDP to account for structural reforms, removal of domestic distortions, and structurally lower exports reflecting production offshoring.  
    - Underlying CA gap in 2016: assessed to be 0.0-2.0 percent of GDP, with a midpoint estimate of 1.0 percent of GDP, leaving it just moderately stronger than warranted by desirable policies and medium-term fundamentals.  
    - 2017 projection: The surplus is expected to rise to about 3.9 percent of GDP under the current policy mix, due to higher goods trade balance.
- Real effective exchange rate (REER)  
  - Background: REER appreciated 13.3 percent between 2015 and 2016, reflecting safe-haven status of Yen amid heightened risk aversion, despite introduction of negative rates on marginal excess reserves and adoption of QQE with yield curve control. As of May 2017, the REER has depreciated 3.5 percent relative to its 2016 average, reflecting partly the US dollar appreciation.  
  - Assessment:  
    - EBA REER Level model estimates the 2016 average REER to be 11 percent weaker (EBA Index REER model: 21 percent weaker) than level consistent with fundamentals and desirable policies, mainly due to a large unexplained residual and omission of fiscal policy. Staff does not use the EBA REER model for Japan.  
    - Using staff-assessed CA gap range and a semi-elasticity of 0.14 yields an indicative REER gap range of -14 to 0 percent (with a midpoint of 7 percent). Considering the broad range and the significant appreciation in 2016, the REER is assessed as broadly in line with medium-term fundamentals and desirable policies.
- Capital and financial accounts — flows and policy measures  
  - Background: Portfolio outflows continued during most of 2016 as institutional investors diversified overseas and FDI outflows continued. Net long yen positions prevailed during most of 2016 but turned into net short positions in December. More recently these positions have eased, contributing to exchange rate strengthening.  
  - Assessment: Vulnerabilities are limited (inward investment tends to be equity-based and home bias of Japanese investors remains strong). No large spillovers from YCC to financial conditions in other economies observed so far. If outflows accelerate, they could provide an offset to tighter domestic financial conditions in the region due to normalization of policy rates in other advanced economies.
- FX intervention and reserves level  
  - Background: Reserves are about 24 percent of GDP, on legacy accumulation. There has been no FX intervention in recent years.  
  - Assessment: The exchange rate is free floating. Interventions are isolated (last in 2011) to reduce short-term volatility and disorderly exchange rate movements.

### Technical Background Notes (selected)
- Staff adjustments to EBA cyclically-adjusted CA: Last year staff adjusted to account for reliance on energy imports after the 2011 earthquake that temporarily reduced the CA; this year staff reduced this adjustment to reflect the decline in energy prices.  
- Rationale for positive CA norm: Japan’s norm is positive because of high corporate saving in excess of domestic investment opportunities, low residential investment, and a sizable income account owing to the large NFA position. Adjustments to the EBA CA norm reflect anticipated effects from structural reforms and removal of domestic distortions (not captured by EBA) and to account for structurally lower exports due to production offshoring, although this latter adjustment has been reduced to reflect recent trends, including the leveling off of production offshoring.

