## cr18333 - 2017. As with the 2017 external sector assessment, the projected 2018 current account balance is ## Source details **Canonical URL:** [cr18333 - 2017. As with the 2017 external sector assessment, the projected 2018 current account balance is](https://www.imf.org/-/media/files/publications/cr/2018/cr18333.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2018/cr18333.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2018/cr18333.pdf.json) --- ### Executive Board assessment and policy priorities - Directors welcomed Japan’s remarkable economic growth performance, especially in per capita terms, and the prospect of continued above-potential growth in the near term. - Key concerns: - Inflation remains below target. - Downside risks have risen, notably from the upcoming consumption tax rate increase and deteriorating global conditions. - Policy priorities: - Reinvigorate the policies of “Abenomics” to achieve sustained high growth, durable reflation, and public debt sustainability. - Fiscal policy: - Maintain a neutral fiscal stance to support near-term growth and reflation. - Implement temporary mitigating measures for the scheduled consumption tax increase with clear public communication. - Develop a well-specified medium-term fiscal framework based on realistic assumptions to anchor a gradual consolidation path toward debt sustainability while addressing demographic challenges. - Views split on an independent fiscal institution. - Structural reforms: - Priority reforms: labor market reforms to enhance labor supply from female, older, and foreign workers; eliminate tax and social security disincentives to full-time and regular work; reduce the gender wage gap; increase availability of childcare and nursing facilities. - Also: deregulate product and services markets, facilitate entry and exit of firms, promote SMEs, deepen corporate governance reform. - Monetary policy: - Keep policy accommodative, possibly for an extended period, while monitoring and mitigating side-effects. - Use effective communication and forward guidance to reduce market volatility and guide inflation expectations. - Financial sector: - Enhance risk management, financial oversight, macroprudential framework; facilitate Fintech adoption; strengthen crypto-asset oversight. - External sector: - Staff assess Japan’s 2018 external position and real exchange rate as projected to be broadly consistent with fundamentals and desirable policies. - Credible fiscal consolidation plus bolder structural reforms needed to maintain external balance over the medium term. ### Outlook, risks, and near-term dynamics - Underlying growth and inflation: - Real GDP projected at 1.1 percent in 2018. - Over the medium term, growth projected to moderate and the output gap to close. - Absent mitigating fiscal measures, the consumption tax increase could cause volatility in private consumption and investment; following a consumption tax-induced spike in 2020, inflation will rise over the medium term but likely remain below the BoJ’s target. - Monetary policy expected to remain accommodative and support favorable financial conditions. - Risk assessment: - Balance of risks shifted to the downside with the global outlook. - Vulnerabilities: macro-financial vulnerabilities, fiscal consolidation needs, limited monetary policy space—heightened as demographic trends intensify. - Near-term risks: sharper-than-expected volatility from the planned consumption tax increase; weaker global growth and trade tensions; disorderly tightening of global financial conditions; rising FX funding cost and bank profitability squeeze. - Medium-term risks: excessive risk taking by financial institutions, viability threats for regional banks and life insurers, fiscal sustainability concerns and bond market stress. ### Key quantitative findings and projections (selected) - Nominal GDP: US$ 4,873 Billion (2017) - GDP per capita: US$ 38,444 (2017) - Population: 127 Million (2017) - Quota: SDR 30.8 billion (2017) - Real GDP growth (percent change): 2017 = 1.7; 2018 (Proj.) = 1.1; 2019 (Proj.) = 0.9 - Output Gap (annual average): 2017 = -0.7; 2018 (Proj.) = -0.3; 2019 (Proj.) = 0.1 - CPI (annual average): 2017 = 0.5; 2018 (Proj.) = 1.2; 2019 (Proj.) = 1.3 - Core Core CPI excluding VAT (annual average): 2017 = 0.1 - Unemployment rate (annual average): 2017 = 2.9; 2018 (Proj.) = 2.9; 2019 (Proj.) = 2.9 - General government revenue (percent of GDP): 2017 = 33.2; 2018 (Proj.) = 33.2; 2019 (Proj.) = 33.3 - General government expenditure (percent of GDP): 2017 = 37.5; 2018 (Proj.) = 36.9; 2019 (Proj.) = 36.0 - Overall balance (percent of GDP): 2017 = -4.3; 2018 (Proj.) = -3.7; 2019 (Proj.) = -2.8 - Public debt, gross (percent of GDP): 2017 = 237.6; 2018 (Proj.) = 238.2; 2019 (Proj.) = 236.6 - Current account balance (billions of USD): 2014 = 59.7; 2015 = 45.9; 2016 = 36.8; 2017 = 136.4; 2018 (Proj.) = 194.9; 2019 (Proj.) = 196.1 - Current account balance (percent of GDP): 2014 = 1.0; 2015 = 0.9; 2016 = 0.8; 2017 = 3.1; 2018 (Proj.) = 3.9; 2019 (Proj.) = 4.0 - Trade balance (billions of USD): 2014 = -53.9; 2015 = -90.0; 2016 = -99.9; 2017 = -7.4; 2018 (Proj.) = 51.4; 2019 (Proj.) = 44.5 - Exports of goods and services (annual percent change): 2017 = 6.7; 2018 (Proj.) = 3.9; 2019 (Proj.) = 2.1 - Imports of goods and services (annual percent change): 2017 = 3.4; 2018 (Proj.) = 3.2; 2019 (Proj.) = 2.3 - Energy imports (billions of USD): 2015 = 133.8; 2016 = 94.9; 2017 = 117.8; 2018 (Proj.) = 153.5; 2019 (Proj.) = 150.9 - Base money (end-period percent change): 2017 = 9.7; 2018 (Proj.) = 10.6; 2019 (Proj.) = 9.3 - Non-financial corporate debt in percent of GDP: 2017 = 139.7; 2018 (Proj.) = 146.7; 2019 (Proj.) = 147.0 - Household debt in percent of disposable income: 2017 = 101.7; 2018 (Proj.) = 101.1; 2019 (Proj.) = 101.0 - Overnight call rate, uncollateralized (end-period): 2017 = -0.1 - 10-year JGB yield (end-period): 2017 = 0.1; 2018 (Proj.) = 0.1; 2019 (Proj.) = 0.2 - Total reserves minus gold (billions of US$): 2017 = 1232.4 - Yen/dollar rate (annual average): 2017 = 112.2; 2018 (Proj.) = 109.8; 2019 (Proj.) = 109.3 - Population Growth (percent): 2017 = -0.2; 2018 (Proj.) = -0.2; 2019 (Proj.) = -0.3 - Old-age dependency (percent): 2017 = 46.0; 2018 (Proj.) = 46.9; 2019 (Proj.) = 47.8 ### Staff analysis and recommended policy package - Main messages: - Rapid aging and shrinking population will dominate economic policy making in coming decades—requiring a fresh look at Abenomics’ objectives and tools. - Six years of Abenomics produced results, but strengthened policies are needed to achieve sustained high growth, durable reflation, and debt sustainability. - Recommended policy package: - Budgetary and income policies anchored by a well-specified and gradual medium-term fiscal consolidation plan to support BoJ reflation efforts and ensure debt sustainability. - Mutually-supportive, reinvigorated macro-structural reforms to boost productivity and raise potential growth; strong government commitment and steady implementation to inspire public confidence. - Maintain monetary policy accommodation, further strengthen the monetary policy framework and lift inflation expectations. - Strengthen financial sector policies to lessen risks from demographic headwinds, prolonged low interest rates, and low profitability. ### Financial conditions and market developments - Recent developments: - Domestic credit growth weakened over the past year. - Super-long yields drifted up, and dollar funding costs rose significantly. - Heightened global uncertainty contributed to a slight appreciation in the yen and weaker equity prices. - Lending by regional banks to small enterprises continued to grow rapidly. - Indirect overseas investments via investment trusts remained strong. - Insurance companies and pension funds shifted from U.S. Treasuries to riskier U.S. securities with higher yields. - Monetary framework and BoJ actions: - BoJ widened the range for the 10-year yield in July, allowing yields to drift upward. - Future ETF purchases conditioned on market conditions; commitment to keep short and long-term policy rates low for an extended period. - BoJ guidance: maintain the target level of long-term yields around zero percent while acknowledging yields might move upward and downward. ### Fiscal consolidation, consumption tax, and fiscal framework - New Plan to Advance Economic and Fiscal Revitalization (June): - Postponed the primary surplus target from FY2020 to FY2025. - Plan relies on relatively optimistic growth assumptions and lacks full specification of mitigating measures for the October 2019 consumption tax increase. - Plan set up a review of the social security system by FY2020; current framework lacks a long-term plan to address rising social security expenditures. - Consumption tax specifics and mitigation: - Scheduled increase from 8% to 10% on October 1, 2019 (described as "2 percentage points in 2019 versus 3 percentage points in 2014"). - Authorities announced mitigating design features: reduced tax rate for food and non-alcoholic beverages; additional spending for the Human Resource Development Revolution partly funded by tax revenue; further mitigating measures to be formulated by December. - Staff recommends temporary, time-bound, well-targeted measures (examples: abolishing automobile acquisition tax; targeted tax rebates/transfers for low-income households). - Staff estimates fiscal stance would be contractionary by 0.7 and 0.6 percent of GDP in 2019 and 2020, respectively, without mitigating measures. - Medium- and long-term fiscal framework recommendations: - Adopt more realistic macroeconomic projections and specify consolidation measures. - Consider establishing an independent fiscal institution (IFI) or strengthen existing institutions. - Medium-term consolidation: annual consolidation of about 0.5 percent of GDP in the structural primary balance starting from 2021. - Essential steps include: - Gradual increases in the consumption tax rate beyond 10 percent toward at least 15 percent to finance social security and reduce debt risks. - Maintain unitary rate structure where possible. - Reform healthcare to contain spending while preserving welfare; staff analysis suggests combined reforms could generate fiscal savings of up to 2 percent of GDP by 2030. - Address income inequality with protections for disadvantaged elderly while tackling intergenerational and regional inequality. - Fiscal policy to support female labor force participation (childcare and nursing-care availability) and remove disincentives to full-time work. ### Macro-structural agenda — modeled effects and reform priorities - Model findings and scenarios: - Under current policies real GDP will decline by over 25 percent in 40 years due to demographics. - Credible implementation of all structural reforms, with accommodative monetary stance and public debt stabilization, could boost real GDP by as much as 15 percent in 40 years relative to current policies. - A not-fully-believed reform path yields lower effects (8 percent boost in 10 years), would not help inflation reach BoJ’s 2 percent target, and would produce smaller decline in long-run government debt-to-GDP ratio. - Tiered reform priorities: - Top-tier (labor market): - Work Style Reform passed in June; needs supporting measures. - Measures: training and career opportunities for non-regular workers, contract reform, stronger reporting frameworks for “equal-pay for