### Debt Sustainability Analysis — Key Findings, Assumptions, and Stress Tests
- Principal finding: Japan’s public debt is unsustainable under current policies, amounting to 239 percent of GDP in 2016.  
- Projection summary:  
  - Debt-to-GDP ratio is projected to decrease slightly during the medium term (up to 2022) due to an improving primary balance and a negative interest-growth differential.  
  - Complementary analysis up to 2030 shows the debt-to-GDP ratio will start to increase from 2023 and reach around 250 percent of GDP in 2030 as the interest-growth differential is assumed to gradually revert to positive territory.  
  - While all debt profile indicators are below early warning benchmarks, extremely high financing needs point to vulnerabilities to various shocks and changes in market perceptions, especially over the medium term. A larger-than-expected increase in public health spending beyond the projection period is an important downside risk.
- Baseline assumptions (selected):  
  - Potential growth: projected to be around 0.5 percent over the projection period.  
  - Fiscal: Projections incorporate the planned 2 percentage point consumption tax rate hike in October 2019, which will reduce the primary deficit to around 2 percent of GDP by 2022.  
  - Monetary policy: Assumed to remain accommodative during the entire projection period, with CPI inflation gradually rising to around 1 percent over the medium term. Interest rate projections are in line with market expectations.  
  - Interest-growth differential: Projected to remain negative in the baseline as effective interest rates will remain low; baseline does not assume an increase in risk premium.  
  - Beyond projection period (to 2030): Potential growth projected to trend down to around 0.1 percent by 2030; interest-growth differential assumed to gradually revert to positive territory toward historical average of 1 percent (around 0.5 percent in 2030).
- Financing needs and debt profile:  
  - Gross financing needs: Estimated to be around 54 percent of GDP in 2016 — the highest among advanced economies. Projected to remain exceptionally large at around 50 percent of GDP while showing a moderate decline over time due to improvement of the primary balance and extended maturity of government bonds.  
  - Maturity: Average maturity is about 7.7 years (relevant to bond-market stress scenario).  
  - No indicators exceed early warning benchmarks. External financing requirement: 8 percent of GDP in 2016, well below early warning threshold. Foreign holdings of JGBs about 10 percent. No direct exchange rate risks as all JGBs are denominated in yen.
- Net debt and financial assets:  
  - Financial assets held by government amount to about 120 percent of GDP. Major items include Social Security Funds assets (about 44 percent of GDP), foreign currency reserve (about 27 percent of GDP), and equity and investment fund shares held by central and local governments (about 29 percent of GDP), as of end-2015. Not all financial assets are available for debt repayment or easy to liquidate. Financial-assets-to-GDP ratio assumed stable over projection period.
- Realism of baseline assumptions:  
  - Past assumptions on real growth, primary balance and inflation have been neither too optimistic nor pessimistic compared to peers.  
  - Projected 3-year adjustment in cyclically adjusted primary balance (CAPB) has a percentile rank of 33 percent compared to historical experience for high-debt market access countries; CAPB level is in the lowest quartile. Baseline assumes fiscal contraction of around 0.6 percent of GDP in 2018 due to fading of fiscal stimulus. Staff sees need for supportive fiscal stance to maintain growth and inflation momentum; risk of primary balance shocks due to supplementary budgets.
- Shocks and stress tests (selected results):  
  - Fan chart: Considerable uncertainty; under the worst quartile case, debt-to-GDP could reach around 260 percent of GDP in 2022 (more than 25 percentage points higher than baseline). When positive primary balance shock is ruled out, debt-to-GDP could be even higher by about 4 percent of GDP in 2022.  
  - Primary balance shock: Shock equal to half of the 10-year historical standard deviation of changes in primary balance. Assumes additional borrowing leads to increase in interest rate of 25 basis points per 1 percent of GDP worsening of the deficit. Gross debt-to-GDP will be marginally higher by around 3 percent of GDP in 2022 than the baseline.  
  - Growth shock: Immediate worsening of debt dynamics with the second largest impact among scenarios. Real output growth rates are reduced by a half of the 10-year historical standard deviation of changes in growth for 2 consecutive years starting in 2018. As a result, the primary balance deteriorates, leading to higher interest rates as in the primary balance shock scenario; a decline in inflation is also assumed.

*International Monetary Fund — Annex IV. Risk Assessment Matrix (excerpt).*

### 0.25 percentage point per 1-point decrease in growth. The impact is significant, bringing the

### cr17242 - 0.25 percentage point per 1-point decrease in growth. The impact is significant, bringing the

### Scenario: Real GDP Growth Shock
- Shock magnitude implied: "0.25 percentage point per 1-point decrease in growth."
- Impact on debt ratio:
  - Brings the debt ratio to about 248 percent of GDP at the peak.
  - This is around 9 percentage points higher relative to the baseline.

### Scenario: Interest Rate Shock
- Timing and nature:
  - Shock based on the historical maximum real interest rate is assumed to occur in 2018 and remain for the rest of the period.
- Mechanics:
  - Weighted average of JGB’s maturity at around 7.7 years slows the pass-through, so the effective interest rate increases only gradually.
- Quantified impacts:
  - Effective interest rate is higher by more than 1 percentage point in 2022 than the baseline.
  - Debt ratio is higher by around 8 percentage points relative to the baseline.
- Additional considerations:
  - Impact becomes larger with the passage of time as the interest rate hike becomes fully reflected.
  - Such a shock could have a material effect on the financial sector with possible knock-on effects on the debt ratio and could lead to distress in the financial sector.

### Scenario: Interest Rate and Contingent Liability Shock (Combined Shock)
- Components:
  - One-time capital injection equivalent to about 3.6 percent of banking sector assets (approximately 10 percent of regional banks assets).
  - Interest rate assumed to rise by 25bps for each percentage point increase in the primary deficit.
  - Combined with the real GDP growth shock.
- Fiscal impact:
  - The capital injection will increase government spending by around 5.8 percent of GDP.
- Debt impact:
  - Debt ratio will increase to around 264 percent of GDP in 2019.
  - This is about 26 percentage points higher than in the baseline.
- Relative magnitude:
  - The impact is by far the largest among the scenarios presented.

### Longer-term Projections and Risks
- Baseline trajectory:
  - Debt-to-GDP ratios are projected to start increasing after 2023.
  - Reach around 250 percent of GDP by 2030, reflecting a gradual rise in interest-growth differential.
- Key risk factors:
  - The current favorable interest-growth differential largely hinges on domestic investors’ home bias with high domestic savings as well as large JGB purchases by the BoJ.
  - This favorable differential will be tested over time in the absence of a credible medium-term fiscal consolidation plan.
- Public health spending risk:
  - A larger increase in public health spending than assumed in the baseline (see Annex II, and Nozaki and others (2014)) is an important downside risk.
  - Maintaining the same macroeconomic assumptions as in the baseline, this would imply a debt ratio of 255 percent of GDP by 2030.