equal-work,” increase labor supply (women, older, foreign workers), remove tax/social-security disincentives, increase childcare/nursing facilities, reduce gender wage gap, reduce excessive overtime, abolish firms’ right to set mandatory retirement age. - Second-tier (product market & corporate): - Facilitate exit of non-viable SMEs, reduce credit guarantee coverage, incentivize alternative SME financing, support R&D and business succession, deregulate sectors (telecom, gas, professional services), deepen corporate governance (outside directors, limits on cross-shareholdings). - Third-tier (trade & FDI): - Progress: Japan-EU agreement and CPTPP; further removal of tariff and non-tariff barriers in high-standard multilateral agreements would boost investment and growth. ### Monetary policy — stance, communication, and side-effects - Recommended stance: - Maintain accommodative monetary policy while enhancing policy sustainability and mitigating side-effects from prolonged easing. - Clarify relation between forward guidance on long-term interest rate target and the inflation target. - Remove quantitative guidance on JGB purchases. - Consider moving closer to full-fledged inflation targeting by publishing BoJ’s staff baseline forecast with underlying policy assumptions to help lift inflation expectations. - Financial-sector side-effects and monitoring: - JGB market: some liquidity indicators improved amid reduced JGB purchases under YCC; number of market transactions declined sharply since early 2018. - ETF purchases: BoJ guideline for annual pace of increase about "¥6 trillion" will be maintained; shift to broader Topix index and condition future purchases on market conditions. - Financial stability concerns: - Low interest rates and demographic headwinds undercut profitability and encourage risk taking. - Ratio of real estate loans-to-GDP reached a historic high. - Banks’ holdings of investment trusts increased from "about ¥6 trillion in 2013 to over ¥18 trillion in August 2017"—"over 80 percent of the increase was contributed by regional financial institutions." - Share of regional banks earning negative core profits rose from 12 percent in 2011 to over 50 percent in 2018. ### Financial sector policies and recommendations - Enhance risk management and oversight: - Make loan-loss provisioning more forward-looking. - Introduce rigorous risk assessment and risk tolerance frameworks; tailor capital requirements to banks’ risk profiles. - Introduce economic-value-based solvency regulation for insurers. - Strengthen macroprudential framework in line with FSAP recommendations. - Adjust business models and crisis preparedness: - Encourage regional institutions to diversify revenue, utilize IT/Fintech, and consolidate. - Expand TLAC and strengthen crisis management and resolution to avoid expectations of public support. - Facilitate Fintech and strengthen crypto-asset oversight: - Increase cyber resilience, reduce regulatory costs via RegTech, incentivize Fintech participation in sandbox. - On crypto-assets: emphasize cybersecurity at exchanges, clarify JFSA’s role in exchange registration, enhance cross-border supervisory collaboration. - Authorities’ perspective: - JFSA reports progress on implementing 2017 FSAP recommendations and is moving to a forward-looking supervisory framework; does not see excessive risk-taking at this time but stresses closer monitoring. ### Debt sustainability and Annex V highlights - Key findings: - Public debt unsustainable under current policies: gross and net public debt amounted to 238 and 155 percent of 2017 GDP, respectively. - Debt-to-GDP projected to be stable over medium term but increase beyond medium term, reaching above 245 percent of GDP in 2030. - Gross financing needs: around 52 percent of GDP in 2017; projected around 45 percent of GDP in the medium term. - Baseline assumptions: - Potential growth around 0.5 percent over the medium term, decreasing to 0.1 percent by 2030. - Structural primary deficit: 3.3 percent of GDP in 2018; around 2 percent in 2023; 2.7 percent by 2030. - Nominal 10-year JGB rate assumed 2 percent by 2030. - Average real interest rate assumed 0.3 percent in 2030; implied interest-growth differential 0.1 percent. - Weighted average JGB maturity: around 7.8 years. - Stress-test scenarios (selected outcomes): - Worst-quartile fan chart: debt-to-GDP around 260 percent in 2023 (more than 25 percentage points above baseline). - Growth shock: debt ratio about 246 percent of GDP (~9 percentage points above baseline). - Interest-rate plus contingent liability shock: debt ratio around 260 percent in 2020 (~22 percentage points above baseline). - Staff recommendation: - Maintain a neutral fiscal stance in 2019 and 2020. - Start gradual adjustment from 2021 with annual consolidation of about 0.5 percent of GDP in the structural primary balance; this path will stabilize public debt at the current level by 2030 and could moderately reduce debt-to-GDP if accompanied by accelerated structural reforms. ### External sector diagnostics and external position - Current account and REER assessment: - The 2018 external position and 2018 real exchange rate preliminarily assessed as in line with fundamentals and desirable policies. - CA background: CA surplus rose since 2013, reaching 4 percent of GDP in 2017; expected to shrink in 2018 to 3.6 percent of GDP per EBA model projections. - Projected CA 3.6 Cycl. Adj. CA 3.5 EBA CA Norm 3.3 EBA CA Gap 0.2 Staff Adj. 0.0 Staff CA Gap 0.2 - Staff notes a large unexplained portion of the EBA CA gap, suggesting investment and consumption bottlenecks remain. - Capital and financial flows: - Portfolio outflows continued during most of 2017 as institutional investors diversified overseas. - Net short yen positions prevailed since Q2 2017 but positions balanced after end-March. - Vulnerabilities limited due to equity/direct investment share and investors’ home bias. - FX intervention and reserves: - Reserves about 25 percent of GDP; no FX intervention in recent years; exchange rate free floating. ### Boxes and thematic findings (highlights) - Box 1 — Low inflation expectations: prolonged deflation, younger cohorts with lower inflation expectations, product downsizing significant. - Box 2 — Regional banks: traditional model challenged; increased overseas lending, SME and real estate exposure; recommend enhanced risk management and FX funding liquidity risk management. - Box 3 — Demographics & structural reforms (GIMF simulations): current policies imply real GDP decline by over 25 percent in about 40 years; credible reforms could boost real GDP by as much as 15 percent in 40 years. - Box 4 — Demographics and natural rate: demographics contributed about -0.3 percentage points on average to the estimated negative natural rate since the Global Financial Crisis; natural rate averaged about -0.7 percent (Bayesian median) during this period. - Box 5 — Crypto-asset regulation: - Legalization date: April 2017. - Hacking losses: about $580 million in total (January 2018 Coincheck hack referenced). - Number of registered CAEs in JVCEA: 16. - JFSA chair role: 2019 G20. - Box 6 — Yen appreciations and carry trade: - Carry-trade reversals can explain a large share of rapid yen appreciations; policy recommendation: BoJ should maintain current accommodative stance and the zero-interest rate target on the benchmark 10-year JGB yield while monitoring carry trade activity. ### Authorities’ views and implementation progress - Authorities broadly agree with need for stronger fiscal framework but favor strengthening existing institutions (CEFP and FSC) over creating an IFI. - Authorities committed to the October 2019 consumption tax increase (8% to 10%) and to formulating additional mitigating measures by December. - Authorities reported progress on structural reforms (Work Style Reform legislation, corporate governance revisions, trade agreements) but acknowledged further implementation and supporting measures are needed. - JFSA is moving toward a forward-looking supervisory framework, assessing regional banks’ business model sustainability, and progressing on FSAP recommendations though implementation is incomplete. _Italic: Source: cr18333 (IMF staff report excerpts and boxes as presented in the provided content)._ ### 2017. As with the 2017 external sector assessment, the projected 2018 current account balance is ### cr18333 - 2017. As with the 2017 external sector assessment, the projected 2018 current account balance is ### Executive Board assessment and policy priorities - Directors welcomed Japan’s remarkable economic growth performance, especially in per capita terms, and the prospect of continued above-potential growth in the near term. - Directors noted that inflation remains below target and that downside risks have risen, notably from the upcoming consumption tax rate increase and deteriorating global conditions. - Directors emphasized the need to reinvigorate the policies of “Abenomics” to achieve sustained high growth, durable reflation, and public debt sustainability. - Fiscal policy: - Importance of maintaining a neutral fiscal stance to support near-term growth and reflation. - Welcomed authorities’ plan to implement temporary measures to alleviate the adverse impact of the scheduled increase in the consumption tax rate, accompanied by clear communication to the public. - For the medium term, Directors saw merit in developing a well-specified fiscal framework, based on realistic assumptions, to reduce policy uncertainty and anchor a gradual consolidation path toward debt sustainability while addressing demographic challenges. - Some Directors supported an independent fiscal institution; others saw scope to achieve objectives within existing institutional arrangements. - Structural reforms: - Welcomed an ambitious structural reform agenda to lift potential growth. - Priority reforms: labor market reforms to enhance labor supply from female, older, and foreign workers; eliminate tax and social security disincentives to full-time and regular work; reduce the gender wage gap; increase availability of childcare and nursing facilities. - Also recommended: further deregulation of product and services markets, facilitate entry and exit of firms, promote small- and medium-sized enterprises, and deepen corporate governance reform. - Monetary policy: - Agreed monetary policy should remain accommodative, possibly for an extended period to successfully reflate the economy, while carefully monitoring and mitigating side-effects. - Effective communication and forward guidance recommended to reduce market volatility and guide inflation expectations. - Financial sector: - Recognized challenges from demographic pressures and low interest rates. - Welcomed progress implementing the 2017 FSAP recommendations, in particular the new more forward-looking supervisory framework. - Highlighted importance of enhancing risk management, financial oversight, and the macroprudential framework; facilitating adoption of Fintech; strengthening crypto-asset oversight. - External sector: - Directors took note that staff assess Japan’s 2018 external position and real exchange rate are projected to be broadly consistent with fundamentals and desirable policies. - Agreed that a credible fiscal consolidation plan combined with bolder structural reforms are needed to maintain external balance over the medium term. - Noted that advancing multilateralism would help mitigate inward spillovers