### Baseline Indicators and Underlying Assumptions (selected exact figures)
- Nominal gross public debt (percent of GDP): 214.8 (2015), 238.2 (2016), 239.4 (2017), 240.7 (2018), 240.3 (2019), 238.7 (2020), 237.1 (2021), 235.5 (2022)
- Public gross financing needs (percent of GDP): 57.5 (2015), 54.5 (2016), 50.2 (2017), 50.1 (2018), 49.5 (2019), 48.7 (2020), 46.7 (2021), 46.6 (2022)
- Net public debt (percent of GDP): 100.0 (2015), 118.5 (2016), 119.9 (2017), 121.3 (2018), 120.9 (2019), 119.3 (2020), 117.7 (2021), 116.1 (2022), 114.2 (projection)
- Real GDP growth (in percent): 0.5 (2015), 1.1 (2016), 1.0 (2017), 1.3 (2018), 0.6 (2019), 0.8 (2020), 0.2 (2021), 0.7 (2022), 0.6 (projection)
- Inflation (GDP deflator, in percent): -0.7 (2015), 2.1 (2016), 0.3 (2017), -0.1 (2018), 0.9 (2019), 1.1 (2020), 1.4 (2021), 0.9 (2022), 1.1 (projection)
- Nominal GDP growth (in percent): -0.2 (2015), 3.2 (2016), 1.3 (2017), 1.2 (2018), 1.5 (2019), 1.9 (2020), 1.6 (2021), 1.6 (2022), 1.7 (projection)
- Effective interest rate (in percent): 0.9 (2015), 0.8 (2016), 0.7 (2017), 0.6 (2018), 0.5 (2019), 0.5 (2020), 0.5 (2021), 0.5 (2022)
- Change in gross public sector debt (cumulative, percent of GDP): 6.4 (2006-2014 actual), -3.9 (2015), 1.2 (2016), 1.3 (2017), -0.4 (2018), -1.6 (2019), -1.5 (2020), -1.6 (2021), -1.9 (2022), -5.8 (projection)
- Identified debt-creating flows (cumulative, percent of GDP): 8.3 (2006-2014 actual), -2.5 (2015), 2.5 (2016), 2.6 (2017), 0.9 (2018), -0.4 (2019), -0.3 (2020), -0.4 (2021), -0.7 (2022), 1.7 (projection)
- Primary deficit (percent of GDP): 6.1 (2006-2014 actual), 3.1 (2015), 4.0 (2016), 4.0 (2017), 3.3 (2018), 2.9 (2019), 2.3 (2020), 2.1 (2021), 2.1 (2022), 16.7 (cumulative)
- Primary (noninterest) revenue and grants (percent of GDP): 28.8 (2006-2014 actual), 31.7 (2015), 31.3 (2016), 31.3 (2017), 31.2 (2018), 31.2 (2019), 31.9 (2020), 31.9 (2021), 31.9 (2022), 189.4 (cumulative)
- Primary (noninterest) expenditure (percent of GDP): 34.9 (2006-2014 actual), 34.8 (2015), 35.2 (2016), 35.3 (2017), 34.5 (2018), 34.1 (2019), 34.2 (2020), 34.1 (2021), 34.0 (2022), 206.1 (cumulative)
- Automatic debt dynamics (percent of GDP): 2.2 (2006-2014 actual), -5.6 (2015), -1.4 (2016), -1.4 (2017), -2.4 (2018), -3.3 (2019), -2.6 (2020), -2.5 (2021), -2.8 (2022), -15.0 (cumulative)
- Real interest rate contribution (percent): 3.3 (2006-2014 actual), -3.1 (2015), 0.9 (2016), 1.8 (2017), -1.0 (2018), -1.3 (2019), -2.1 (2020), -0.8 (2021), -1.3 (2022), -4.7 (cumulative)
- Real GDP growth contribution (percent): -1.1 (2006-2014 actual), -2.5 (2015), -2.4 (2016), -3.1 (2017), -1.4 (2018), -1.9 (2019), -0.5 (2020), -1.7 (2021), -1.5 (2022), -10.2 (cumulative)
- Residual, including asset changes (percent of GDP): -2.0 (2006-2014 actual), -1.5 (2015), -1.3 (2016), -1.3 (2017), -1.3 (2018), -1.3 (2019), -1.2 (2020), -1.2 (2021), -1.2 (2022), -7.5 (cumulative)

### Stress Tests and Alternative Scenarios (selected outcomes)
- Baseline, Historical, and Constant Primary Balance scenarios presented with underlying assumptions (real GDP growth, inflation, primary balance, effective interest rate) for 2017–2022.
- Selected scenario snapshots (exact series shown in source for 2017–2022):
  - Baseline Real GDP growth: 1.3, 0.6, 0.8, 0.2, 0.7, 0.6
  - Historical Real GDP growth: 1.3, 0.5, 0.5, 0.5, 0.5, 0.5
  - Constant Primary Balance Primary Balance: -4.0, -4.0, -4.0, -4.0, -4.0, -4.0
  - Real Interest Rate Shock Effective interest rate: 0.6, 0.5, 1.0, 1.3, 1.5, 1.7
  - Combined Shock Real GDP growth: 1.3, -0.7, -0.4, 0.2, 0.7, 0.6
  - Contingent Liability Shock Primary balance: -4.0, -12.7, -2.9, -2.3, -2.1, -2.1
- Stress-test results:
  - Under the Combined Shock and Contingent Liability Shock scenarios, gross nominal public debt trajectories and public gross financing needs increase markedly relative to baseline (exact charted series in source).