from heightened trade tensions. ### Outlook, risks, and near-term dynamics - Underlying growth: - Expected to remain solid, notwithstanding the scheduled increase in the consumption tax rate in October 2019. - Real GDP projected at 1.1 percent in 2018. - Over the medium term, growth is projected to moderate and the output gap close. - Consumption tax: - Absent mitigating fiscal measures, the consumption tax increase could lead to volatility in private consumption and investment. - Following a consumption tax-induced spike in 2020, inflation will rise over the medium term, but likely remain below the BoJ’s target. - Monetary stance: - Monetary policy expected to remain accommodative and support favorable financial conditions. - Risks: - Balance of risks has shifted to the downside in line with the global outlook. - Japan’s macro-financial vulnerabilities, fiscal consolidation needs, and limited monetary policy space make the economy vulnerable to adverse shocks—particularly over the medium term as demographic trends intensify. ### Key quantitative findings and projections (selected) - Nominal GDP: US$ 4,873 Billion (2017) - GDP per capita: US$ 38,444 (2017) - Population: 127 Million (2017) - Quota: SDR 30.8 billion (2017) - Real GDP growth (percent change): 2017 = 1.7; 2018 (Proj.) = 1.1; 2019 (Proj.) = 0.9 - Output Gap (annual average): 2017 = -0.7; 2018 (Proj.) = -0.3; 2019 (Proj.) = 0.1 - CPI (annual average): 2017 = 0.5; 2018 (Proj.) = 1.2; 2019 (Proj.) = 1.3 - Core Core CPI excluding VAT (annual average): 2017 = 0.1 - Unemployment rate (annual average): 2017 = 2.9; 2018 (Proj.) = 2.9; 2019 (Proj.) = 2.9 - General government revenue (percent of GDP): 2017 = 33.2; 2018 (Proj.) = 33.2; 2019 (Proj.) = 33.3 - General government expenditure (percent of GDP): 2017 = 37.5; 2018 (Proj.) = 36.9; 2019 (Proj.) = 36.0 - Overall balance (percent of GDP): 2017 = -4.3; 2018 (Proj.) = -3.7; 2019 (Proj.) = -2.8 - Public debt, gross (percent of GDP): 2017 = 237.6; 2018 (Proj.) = 238.2; 2019 (Proj.) = 236.6 - Current account balance (billions of USD): 2014 = 59.7; 2015 = 45.9; 2016 = 36.8; 2017 = 136.4; 2018 (Proj.) = 194.9; 2019 (Proj.) = 196.1 (table also shows Current account balance in percent of GDP: 2014 = 1.0; 2015 = 0.9; 2016 = 0.8; 2017 = 3.1; 2018 (Proj.) = 3.9; 2019 (Proj.) = 4.0) - Trade balance (billions of USD): 2014 = -53.9; 2015 = -90.0; 2016 = -99.9; 2017 = -7.4; 2018 (Proj.) = 51.4; 2019 (Proj.) = 44.5 - Exports of goods and services (annual percent change): 2017 = 6.7; 2018 (Proj.) = 3.9; 2019 (Proj.) = 2.1 - Imports of goods and services (annual percent change): 2017 = 3.4; 2018 (Proj.) = 3.2; 2019 (Proj.) = 2.3 - Energy imports (billions of USD): 2015 = 133.8; 2016 = 94.9; 2017 = 117.8; 2018 (Proj.) = 153.5; 2019 (Proj.) = 150.9 - Base money (end-period percent change): 2017 = 9.7; 2018 (Proj.) = 10.6; 2019 (Proj.) = 9.3 - Non-financial corporate debt in percent of GDP: 2017 = 139.7; 2018 (Proj.) = 146.7; 2019 (Proj.) = 147.0 - Household debt in percent of disposable income: 2017 = 101.7; 2018 (Proj.) = 101.1; 2019 (Proj.) = 101.0 - Overnight call rate, uncollateralized (end-period): 2017 = -0.1 - 10-year JGB yield (end-period): 2017 = 0.1; 2018 (Proj.) = 0.1; 2019 (Proj.) = 0.2 - Total reserves minus gold (billions of US$): 2017 = 1232.4 - Yen/dollar rate (annual average): 2017 = 112.2; 2018 (Proj.) = 109.8; 2019 (Proj.) = 109.3 - Population Growth (percent): 2017 = -0.2; 2018 (Proj.) = -0.2; 2019 (Proj.) = -0.3 - Old-age dependency (percent): 2017 = 46.0; 2018 (Proj.) = 46.9; 2019 (Proj.) = 47.8 ### Staff analysis and recommendations - Main messages: - Rapid aging and shrinking population will dominate economic policy making in coming decades—impelling a fresh look at the objectives and tools of Abenomics. - Six years of Abenomics have yielded some important results, but achieving sustained high growth and durable reflation, while also tackling debt sustainability and a shifting global economic landscape, will require strengthened policies. - Policy package recommended: - Budgetary and income policies anchored by a well-specified and gradual medium-term fiscal consolidation plan to support BoJ reflation efforts and ensure debt sustainability. - Mutually-supportive, reinvigorated, and credible macro-structural reforms to boost productivity and raise potential growth; strong government commitment and steady implementation to inspire public confidence. - Maintain monetary policy accommodation, but further strengthen the monetary policy framework and lift inflation expectations. - Strengthen financial sector policies to lessen risks from demographic headwinds, prolonged low interest rates, and low profitability. *Source: cr18333 - 2017. As with the 2017 external sector assessment, the projected 2018 current account balance is* ### 3. Financial conditions have tightened slightly, but remain accommodative (Annex II). Domestic ### 3. Financial conditions have tightened slightly, but remain accommodative (Annex II). Domestic ### Financial conditions and market developments - Domestic credit growth weakened over the past year. - Super-long yields drifted up, and dollar funding costs rose significantly. - Heightened global uncertainty contributed to a slight appreciation in the yen and weaker equity prices. - Lending by regional banks to small enterprises continued to grow rapidly. - Indirect overseas investments via investment trusts remained strong (Box 2). - Insurance companies and pension funds shifted from U.S. Treasuries to more risky U.S. securities with higher yields. ### Fiscal consolidation and structural reforms (summary of recent actions) - Fiscal policy - The authorities announced the “New Plan to Advance Economic and Fiscal Revitalization” in June, based on the interim fiscal review. - The plan postponed the primary surplus target from FY2020 to FY2025. - The plan made limited progress in strengthening the fiscal framework by continuing to rely on relatively optimistic growth assumptions. - The plan set up a review of the social security system by FY2020, but the current framework lacks a long-term plan to address increases in social security expenditures and ensure debt sustainability. - The government reaffirmed commitment to the October 2019 two-percentage point consumption tax rate increase, but associated mitigating measures are yet to be fully specified. - Structural policies - Labor market legislation (staff’s top reform priority) was passed by the Diet in June; effectiveness will depend on implementation, including equal-pay for equal-work guidelines. - Progress was made on enhancing labor supply—women and older workers’ participation rates are on a rising trend, and foreign labor is increasing. - Efforts to eliminate disincentives to regular work stemming from the tax and social security system have been left out of the policy debate over the past year; progress on deregulation remains slow. - Revisions and guidelines for the corporate governance code (staff’s second-tier priority) were completed recently. - Trade reforms (staff’s third-tier priority) have accelerated, with the Japan-EU trade agreement and the CPTPP. ### Monetary framework and financial supervision - Monetary policy - The BoJ decided in July to widen the range for the 10-year yield, in effect allowing yields to drift upward. - BoJ announced that future ETF purchases would depend on market conditions. - BoJ explicitly committed to keep short and long-term policy rates low for an extended period of time to address speculation of premature policy normalization. - Financial policies - The Japanese Financial Services Agency (JFSA) is moving towards a new forward-looking and dynamic supervisory framework. - JFSA is assessing the sustainability of regional banks’ business models given demographic and low profitability challenges. - Implementation of other main FSAP recommendations—particularly on macroprudential policies, and crisis management and resolution—is incomplete. ### Authorities’ views on macro-financial conditions - Authorities’ assessment - The authorities noted the economy is expanding moderately in a well-balanced manner, but inflation developments remain weak. - Growth is supported by both domestic demand and external demand where corporate profits and fixed business investment remain favorable, even after recent natural disasters. - Inflation has been sluggish despite a steadily improving labor market and a positive output gap; authorities attribute this partly to firms’ preference to invest in labor-saving technology rather than raise prices and wages. - The new fiscal plan is a step toward making the fiscal consolidation path more realistic; structural reforms are progressing, including preparation of the Work Style Reform implementation guidelines. - Adjustments to the monetary policy framework are not a change in policy stance but improve the sustainability of the framework. - JFSA highlighted that organizational changes included in revisions to the supervisory framework should help bring a macro perspective into supervision. ### Outlook and risks - Growth and inflation projections - Real GDP growth is projected to stay above potential in 2018 at 1.1 percent, assuming external demand remains supportive and the economy bounces back from recent natural disasters. - Without effective mitigating measures, the consumption tax increase is likely to lead to volatility in private consumption and investment; effects are expected to carry past 2019 and adversely affect domestic demand and overall growth in 2020. - Over the medium term, growth is expected to moderate and the output gap to close. - Following a consumption tax-induced spike in 2020, inflation will rise over the medium term, but likely remain below target. - Near-term risks - Sharper-than-expected volatility in private consumption and investment due to the planned consumption tax increase in 2019 could undermine near-term growth momentum. - Weaker global growth and heightened uncertainty—from trade or geopolitical tensions—could undermine growth, trigger yen appreciation and equity market shocks, and renew deflationary risks. - Disorderly tightening of global financial conditions could increase macro-financial risks; financial institutions are particularly sensitive to a sharp fall in equity prices or a spike in JGB yields. - Rising FX funding cost may increase FX funding liquidity risk in some internationally active banks and, together with a flattening trend in the U.S. yield curve, further squeeze bank profitability and lead to excessive risk taking. - Medium-term risks - Continued monetary accommodation amidst tightening by other advanced economies could encourage financial institutions, particularly regional ones, to engage in excessive risk taking. - If regional banks and life insurance companies do not adapt business models to the low interest rate environment and adverse demographics, their viability could be threatened. - Fiscal sustainability concerns and associated bond market stress could have adverse feedback effects on the financial system and the real economy. - Authorities’ perspective on risks - Authorities partly agreed with staff’s risk assessment but were more upbeat on the macro-financial situation and policy space. - Authorities were confident the economy will continue moderate expansion as the main scenario, while noting growth will likely moderate over the medium-term due to a modest slowdown in business fixed investment and Olympic