*Source: IMF staff (Japan Public Sector Debt Sustainability Analysis, as of June 20, 2017).*

### Annex VII. Main Recommendations of the 2016 Article IV Consultation

### Annex VII. Main Recommendations of the 2016 Article IV Consultation

### Policy Coordination
- Coordinated fiscal and monetary demand support recommended to facilitate the pass-through of higher wages to prices and the implementation of structural reforms; fiscal and monetary actions should be closely coordinated in terms of timing, mix, and level of stimulus.
- Policy actions noted:
  - The BoJ implemented its “QQE and Yield Curve control“ program which stabilizes the 10-year JGB yield at around zero.
  - A 1.5 percent of GDP fiscal stimulus package was announced in August 2016.
  - The government is trying to address wage gaps between regular and non-regular workers under the Work Style Reform (WSR), and has adjusted income policies by increasing the minimum wage by 3 percent in FY2017 and enhancing tax incentives for wage increases.

### Fiscal Policy
- Main Fund recommendations:
  - Chart a credible fiscal consolidation course.
  - Commit to a gradual increase in the consumption tax towards at least 15 percent, e.g., in increments of 0.5–1 percentage points over regular intervals.
  - Maintain the single rate structure as much as possible and address tax impact on low income households by targeted cash transfers.
  - Pursue a steady fiscal consolidation by 0.5 percent of GDP per year through 2030 to put the public debt-to-GDP ratio on a downward path.
  - Broaden the tax base, contain nominal social security spending growth to 0.5 percent, and implement other expenditure reforms to balance adjustment between revenue and expenditure.
  - Strengthen the fiscal framework by adopting rules to curb expenditures, limits on the use of supplementary budgets, and publication of more independent assessments of the outlook and budget projections; consider creating an independent fiscal institution.
- Policy actions and developments:
  - The authorities remain committed to achieving a primary surplus by FY2020, although concrete measures haven’t been identified.
  - The authorities remain committed to implementing the 2019 consumption tax hike.
  - In line with the authorities’ medium-term fiscal consolidation plan, the growth of social security expenditure has been contained by JPY 100 billion in FY2017 initial budget.
  - The stop-go nature of yearly stimulus packages makes it difficult to gauge the actual fiscal stance.
  - No significant progress has been made on strengthening the fiscal framework or adopting the recommended fiscal rules.

### Monetary Policy
- Main Fund recommendations:
  - BoJ can improve monetary policy credibility and reduce policy uncertainty by publishing the staff forecast.
  - BoJ could provide stronger forward guidance, including by communicating willingness to overshoot the inflation target and maintaining a large balance sheet, even once objectives are achieved, to strengthen its commitment and facilitate portfolio rebalancing.
  - BoJ’s pre-specified time horizon for meeting its inflation target has merit during the transition phase to higher inflation; its function as a commitment mechanism should be gradually phased out as inflation expectations become better anchored.
- Policy actions and developments:
  - The BoJ has currently no plans to publish staff forecasts of inflation.
  - In September 2016, the BoJ implemented an inflation overshooting commitment: “The Bank committed itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index exceeds the price stability target of 2 percent and stays above the target in a stable manner.”
  - The BoJ has moved away from its previous language of achieving the price stability target of 2 percent “at the earliest possible time”. The new language states that “The Bank will continue with "Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control," aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner.”

### Income Policies
- Main Fund recommendations:
  - Replicate the “comply or explain” approach to ensure profitable companies raise wages by at least three percent (the inflation target plus average productivity growth), backed by stronger tax incentives or penalties as a last resort.
  - Commit to raising administratively controlled wages annually in line with the inflation target and ensure similar policies at the prefectural level.
  - Support measures with calls for supplementary wage rounds in addition to the “Shunto” and conversion of bonuses to base pay.
- Policy actions:
  - The government increased the minimum wage by 3 percent in FY2017 and enhanced tax incentives for wage increases.