Games-related demand winding down. - Authorities acknowledged the 2019 consumption tax increase could cause economic fluctuation and consider mitigating measures important; they did not view risks associated with higher FX funding cost or liquidity as significant at this time but noted they warrant close monitoring. ### Policies: navigating demographic headwinds - Demographic challenge - Japan’s population fell by about one million between 2012 and 2017. - Official projections anticipate the population will rapidly age and shrink by over 25 percent in the next 40 years. - Projections by the National Institute of Population and Social Security Research: over the next 40 years the fraction of the population aged 65 years and older will increase from 28 to 38 percent, and the total population will shrink by over 25 percent (from 127 million at present to only 95 million by 2058). - Demographic change will depress growth and productivity due to a shrinking and aging labor force and a shift toward consumption, while fiscal challenges will magnify with rising age-related government spending and a shrinking tax base. - Labor market rigidities limit productivity growth and hamper pass-through of demand stimulus to real wages and prices—undercutting monetary transmission and blunting the impact of fiscal support. - Assessment of Abenomics - After six years, Abenomics has eased financial conditions, reduced the fiscal deficit, and raised employment and female labor force participation. - Inflation remains well below BoJ’s two-percent target and fiscal policies have yet to put public debt on a sustainable path. - The ‘third arrow’ (structural reforms) has made some headway but has fallen short overall; bottlenecks remain in labor and product markets and in the corporate sector. - Strategy recommendations - The strategy of Abenomics remains appropriate, but reinvigorated and credible policies are needed; the three arrows must be reinforced and be mutually supportive. - Fiscal policy: Near-term fiscal and income policies should support BoJ’s reflation efforts and implementation of structural reforms. A well-specified and gradual medium-term consolidation plan, based on realistic growth assumptions, would help enhance near-term fiscal space, ensure debt sustainability, and bolster public confidence. - Structural reforms: Credible macro-structural reforms are imperative to lift long-run growth and stabilize government debt. Confidence and anticipation effects associated with a credible reform program will be key to avoid deflationary impact. Structural reforms would help boost inflation through more effective monetary policy transmission, resulting from a higher natural interest rate and reinvigorated wage-price dynamics. - Monetary and financial policies: Maintain accommodative monetary policy stance, with clear forward guidance and further strengthening of the monetary policy framework to help lift inflation expectations. Strengthened financial sector policies could mitigate financial risks from demographic headwinds and prolonged low interest rates, improving BoJ’s ability to maintain its accommodative stance for longer. A. Fiscal policy—near-term support and long-term sustainability - Credibility of FY2025 primary surplus target - Credibility would be enhanced by adopting more realistic macroeconomic projections and specification of consolidation measures. - Authorities’ macroeconomic projections still rely on relatively optimistic assumptions on TFP growth based on Japan’s experience of the 1980s. - Optimistic growth projections for FY2019 and FY2020 do not provide guidance on the size of mitigating measures needed to offset the adverse impact of the October 2019 consumption tax increase. - Absence of concrete revenue and expenditure measures does not build confidence in the new fiscal plan. - Japan continues to have some fiscal space in the near-term, helped by limited funding risks and low borrowing costs, but this is conditional on adoption of a credible medium-term fiscal consolidation plan. - Demographics and a generous social security system will further increase age-related costs, constraining fiscal space over the medium and long-term and calling for a credible strategy that reaches well beyond FY2025. - Near-term fiscal stance - Staff recommends avoiding near-term fiscal tightening—maintaining a neutral fiscal stance in 2019 and 2020 to make the planned consumption tax hike successful. - Staff estimates the 2019 and 2020 fiscal stance would be contractionary by 0.7 and 0.6 percent of GDP, respectively, without mitigating measures, as effects of the 2018 supplementary budget fade and the October 2019 consumption tax increase comes into play. - Measures should be implemented to support near-term reflation and growth momentum while helping advance accelerated structural reforms. - Mitigating the impact of the 2019 consumption tax rate increase - Temporary mitigating measures should be carefully designed to alleviate adverse impacts from the October 2019 tax increase, including addressing concerns over durable consumption such as automobiles and housing. - Example: abolishing the automobile acquisition tax could help partly offset the impact. - Consider a time-bound and well-targeted tax rebate or transfer program to reduce the tax burden on households at the lower end of the income distribution. - Clear communication to the public on timing and content of measures will help alleviate adverse effects due to uncertainty. - Strengthening income policies and raising administered prices - Corporate tax incentives for wage increases should be strengthened, minimum wages raised further, and administratively-controlled wages and social transfers increased—including to reflect the impact of the consumption tax increase on prices. - To support reflation efforts, consider reforming price-setting mechanism of administered prices to better reflect costs, with safeguards for low-income households. - Medium- and long-term fiscal framework and adjustment options - A well-specified fiscal framework for the medium and long-term is needed to reduce policy uncertainty, address demographic challenges, and mitigate debt sustainability risks. - The fiscal framework needs to rely on more independent and realistic assessments of the economic outlook and budget projections, specify fiscal consolidation measures, and limit the use of supplementary budgets. - An independent fiscal institution (IFI) could play an important role. - To protect growth while putting debt on a stable path, medium-term fiscal consolidation should embed a gradual approach with annual consolidation of about 0.5 percent of GDP in the structural primary balance, starting from 2021. - Essential steps include: - Gradual and steady increases in the consumption tax rate, beyond 10 percent, with the rate moving toward at least 15 percent to finance growing social security costs and reduce debt sustainability risks. - Maintain the unitary rate structure as far as possible to enhance efficiency and support revenue-raising capacity. - Reforming healthcare to contain total healthcare spending while preserving public welfare and focusing on improving efficiency; increasing the share of out-of-pocket spending with safeguards for low-income households. - Staff analysis suggests a combination of reforms could generate fiscal savings of up to 2 percent of GDP by 2030. - Addressing income inequality: reforms to curb social security outlays should protect the most disadvantaged elderly while addressing intergenerational and regional inequality. - Fiscal policy should support opportunities for women in the labor force, including by increasing availability of childcare and nursing-care facilities, and eliminating disincentives to full-time and regular work embedded in the tax and social security systems. - Options for fiscal policy adjustment by 2030 (text chart summary) - Improve structural primary balance by 0.5 percent of GDP to stabilize debt. - Health and long-term care reform potential gains by 2030: Up to 2 (percent of GDP). - Other potential options up to 2.5 (percent of GDP), including: - Personal income tax reform: broaden personal income tax base 0.5 - 1 (percent of GDP). - Eliminate preferential tax treatment for pension benefit income 0.25 (percent of GDP). - Targeted tax credits 2/－ (credits will reduce personal income tax revenue gains). - Raise pension eligibility age to 67 or higher 0.25 (percent of GDP). - Increase consumption tax rate from 8 to 15 percent (as an option listed among adjustment measures). *Source: IMF staff report (excerpt).* ### 16. The authorities noted that the impact from the 2019 planned consumption tax rate ### 16. The authorities noted that the impact from the 2019 planned consumption tax rate ### Consumption tax increase and fiscal framework - Planned consumption tax rate increase: "2 percentage points in 2019 versus 3 percentage points in 2014." - Mitigating design features: - Reduced tax rate for food and non-alcoholic beverages. - Additional spending for the Human Resource Development Revolution—mainly funded by part of the revenue raised by the consumption tax rate increase—will ease households’ net tax burden. - Authorities will formulate additional mitigating measures by December, such as addressing demand fluctuations. - Authorities agreed on the importance of clear communication regarding the consumption tax increase and related mitigating measures. - Fiscal institutions and projections: - Authorities broadly agreed with the need for a stronger fiscal framework but favored strengthening the existing framework and institutions. - Two advisory councils considered able to deliver IFI objectives: the Council on Economic and Fiscal Policy (CEFP) and the Fiscal System Council (FSC). - CEFP has four outside members from academia and the private sector; revision in medium and long-term growth projections in January 2018 was done in response to CEFP input. - Social security consolidation: start implementing specific consolidation measures in social security, including a method for appropriately balancing benefits and burdens, within FY2019–FY2021 while conducting a comprehensive review of the social security system by FY2020. - 2017 revision of the spousal tax deduction is expected to contribute to resolving the tax disincentive to full-time and regular work. *Italic: Source: cr18333 - 16. The authorities noted that the impact from the 2019 planned consumption tax rate* ### Macro-Structural Agenda — Reinvigorated Reforms: rationale and modeled effects - Rationale: - Aging and depopulation will depress productivity and growth—shrinking real GDP. - Weak growth and inflation prospects, together with rising age-related spending, pose serious fiscal challenges. - Structural rigidities in the labor market dampen productivity growth and hamper the pass-through of demand stimulus to real wages and prices. - A credible and well-coordinated reform package is paramount to achieving faster short- and long-term growth, higher inflation, and stabilization of government debt. - Staff model findings and scenarios: - Under current policies real GDP will decline by over 25 percent in 40 years due to demographics. - Credible implementation of all structural reforms, accompanied by a continued accommodative monetary stance and public debt stabilization, could significantly boost real GDP. - Simulations suggest real GDP could be higher by as much as 15 percent in 40 years due to credible reforms, relative to the current-policies scenario. - A not-fully-believed path of reforms would deliver significantly lower effects on near-term real GDP (8 percent boost in 10 years), would not help inflation reach BoJ’s two-percent target, and would lead to a smaller decline in the government long-run debt-to -GDP ratio. ### Reform priorities and specific measures (tiered) - Top-tier reform: Labor market reforms to increase productivity and labor supply. - Work Style Reform legislation passed in June; effects may be limited without supporting measures. - Measures: training and career opportunities for non-regular workers (including via contract reform), complementing “equal-pay for equal-work” with job descriptions and a stronger reporting framework. - Increasing labor supply via: greater labor participation by women, older workers, and foreign workers; eliminating tax and social security disincentives to full-time and regular work; increasing availability of childcare and nursing facilities; reducing the gender wage gap; reducing excessive overtime; abolishing firms’ right to set a mandatory retirement age. - Second-tier reform: Product market and corporate reforms to lift productivity and investment. - Facilitate exit of non-viable SMEs and entry of more productive firms; reduce coverage of the credit guarantee system; incentivize alternative SME financing; support R&D investment and business succession for high-potential firms. - Continued deregulation: lower barriers to entry, remove incumbents’ protections (telecom and gas), deregulate professional services, expedite deregulation in Special Economic Zones. - Deeper corporate governance reform: more ambitious requirements for outside directors, explicit limits on cross-shareholdings, enhanced transparency of beneficial ownership. - Encourage broader adoption of automation and AI while addressing distributional concerns. - Third-tier reform: Trade liberalization and FDI promotion. - Progress: Japan-EU Trade Agreement and the CPTPP; announced intention to enter into negotiations with the United States. - Further removal of tariff and non-tariff barriers in high-standard multilateral trade agreements would boost investment and growth. ### Authorities’ views on structural reforms - Authorities committed to an ambitious structural reform agenda and noted continued progress. - Acknowledged challenges from the dual labor market, seniority system, and long-working-hours culture. - Expected new regulations on wage gaps, working hours and overtime (coming into effect in April 2020) to boost productivity. - Continued efforts to boost labor supply from female, older and foreign workers. - SME lending decreased since coverage reduction in the SME credit guarantee system in April (from 100 to 80 percent); banks’ SME risk assessments had improved. - Continued deregulation efforts in gas and electricity markets. - New guidelines and revisions to the corporate governance code expected to increase board diversity and reduce cross-shareholdings. - Authorities agreed on importance of a credible and reinvigorated reform program to maximize economic impact including by supporting reflation efforts. *Italic: Source: cr18333 - 16. The authorities noted that the impact from the 2019 planned consumption tax rate* ### Monetary policy — stance, communication, and side-effects - Recommended stance and priorities: - Monetary policy should remain accommodative while putting a premium on policy sustainability. - Given limited progress to generate inflationary pressures since Abenomics, the BoJ must maintain the accommodative stance for a prolonged period. - Efforts to make accommodative stance more sustainable—including mitigating side-effects from prolonged easing—are crucial. - Communication and framework improvements suggested: - Clarify the relationship between forward guidance on the long-term interest rate target and the inflation target. - Remove the quantitative guidance on JGB purchases. - To strengthen policy framework and help lift inflation expectations, the BoJ should consider moving closer to full-fledged inflation targeting by publishing BoJ’s staff baseline forecast together with underlying policy assumptions. - Publishing staff baseline forecasts would help reduce the discrepancy between market and BoJ Board’s inflation forecasts and reduce likelihood of overly optimistic inflation forecasts by BoJ Board members. - Inflation target reference: - BoJ’s price stability target of "2 percent." ### Financial sector side-effects and monitoring - JGB market functioning: - Some liquidity indicators improved amid reduced JGB purchases under Yield Curve Control (YCC). - Number of market transactions declined sharply since the beginning of 2018, raising concerns about market functioning. - July increase in the range for 10-year JGB yields could help improve market conditions. - Better coordination among BoJ, Ministry of Finance (MoF) and market participants could make MoF’s Liquidity Enhancement Auctions and re-opening issuances more flexible. - ETF purchases: - BoJ’s ETF purchases have increased substantially over the past few years, making BoJ one of the largest shareholders of listed companies. - Concerns that ETF purchases are distorting equity prices, particularly of small-cap firms, and adversely affecting corporate governance (due to ETF’s passive voting power). - Recent BoJ actions: shift ETF purchases to the broader, market cap weighted Topix index, and condition future ETF purchases on market conditions to help alleviate side-effects. - BoJ guideline for the annual pace of increase of about "¥6 trillion" will be maintained. - Authorities’ stance: - BoJ acknowledged reaching the inflation target will likely take more time than previously expected. - BoJ maintains that current forward guidance on policy rates is appropriate and that publishing staff forecasts would be confusing given board members’ forecasts are published. - BoJ emphasized careful monitoring of financial sector side-effects and expects measures taken in July to help market functioning. - Financial stability concerns and indicators: - Japan’s financial sector remains stable, but low interest rates and demographic headwinds undercut profitability and encourage risk taking. - Overall banking sector remains well capitalized and liquid, but risks taken by some institutions have exceeded their capital levels. - Market risks from a large decline in equity prices or a sharp rise in JGB yields could lead to substantial losses for major banks and life insurers. - Solvency concerns and higher risk taking are more severe for regional banks. - Riskiness of credit allocation has increased significantly in recent years on the back of strong growth in lending to small enterprises, and exceeded the levels seen during the global financial crisis. - Ratio of real estate loans-to-GDP has reached an historic high. - Banks increased holdings of investment trusts: from "about ¥6 trillion in 2013 to over ¥18 trillion in August 2017"—"over 80 percent of the increase was contributed by regional financial institutions." - Recent BoJ stress testing highlighted concerns over the impact of low profitability on capital levels, and increased lending to financially vulnerable firms. *Italic: Source: cr18333 - 16. The authorities noted that the impact from the 2019 planned consumption tax rate* ### 28. Financial sector policies should be enhanced to contain the build-up of systemic risks ### 28. Financial sector policies should be enhanced to contain the build-up of systemic risks ### Enhance risk management and strengthen financial oversight - Financial institutions (particularly regional) should improve the effectiveness of credit risk management by, for example, making loan-loss provisioning more forward-looking. - The JFSA’s new supervisory framework is a step in the right direction to help keep pace with more sophisticated activities among financial institutions. - Introduce a more rigorous risk assessment process and a risk tolerance framework to support the transition to a full risk-based approach. - Capital requirements should be better tailored to individual bank’s risk profiles. - Corporate governance could be further strengthened across the banking and insurance sectors. - Introduce an economic-value-based solvency regulation for the insurance sector. - The JFSA’s recent move to include four more banks in its stress testing framework is welcome. - The macroprudential framework should be further strengthened in line with FSAP recommendations. ### Adjust business models and strengthen crisis management and resolution - The JFSA should encourage regional financial institutions to adapt their business models to prevailing demographic trends through: - revenue diversification; - utilization of IT and Fintech; and - consolidation. - The JFSA recently expanded the total loss absorbing capacity (TLAC) requirement to one domestic systemically-important bank (D-SIB). - Further strengthen the crisis management and resolution framework to avoid expectations of public support. ### Facilitate Fintech adoption and strengthen crypto-asset oversight - Japan remains a heavily cash-based society with relatively low Fintech penetration—particularly in regional economies—despite the government’s efforts to increase cashless payments. - Barriers to Fintech adoption by regional banks include: - an aged customer base; - limited resources; - lack of experience in managing cyber risk; and - lack of clear Fintech regulations. - Measures to increase cyber resilience are needed for regional financial institutions and Fintech firms. - The JFSA should continue to promote RegTech to reduce regulatory costs and incentivize Fintech firms to participate in the regulatory sandbox (for example, by reducing the regulatory reporting costs inside the sandbox for small start-ups). - On crypto-asset oversight: - place more emphasis on cybersecurity in crypto-asset exchanges, which requires adequate human and IT resources at the JFSA (Box 5); - clarify with the public the JFSA’s role in the exchange registration process to reduce reputational risk; - enhance cross-border supervisory collaboration to help prevent regulatory arbitrage and avoidance. ### Authorities’ views (as reported) - The JFSA stressed close monitoring of financial risks and argued that significant progress was made in implementing the 2017 FSAP recommendations. - The JFSA is examining whether regional banks have adequate risk management capacity for emerging risks, but does not see excessive risk taking at this moment. - On insurance oversight, the JFSA plans to incorporate the idea of economic-value-based solvency assessments in its supervision and inspection, while working towards the introduction of economic-value-based solvency regulation in line with the development of the Insurance Capital Standard by the IAIS. - The JFSA reiterated its preference to implement measures to contain potential systemic risks through microprudential approach, while introducing some macroprudential policies such as countercyclical buffer. - The JFSA emphasized efforts made to limit the need for temporary public funding, such as works to improve financial institutions' resolvability and the expansion of the scope of the requirements on Total Loss Absorbing Capacity. - The JFSA agreed more could be done to facilitate the use of Fintech and stressed the need for regional banks to: - further streamline