### Financial Sector Policy
- Main Fund recommendations:
  - Enhance the financial sector’s role in promoting innovation and new growth by encouraging securitization and private-equity funds; reducing government guarantees to SME lending to promote restructuring of viable firms and exit of nonviable ones; and fostering business succession.
  - Further strengthen monitoring to enhance JGB liquidity by regularly assessing the impact of developments in inventories of primary dealers on their market-making activities.
  - Ensure a sufficiently high liquidity coverage for significant foreign currencies if FX loans grow more rapidly than corresponding FX deposits.
  - Reform regulation of regional banks, including required level of capital and the calculation of risk-weighted assets while enhancing some elements of core capital; consolidation could help improve profitability.
  - FSA and BoJ should intensify cooperation via enhanced sharing of systemic risk assessments and supervisory findings; clarify respective roles of the BoJ and FSA in managing relevant tools.
- Policy actions and developments:
  - Bills passed by the Diet in June 2017 to reform the SME Credit Guarantee Scheme, including a reduction in the coverage from 100 to 80 percent in the largest 100 percent guarantee scheme (safety net program 5).
  - The BoJ’s bond market survey monitors the functioning of the bond market; responsibility and entitlement of primary dealers were revised by the MoF in response to BTMU’s withdrawal of its primary dealership and issuance market demand-supply developments.
  - The FSA enhanced supervision on FX liquidity risk, but has not introduced any requirement on FX liquidity buffers.
  - Regulatory reform of domestic banks is in progress.
  - The FSA is the ultimate agency responsible for macroprudential policy making; sharing of systemic risk assessments and findings from supervisory activities remains limited.

### Growth Strategy
- Main Fund recommendations:
  - Accelerate the “equal pay for equal work” program; promote “intermediate” contracts that balance job security and wage increases, including by clarifying the legal framework; provide subsidies for converting non-regular workers to “intermediate” contracts.
  - Eliminate disincentives to full-time or regular work due to the tax and social security system such as the spousal deduction and allowance; raise availability of child-care facilities through deregulation.
  - Boost labor supply of women and older workers and allow for more foreign labor.
  - Pursue further corporate governance reform: more ambitious requirements for outside directors, greater transparency of beneficial ownership and explicit limits on cross-shareholdings.
  - Promote trade, FDI, and technology sharing by supporting full implementation and possible expansion of TPP and proceeding with other trade and bilateral investment agreements.
  - Reduce barriers to entry to retail trade, professional services, and certain segments of network industries.
- Policy actions and developments:
  - WSR action plan published in March 2017, including the "equal pay for equal work" initiative and subsidies/support to firms converting non-regular workers to regular positions; legislation to be submitted to the Diet promptly.
  - The government raised the threshold for spousal deduction from JPY 1.03 million to JPY 1.5 million, effective January 2018.
  - WSR action plan includes measures to limit overtime and increase the use of foreign human resources (especially high-skilled), with legislation to be submitted to the Diet promptly.
  - Since the corporate governance code introduction in 2015, the share of companies with independent directors has increased and cross-shareholdings have decreased; revisions to the Stewardship Code completed in May 2017.
  - TPP, the 12-nation free trade plan, was ratified by Japan in 2017; Japan continues to push for TPP, TPP-11, and other trade agreements including with the EU.
  - Deregulation efforts include liberalization of the retail gas sector in April 2017 (with plans to unbundle gas distribution from manufacturing and retail by 2022).

*Source: Annex VII. Main Recommendations of the 2016 Article IV Consultation (cr17242).*

### 5.      We share the staff’s view on the importance of a comprehensive policy package

### 5.      We share the staff’s view on the importance of a comprehensive policy package

### Overview
- Authorities endorse a comprehensive package exploiting complementarities among monetary policy, fiscal policy, structural reforms, and financial sector policies.
- Abenomics’ “three arrows” — monetary policy, fiscal policy, and structural reforms — are the framework to boost inflation and lift potential growth.
- Authorities aim to ensure the positive economic cycle created by Abenomics becomes a sustained virtuous cycle of growth and distribution, where wealth generated by growth is widely shared by the citizens.