management; - increase the use of IT; - develop areas of expertise; and - improve corporate governance. - The JFSA highlighted cyber risk as a key (although not systemic) risk, and agreed measures could be taken to increase cyber resilience in regional financial institutions and crypto-asset exchanges. - The JFSA does not see significant reputational risks from registered exchanges, but echoed the need for enhanced cross-border collaboration in crypto-asset oversight. *INTERNATIONAL MONETARY FUND* ### 42. The Japanese economy continues to grow above potential, but inflation remains low ### 42. The Japanese economy continues to grow above potential, but inflation remains low ### Outlook and risks - Underlying growth expected to remain solid notwithstanding the scheduled increase in the consumption tax rate in October 2019. - Near-term inflation reaching slightly above one percent in light of a still-negative output gap. - Over the medium term: - Growth projected to moderate and the output gap to close. - Following a consumption tax-induced spike in 2020, inflation will rise over the medium term but will likely remain below the Bank of Japan’s target. - Downside risks have risen in line with the cooling global outlook and adverse demographic pressures. ### Near-term fiscal and income policy guidance - Near-term fiscal tightening should be avoided to support reflation and growth momentum. - Fiscal measures and stronger income policies should be implemented to support near-term reflation and growth momentum while helping advance accelerated structural reforms. - Temporary mitigating measures should be carefully designed to alleviate the adverse macroeconomic impact from the planned October 2019 consumption tax rate increase. ### Medium- and long-term fiscal framework - A well-specified fiscal framework is needed to: - Reduce policy uncertainty, - Address demographic challenges, - Mitigate debt sustainability risks. - The fiscal framework should: - Rely on independent and realistic assessments of the economic outlook and budget projections, - Set out fiscal consolidation measures, - Limit the use of supplementary budgets. - To protect growth while putting debt on a stable path, medium-term fiscal consolidation should embed a gradual approach with annual consolidation of about 0.5 percent of GDP in the structural primary balance, starting from 2021. - Essential steps include: - Gradual and steady increases in the consumption tax rate beyond 10 percent, - Containment of healthcare spending. ### Structural reforms (labor, product market, corporate) - An ambitious effort toward labor, product market, and corporate reforms is needed; a high degree of government commitment will strengthen credibility and help counter deflationary effects. - Labor market reforms prioritized as they would have the largest growth and inflation impact: - Foster training and career opportunities for non-regular workers, including via contract reform. - Enhance labor supply from women, older workers, and foreign workers. - Eliminate disincentives in the tax and social security system to full-time and regular work. - Reduce the gender wage gap. - Increase childcare and nursing facilities’ availability. - Corporate and product market reforms (second priority): - Increase exit of non-viable SMEs and entry of firms with potential. - Reduce coverage of the credit guarantee system. - Provide incentives for alternative sources of SME financing and SME R&D investment. - Support business succession of firms with potential. - Continue deregulation in product and services markets and deepen corporate governance reform. - Further remove tariff and non-tariff barriers within multilateral trade agreements. ### Monetary policy and Bank of Japan (BoJ) guidance - The BoJ should maintain its long-term interest rate target while further strengthening the policy framework. - Recent emphasis on making the accommodative stance more sustainable by mitigating side-effects is appropriate and complements a more patient approach to reaching the inflation target. - Recommendations to strengthen the framework include: - Clarify the relationship between forward guidance on the long-term interest rate target and the inflation target. - Remove the quantitative guidance on JGB purchases. - Consider moving closer to a full-fledged inflation targeting framework by publishing BoJ’s staff baseline forecast together with underlying policy assumptions to help lift inflation expectations. ### Financial sector policies and regional banks - Strengthen financial sector policies to safeguard financial stability and adapt regional financial institutions’ business models to demographic trends. - The JFSA’s new supervisory framework is a step toward a full risk-based approach. - Recommendations: - Continue to encourage financial institutions (particularly regional) to improve risk management capacity. - Further enhance financial oversight (including macroprudential framework) to prevent systemic risk build-up. - Engage with regional banks to facilitate adaptation of business models to demographic change. - Strengthen crisis management and resolution framework to reduce expectations of public support and facilitate smooth exit of unviable financial entities. - Facilitate financial institutions’ efforts to leverage Fintech and continue strengthening crypto-asset oversight. - Key facts on regional banks: - 104 regional banks operating in Japan’s 47 prefectures, accounting for 45 percent of outstanding domestic loans. - Deposits account for about 90 percent of liabilities. - Assets composition: loans 64 percent, securities 22 percent. - About half of regional banks’ total income now comes from lending operations; interest income from securities and fee income account for 19 and 17 percent, respectively. - Share of regional banks earning negative core profits rose from 12 percent in 2011 to over 50 percent in 2018. ### External position - The 2018 external position is projected to be broadly consistent with fundamentals and desirable policies. - The projected 2018 current account balance is preliminarily assessed as in line with the current account level consistent with fundamentals and desirable policies. - The 2018 real exchange rate is preliminarily assessed as in line with the real exchange rate level consistent with fundamentals and desirable policies. - A well-specified medium-term fiscal consolidation plan and bolder structural reforms that support growth and domestic demand are needed to maintain external balance over the medium term. - Japan’s leadership in advancing multilateralism can help mitigate inward spillovers from a rise in protectionism. ### Enforcement and other recommendations - Efforts to improve enforcement against foreign bribery should continue; concerns remain regarding the low level of enforcement of Japan’s offence of bribing foreign public officials. - It is recommended that the next Article IV consultation take place on the standard 12-month cycle. ### Box summaries — Inflation expectations, regional banks, demographics, and natural rate - Box 1 — What Explains Low Inflation Expectations in Japan? - A prolonged period of deflation from the mid-1990s has led to stubbornly-low inflation expectations. - Younger cohorts have lower inflation expectations than older Japanese, attributed to limited exposure to inflation. - Product downsizing accounts for about one third of product substitutes within the studied dataset over the last 10 years. - Nearly half of the goods items in the CPI basket exhibit an annual rate of price change of near zero; concentration of zero-price inflation differs markedly from other advanced economies (e.g., United States mode around three and a half percent). - Box 2 — Challenges for Regional Banks in Japan - Traditional business model challenged by adverse demographic trends and prolonged low interest rates. - Loan-deposit ratios have fallen as deposit growth is less sensitive to demographic trends than loan growth. - Regional banks have increased overseas lending, SME lending to domestic middle-risk firms and real estate sector, and holdings of investment trusts (which mainly invested in foreign bonds 41 percent, domestic equities 19 percent, and real estate funds 17 percent as of end June 2018). - Regional banks should enhance risk management, manage FX funding liquidity risk, and ensure cybersecurity amid increased IT and Fintech use. - Box 3 — Demographics and Structural Reforms - Using GIMF with demographic features, staff estimate: - Japan’s real GDP will decline by over 25 percent in about 40 years due to demographics under current policies. - Structural reforms can significantly reverse adverse demographic effects and boost real GDP by as much as 15 percent in 40 years relative to the current policies scenario, with labor market reforms having the largest impact. - Credible reforms estimated to reduce the external current account surplus in the medium term (by over 1 percent of GDP) and significantly reduce public debt. - Simulation caveats: results represent an upper bound assuming full credibility and perfect foresight; labor market duality reform assumptions include a gradual but full catch up in productivity of non-regular to regular workers, boosting real GDP by over 6 percent in the long run. If only half of the productivity difference is closed, the labor market reform yields smaller real GDP gains (about 3 percentage points in the long run). - Box 4 — Demographics and the Natural Rate of Interest in Japan - Aging and shrinking population could lower the natural rate of interest, constraining monetary policy effectiveness. - Estimation using a semi-structural Bayesian framework finds demographics have contributed to the decline in Japan’s natural rate: - Since the Global Financial Crisis, the decline in working-age population growth contributed about -0.3 percentage points on average to the estimated negative natural rate. - The natural rate averaged about -0.7 percent (Bayesian median) during this period. - The negative demographic impact increased from less than -0.2 ppts in Q1 2010 to -0.4 percentage points in Q1 2018. - Findings highlight the need to implement structural reforms (including more active migration policies) to boost potential growth and raise the natural rate. *International Monetary Fund — Chapter: The Japanese economy continues to grow above potential, but inflation remains low* ### Box 5. Crypto-Asset Regulation in Japan ### Box 5. Crypto-Asset Regulation in Japan ### Overview - Crypto-asset trading in Japan experienced explosive growth in 2017. - Crypto-assets became a legal form of payment in April 2017. - Trading grew rapidly in both spot and derivatives markets. - The investor base is largely retail, which has limited direct linkages with the rest of the financial system and hence immediate risks to financial stability appear low. - Recent hacking incidents led to large losses of about $580 million in total for customers and the hacked exchanges, raising public concerns over cybersecurity and customer protection. - Two noted exceptions where financial institutions partnered with CAEs: - The purchase of Coincheck (the CAE hacked in January 2018) by Monex—an online brokerage partly owned by a regional bank. - The investment by Money Partners Group in Kraken. ### Regulatory framework - Japan became the first country to regulate CAEs in 2017 through a registration process. - Regulation consists of four layers, with the first two legally binding: - Payment Services Act; Act on Prevention of Transfer of Criminal Proceeds (legal layer requiring CAEs to register with the Japanese Financial Services Agency (JFSA) and to conduct “know-your-customer” procedures). - Cabinet Office Ordinance concerning Virtual Currency Exchange Service Provider (detailed rules for CAEs). - JFSA’s Guidelines for Administrative Processes (guidelines for the registration process specifying scope, timeline, and requirements). - Japan Virtual Currency Exchange Association (JVCEA)’s self-regulations (self-regulation proposed by the JVCEA, which consists of the 16 registered CAEs), focusing on business appropriateness (including caps on margin trading), market fairness (including consumer protection), and sound business development. ### Supervision and enforcement - JFSA has stepped up supervision of all CAEs and tightened regulation following hacking incidents. - After on-site inspections following the January 2018 Coincheck hacking, the JFSA issued business improvement orders to exchanges with weak AML/CFT measures or customer protection systems to strengthen internal control and governance. - The JFSA has strengthened the registration process by implementing more rigorous screening for risk-management procedures. ### Cybersecurity and reputational risk - CAEs are typically more vulnerable to cyber risk than banks, often lacking the same level of cybersecurity while providing similar custody services (custody of crypto-assets) to customers. - Cyber attacks may result in significant reputational risk for the JFSA in addition to losses for consumers and CAEs. - Recommendations and actions noted: - The JFSA needs to further enhance its resources and expertise in cybersecurity. - Clear communication with the public about the JFSA’s role in the regulatory framework may help increase public awareness of the risks involved in crypto-assets and limit reputational risk. - The JFSA’s commitment to promote global cooperation to form regulations on crypto-assets as the chair of the 2019 G20 should help leverage international experiences and contribute to multilateral responses to risk from crypto-assets. ### Key facts and figures - Legalization date: April 2017. - Hacking losses: about $580 million in total. - Hacking incident referenced: January 2018 Coincheck hack. - Number of registered CAEs in JVCEA: 16. - JFSA chaired role: 2019 G20. *Prepared by Fei Han (MCM) and Todd Schneider (APD).* ### Box 6. Yen Appreciations, Safe Havens, and the Carry Trade ### Box 6. Yen Appreciations, Safe Havens, and the Carry Trade ### Mechanisms: safe havens, interest differentials, and carry trade - Safe haven appreciations occur during heightened market uncertainty when investors move into assets perceived as “safe”—such as Japanese government bonds (JGBs). - Carry trade strategy: investors borrow (short) in a low-interest rate currency (e.g., yen) and invest (long) in a high-interest currency (e.g. the Australian dollar). - Carry trade positions are typically leveraged and unhedged; any initial appreciation of the funding currency can generate a sharp unwinding of these positions, reinforcing the appreciation. - Rising global interest rates, combined with BoJ’s yield curve control, should weaken the yen and raise inflation. But widening interest rate differentials also encourage investors to take unhedged short positions in yen to earn the interest rate carry. - An initial yen appreciation (triggered by global uncertainty and a flight to safety) could result in a sudden unwinding of these positions—amplifying the yen appreciation and undermining BoJ’s efforts to reflate the economy. ### Historical evidence: 2005–2006 episode - In 2005 the U.S.-Japan interest rate differential rose sharply as the Fed tightened policy, leading to a weaker yen and spurring an expansion of carry trade (short) positions in the yen. - By early 2006, global risk perception had risen and BoJ signaled an exit from quantitative easing. As investors unwound carry trade positions, the yen appreciated sharply. - Estimates suggest the carry trade reversal explains about 40 percent of the appreciation. ### Risks and current conjuncture - Rising global rates may increase the risk of a sudden and large yen appreciation by fostering large carry trade positions. - Empirical evidence shows safe haven effects and carry trade reversals can trigger and amplify yen appreciations. - Empirical evidence also suggests that safe haven effects are likely to be significantly larger in times of heightened uncertainty. - The current conjuncture of widening U.S.-Japan interest rate differentials, and heightened global policy uncertainty (e.g., due to trade wars), appears particularly conducive to exchange rate volatility due to carry trade activities. ### Policy recommendation - Stay the course: Notwithstanding a potentially higher risk of a sudden yen appreciation, the BoJ should maintain the current accommodative monetary policy stance and the zero-interest rate target on the benchmark 10-year JGB yield. - Authorities should keep in mind the heightened risk for a sharp yen appreciation and closely monitor carry trade activities. ### Attribution and provenance - Prepared by Fei Han (MCM) and Niklas Westelius (APD). - The Box is based on the 2018 Japan Selected Issues Paper “What Drives Rapid Yen Appreciations?” *Source: IMF staff box text from cr18333 - Box 6. Yen Appreciations, Safe Havens, and the Carry Trade.* ### Annex I. Estimating Japan’s Potential Output ### Annex I. Estimating Japan’s Potential Output ### Overview - Potential output is used to gauge current economic health, expectations of future growth, and to inform economic policy. - Estimates are subject to uncertainty due to differing methodologies and judgement. ### Methodologies Used - Multivariate filter (MVF) model: - Developed by the IMF’s Research Department. - Uses Bayesian techniques. - Incorporates the relationship between cyclical unemployment and inflation (Phillips curve) and between cyclical unemployment and the output gap (Okun’s law). - Production-function approach: - Used to complement MVF results and to identify drivers of medium-term growth. - Team’s projection using production-function approach is labeled as WEO in Figure A. ### Key Findings - Medium-term potential growth: - Both MVF and production-function approaches indicate Japan’s potential growth will stabilize at around 0.5–0.6 percent over the medium-run. - Output gap dynamics: - Output gap is estimated to be negative for 2018 and is expected to close in 2019. - A small negative output gap reappears in 2020 due to the consumption tax increase in 2019Q4, and the gap closes from 2021 onwards. - Drivers shown in decomposition (Figure A): - Capital, Employment, Hours, and TFP components contribute to potential growth dynamics (Figure A labels these components). ### Comparison with Other Institutions - IMF staff’s current estimate of potential growth: around 0.8 percent (y/y growth). - Bank of Japan estimate: 0.85 percent. - Japan’s Cabinet Office estimate: about 1.0 percent. - Output gap estimates for 2017 (measured as (actual output − potential output)/potential output): - IMF staff: -0.8 percent. - Cabinet Office: 0.5 percent. - Bank of Japan: 1.2 percent. - Differences across institutions: - Small differences in potential growth estimates coexist with larger differences in output gap estimates. - These differences largely reflect differing views on potential growth during and after the Global Financial Crisis in 2008. ### Implications for Policy and Analysis - Using multiple methods (MVF and production-function) helps improve understanding of potential growth levels and drivers. - Timing of the consumption tax increase (2019Q4) is an important short-term driver of fluctuations in the output gap and growth around 2019–2021. - Persistent uncertainty around potential output estimates implies caution in drawing policy conclusions from any single-method estimate. *Source: IMF staff calculations.* ### Annex V. Debt Sustainability Analysis ### Annex V. Debt Sustainability Analysis ### Key findings - Japan’s public debt is unsustainable under current policies. Gross and net public debt amounted to 238 and 155 percent of 2017 GDP, respectively. - The debt-to-GDP ratio is projected to be stable over the medium term but will start to increase beyond the medium term due to demographic headwinds, reaching above 245 percent of GDP in 2030. - All debt profile indicators are below early warning benchmarks, but extremely high financing needs create vulnerabilities to shocks and changes in market perception. - The absence of a credible fiscal framework (with annual supplementary budgets) implies risk of future primary balance shocks. ### Baseline assumptions and projections - Time horizon extended to 2030 to capture demographic headwinds. - Growth: - Potential growth projected around 0.5 percent over the medium term, decreasing to 0.1 percent by 2030. - Fiscal policy: - Structural primary deficit projected to narrow from 3.3 percent of GDP in 2018 to around 2 percent in 2023 (mainly due to a two-percentage point increase in the consumption tax planned for October 2019 and fading effects of past supplementary budgets). - Structural primary deficit projected to increase to 2.7 percent of GDP by 2030 as age-related expenditures rise. - Monetary policy and interest rates: - Monetary policy assumed accommodative over the medium term; CPI inflation assumed to rise gradually to around 1 percent. - Nominal interest rate on 10-year JGBs assumed to reach 2 percent by 2030. - Average real interest rate assumed to increase to 0.3 percent in 2030, with implied interest-growth differential of 0.1 percent. - Baseline does not assume an increase in risk premiums. ### Financing needs and debt profile - Gross financing needs: - Estimated around 52 percent of GDP in 2017 (highest among advanced economies). - Projected to decline to around 45 percent of GDP in the medium term due to improving primary balance and extended maturity of government bonds. - Debt profile: - No indicators exceed early warning benchmarks. - 10-year bond yield stable at an extremely low level, with a negative spread against U.S. Treasuries. - External financing requirement stood at 8 percent of GDP in 2017. - Foreign holdings of JGBs relatively low at around 10 percent. - No direct exchange rate risks; JGBs denominated in yen. ### Net debt and financial assets - Government financial assets about 83 percent of GDP. - Net debt is an important indicator, but not all financial assets are available to meet obligations or easy to liquidate (e.g., social security assets). - Financial-assets-to-GDP ratio assumed stable over projection period. - Note: Relative to the previous DSA, net debt is higher by about 35 percent of GDP due to revised asset classification (alignment with GFSM and removal of equity assets from net debt). ### 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 the cyclically adjusted primary balance (CAPB) has a percentile rank of 31 percent compared to historical experience for high-debt market access countries; CAPB level is in the lowest quartile. - Baseline assumes fiscal contraction of around 0.7 percent of GDP in 2019 due to fading supplementary budgets and the planned consumption tax hike. - Risk noted from historical pattern of yearly supplementary budgets which indicates potential primary balance shocks throughout the