### Structural Reforms
- Progress noted in structural reforms since 2012: increasing corporate profits, boosting employment and female labor force participation, promoting trade and investment, and improving corporate governance.
- Authorities recognize the need to continue labor market reforms to increase productivity and boost wages, and to pursue reforms to increase private investment and long-term growth in the face of demographic challenges.
- Key policy instruments and commitments:
  - “Basic Policies 2017” (decided by the cabinet in June) to promote “Work Style Reform” and enhance investment in human capital by improving quality of education.
  - Publication of "The Action Plan for the Realization of Work Style Reform” in March 2017.
  - Policies to facilitate female and older people’s labor force participation and to raise productivity.
  - Minimum wage raised by 3 percent.
  - Enhanced tax incentives for wage increases.
  - Policies such as “equal pay for equal work”.
  - Plan to submit new legislation based on the Action Plan to the Diet promptly.
  - Use of open IT infrastructure (cloud computing) to accelerate development of artificial intelligence, Internet of Things, and robotics.
  - Continued push for corporate governance reforms and several deregulations to improve the business environment.
- Authorities welcome staff suggestions, including clarification for legal frameworks for “intermediate” contracts and the introduction of job descriptions.
- Objective: realize a virtuous cycle of steadily raising wages, boosting inflation, and increasing consumption.

### Fiscal policy
- Principle: "no fiscal consolidation without economic revitalization".
- Three reform pillars:
  - overcoming deflation/economic revitalization,
  - expenditure reforms,
  - revenue reforms.
- Fiscal targets and commitments:
  - Aim to achieve a primary surplus by FY 2020.
  - At the same time, steadily reduce the public debt to GDP ratio.
  - The “fiscal consolidation targets” set in the “Plan to Advance Economic and Fiscal Revitalization” remain important.
  - In FY 2018, authorities will assess progress toward the targets and consider additional expenditure and revenue reforms if required.
  - Commitment to implement the 2019 consumption tax hike to strengthen the foundation of social security and ensure trust in Japan from overseas and markets.
- Social security:
  - Social security reform is central to addressing income inequality and implementing fiscal consolidation.
  - Authorities have implemented several policies to make social security expenditure more efficient.
  - Authorities expect further staff work on social security issues.

### Monetary policy
- BOJ introduced “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (YCC)” in September 2016 with two major components:
  - "YCC" in which the BOJ controls short-term and long-term interest rates;
  - an "inflation-overshooting commitment" in which the BOJ commits itself to expanding the monetary base.
- BOJ will continue with “QQE with YCC,” aiming to achieve the price stability target of 2 percent, as long as necessary for maintaining that target in a stable manner.
- BOJ will make policy adjustments as appropriate, taking account of developments in economic activity and prices as well as financial conditions.
- Policy aligns with staff’s suggestion that “monetary policy should maintain a sustained accommodative stance”.

### Financial Sector
- Authorities welcome FSAP finding that the Japanese financial system is stable and broadly sound.
- Authorities note IMF focus on effects of low growth, low interest environments, and demographic headwinds on the financial system.
- Authorities will continue enhancing supervision to maintain soundness of the financial system, taking into account staff recommendations.
- Financial institutions must review business models given:
  - globally persistent low and flat yield curve,
  - technological innovations,
  - unsustainability of balance-sheet-size oriented business models.
- Authorities will enhance forward-looking supervision, continue in-depth dialogue with financial institutions, and encourage innovative responses.
- Authorities highlight creating shared value with customers as a way to enhance business model sustainability and strengthen customer bases.

### Trade Policy
- Authorities consider promotion of free trade and maintenance of free, fair and rules-based markets important.
- Japan commits to a leadership role as a flag-bearer of free and fair rules of trade and investment.
- Regional and bilateral trade initiatives:
  - Agreement in principle reached with the EU on their bilateral Economic Partnership Agreement (EPA).
  - Japan-EU EPA envisioned to create a new economic zone accounting for about 28 percent of the world GDP and 37 percent of the world trade.
  - Authorities will make every effort to reach a final agreement as soon as possible.
  - Authorities will push forward the TPP, RCEP, other trade partnerships like Japan-China-Korea FTA, and investment partnerships.

### External Sector Assessment
- Authorities concur that excess current account imbalances can be potential risks but emphasize that external sector analyses can be market-sensitive and must be handled carefully.
- Authorities have serious reservations about the external sector assessment for Japan, including the methodology and its application.

- Concerns with staff’s adjustments to EBA model results:
  - Authorities disagree with the three adjustors staff used to modify EBA model results, calling their theoretical underpinnings and quantification unconvincing and unevenly applied across countries.
  - Authorities state it is regrettable that convincing justifications for these adjustors have not been provided.
  - Specific numeric example presented:
    - EBA model estimate implied a gap of -0.3 percent of GDP — with the cyclically-adjusted current account at 3.1 percent and the current account norm at 3.4 percent — which indicates Japan’s external position is slightly weak.
    - Staff applied three adjustors — (1) domestic distortions holding back demand and imports, (2) structurally lower exports reflecting production offshoring, and (3) elevated energy imports with the nuclear power plant shutdown — and assessed the gap to be 0.0-2.0 percent of GDP.
    - As a result, a midpoint estimate of +1.0 percent placed Japan’s current account position on the borderline between “moderately stronger” and “in line with fundamentals”.
  - Authorities express skepticism that staff’s discrete adjustments may have led to a pre-determined conclusion.
  - Additional points:
    - The adjustment related to the nuclear power plant shutdown is said to be based on an inaccurate understanding of the current situation of those plants in Japan.
    - Domestic distortions and production offshoring are not unique to Japan, yet the related adjustors were applied only to Japan to lower the current account norm.
  - Authorities note absence of convincing explanation why staff did not apply other adjustors that would adjust the assessment in the opposite direction (e.g., structural increases in tourism receipts from relaxation of visa requirements and deregulation of lodging business).
  - Authorities will continue requesting clear and convincing explanations from staff about these adjustments.

- Limitations of the EBA model identified by authorities and suggested improvements:
  - Existing EBA models should better capture country-specific characteristics such as differences between trade and income balances and differences in propensity to consume and save.
  - Three specific suggested improvements:
    - First: take into full account the discrepancy between the rates of return of foreign assets and liabilities to better reflect structural net income receipts (example: United States has negative NIIP but positive net primary income; Japan’s rate of return on foreign assets exceeds that on liabilities, contributing to a large income surplus and current account surplus). Authorities argue Japan’s current account norm should be larger than the EBA model suggests.
    - Second: explore introducing country residents’ risk appetite as a new variable, since differences in risk attitudes affect saving behavior and IS balance; rate of safe assets among household assets might be an option for a proxy.
    - Third: improve the method of calculating real effective exchange rate (REER):
      - i. Consider weighting REER by the ratio of trade currency settlement volume to overall trade volume instead of conventional “trade-weighted” REER.
      - ii. Given rising capital flows and the fact that foreign exchange transactions of hard currencies are mainly driven by capital flows rather than trade flows, explore using a “capital-weighted” REER instead of the canonical “trade-weighted” REER by leveraging related studies.

- Role of the exchange rate in external sector assessment:
  - Authorities argue that assessing the exchange rate in the context of addressing global excess imbalances might have become less meaningful.
  - Staff themselves noted in the 2017 External Sector Report that automatic adjustment mechanisms, such as nominal exchange rate adjustment, have been weak in key countries, including Japan.
  - Where income balance dominates the current account (as in Japan), changes in the exchange rate do not lead to structural changes in the current account balance; expenditure switching through exchange rate changes may be less relevant for correcting excess trade imbalances and is not useful for correcting excess income imbalances.
  - For a large economy with a freely floating currency like Japan, conventional theoretical relationships between the current account and the exchange rate are asserted to be less convincing.
  - Authorities suggest staff give serious consideration to recent developments and reconsider the meaning of exchange rate assessment in the context of addressing global excess imbalances.

*Source: IMF country report content unit "5.      We share the staff’s view on the importance of a comprehensive policy package" (cr17242).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17242.pdf_