projection period. ### Stress tests and scenario results - Fan chart: - Considerable uncertainty around the baseline; under the worst quartile case, debt-to-GDP could reach around 260 percent in 2023—more than 25 percentage points higher than baseline. - Ruling out a positive primary balance shock could raise the debt-to-GDP by about 4 percent of GDP in 2023. - Primary balance shock: - Shock equals half of the 10-year historical standard deviation of changes in the primary balance. - Assumes additional borrowing increases interest rates by 25 basis points for every 1 percentage point of GDP worsening of the primary deficit. - Gross debt-to-GDP marginally higher by around 3 percent of GDP in 2023 versus baseline. - Growth shock: - Real output growth reduced by one half of the 10-year historical standard deviation of changes in growth for 2 consecutive years starting in 2019. - Assumes a decline in inflation of 0.25 percentage point per 1-point decrease in growth and interest rate feedback as in the primary balance shock. - Debt ratio increases to about 246 percent of GDP—around 9 percentage points higher than baseline. - Interest rate shock: - Shock based on historical maximum real interest rate occurs in 2019 and remains thereafter. - Due to weighted average JGB maturity around 7.8 years, effective interest rate is higher by more than 1 percentage point in 2023 versus baseline. - Debt-to-GDP about 9 percentage points higher versus baseline in 2023; effects grow over time and could materially affect the financial sector. - Interest rate plus contingent liability shock: - One-time capital injection equivalent to about 3.6 percent of banking sector assets (approximately 10 percent of regional banks assets) increases government spending by around 6 percent of GDP. - Combined with real GDP growth shock, debt ratio increases to around 260 percent of GDP in 2020—about 22 percentage points higher than baseline. ### Longer-term projections, risks, and policy recommendations - Beyond 2023, debt-to-GDP ratios projected to increase, reaching above 245 percent of GDP by 2030 due to rising age-related expenditures and gradual increases in interest-growth differential. - Favorable interest-growth differential depends on domestic investors’ home bias, high domestic saving, and large JGB purchases by the BoJ; this could be tested in the absence of a credible fiscal policy framework. - Staff recommendation: - Maintain a neutral fiscal stance in 2019 and 2020. - Start gradual adjustment from 2021 with annual consolidation of about 0.5 percent of GDP in the structural primary balance. - Such a path will stabilize public debt at the current level by 2030; if accompanied by a comprehensive policy package with accelerated structural reforms, debt-to-GDP could moderately decline. ### Selected exact figures and projections (as presented) - Gross public debt: 238 percent of 2017 GDP. - Net public debt: 155 percent of 2017 GDP. - Projected gross financing needs: 52 percent of GDP in 2017; around 45 percent of GDP in the medium term. - External financing requirement: 8 percent of GDP in 2017. - Foreign holdings of JGBs: around 10 percent. - Government financial assets: about 83 percent of GDP. - Structural primary deficit: 3.3 percent of GDP in 2018; around 2 percent in 2023; 2.7 percent by 2030. - Potential growth: around 0.5 percent over the medium term; 0.1 percent by 2030. - Nominal 10-year JGB rate: 2 percent by 2030 (assumption). - Average real interest rate: 0.3 percent in 2030; implied interest-growth differential 0.1 percent. - Weighted average JGB maturity: around 7.8 years. - Worst-quartile fan chart outcome: debt-to-GDP around 260 percent in 2023 (more than 25 percentage points above baseline). - Growth-shock outcome: debt ratio about 246 percent of GDP (~9 percentage points above baseline). - Interest-rate & contingent-liability scenario: debt ratio around 260 percent in 2020 (~22 percentage points above baseline). - Recommended annual consolidation from 2021: about 0.5 percent of GDP in the structural primary balance. *Source: IMF staff.* ### Annex VI. Progress on 2017 FSAP Key Recommendations ### Annex VI. Progress on 2017 FSAP Key Recommendations ### Cross-Cutting Issues - Further raise corporate governance standards to bolster independence of board and oversight functions from senior management across banking and insurance sectors (JFSA). Time Frame: NT - The JFSA published the revised Corporate Governance Code in June 2018, which requires that a company should appoint a sufficient number of independent directors (rather than just disclose a roadmap for doing so as in the previous version) if the company believes that it needs to appoint at least one-third of directors as independent directors based on a broad consideration of factors. - The revised Corporate Governance Code requires companies to annually assess whether or not to hold each individual cross-shareholding and disclose the results of the assessment. - The revised Code requires that the board should appoint and dismiss a CEO through objective, timely and transparent procedures. - Further develop internal processes to support full risk-based supervision for banks, insurers, and securities firms (JFSA, SESC). Time Frame: I - The JFSA finalized the revised JFSA’s Supervisory Approaches in June 2018, moving from backward-looking, element-by-element compliance checks to a substantive, forward-looking, and holistic framework. - To ensure effective implementation, the JFSA is enhancing governance and quality control of supervision, making effective use of feedback from outside the JFSA, and restructuring internal organization, human resource policy, and IT infrastructure. - Consider enhancing independence of JFSA and BoJ in key supervisory issues (PM, MoF, JFSA, BoJ). Time Frame: MT - Under consideration by the authorities. ### Systemic Risks - Develop own supervisory stress testing model for both solvency and liquidity risk analysis for banks, and for solvency risk analysis for insurers, as well as stress test large exposures periodically (JFSA). Time Frame: NT - In its revised supervisory approaches published in June 2018, the JFSA stated that it will explore how to benefit better from supervisory stress tests with common scenarios (universal tests), with due regard to the possible unintended consequences from the use of common scenarios. - Continue conducting liquidity stress testing regularly for significant foreign currencies and require banks to hold sufficient counterbalancing capacity, particularly high-quality liquid assets (JFSA). Time Frame: I - The JFSA stated in its “Providing Better Financial Services in the Era of Transition” published in September 2018 that it will promote securing stable foreign currency funding and enhancing foreign currency liquidity management in the three megabank groups. ### Financial Sector Oversight - Give JFSA the power to set capital requirements for banks based on specific risk profiles (Gov). Time Frame: I - The JFSA continues to encourage banks with soundness concern to improve management through the “Early Warning System” where the JFSA engages in deep dialogues regarding prospects and business models of specific banks. - The JFSA will review the Early Warning System to further improve its effectiveness. - The JFSA may request a bank to submit an improvement plan, order a change to the submitted improvement plan, or order other measures necessary for the purpose of supervision. - Take further steps to implement an economic-value-based solvency regime for insurers (JFSA). Time Frame: NT - The JFSA plans to incorporate the idea of economic-value-based solvency assessment in its supervision and inspection, while working towards the introduction of economic-value-based solvency regulation in line with the development of the Insurance Capital Standard by the IAIS. - Introduce more specific periodic reporting requirements and more proactive investigations into related party transactions (JFSA). Time Frame: I - The JFSA requires approval when banks conduct transactions with related parties where arm’s length rule may apply; there was no such approval during 2017. - The JFSA imposes business scope restrictions on banking groups and prevents contamination of heterogeneous risks; JFSA does not plan to change the current treatment. - Ensure robust supervision of the systemically important securities firms by ensuring access to sufficient number of experienced staff and onsite monitoring of overseas operations (JFSA, SESC). Time Frame: I - The JFSA monitors major securities firms through the Securities Firms Monitoring Office (SFMO). - SFMO has 14 staff for monitoring major securities firms, at the end of October, 2018. - SFMO carried out on-site visits to overseas offices 4 times in 2017 (New York, London (twice), Singapore), and 5 times in 2018 (New York (twice), London, Hong Kong SAR (twice)). - Enhance recovery plan further by including extreme stress scenarios while ensuring continuity of critical services and mitigating contagion risks through clearing members (JSCC). Time Frame: I - The JSCC implemented replenishment regime of JSCC’s Settlement Guarantee Reserve (i.e., Skin in the Game). - JSCC documented its existing recovery arrangements as the enhanced “Recovery Plan based on PMFI” of JSCC as its internal rules. - JSCC implemented temporary utilization scheme of cash portion of clearing fund to cash settlement for listed products. - Address recovery planning issues on regulation for central counterparties (JFSA). Time Frame: I - Under consideration by the authorities. ### Macroprudential Policy - Clarify the mandate of the Council for Cooperation on Financial Stability (JFSA, BoJ). Time Frame: NT - The JFSA and BoJ have been holding bi-annual meetings of the Council for Cooperation on Financial Stability to exchange views on the current situation of the financial system and the market among senior officials, including the Commissioner of the JFSA and the Deputy Governor of the BoJ. - Consider proactively enhancing the macroprudential tool box, including sectoral tools (JFSA). Time Frame: NT - The JFSA prefers to contain potential systemic risk through microprudential approach, while introducing some macroprudential policies such as countercyclical buffers. - Continue to broaden and deepen the scope of systemic risk assessments (JFSA, BoJ). Time Frame: NT - The JFSA has expanded intensive monitoring of stress testing to some D-SIBs and other large banks in addition to Japanese G-SIBs (three megabanks) for systemic risk assessment. ### Crisis Management, Resolution, and Financial Safety Nets - Strengthen resolution framework by removing ambiguities in the choice of tools, introducing a statutory bail-in power, clarifying triggers to enable early entry into resolution, and ensure that the role for the courts does not hinder effective resolution (JFSA). Time Frame: NT - The JFSA has made efforts to limit financial institutions’ need for temporary public funding and to improve resolvability. - Consider broadening the perimeter of institutions to establish loss-absorbing capacity (JFSA). Time Frame: NT - The JFSA has expanded the scope of the requirements on Total Loss Absorbing Capacity (TLAC) to one D-SIB. - Encourage earlier prompt corrective action and provide a clearer path to resolution (JFSA). Time Frame: NT - The JFSA continues to encourage banks with soundness concern to improve management through the “Early Warning System” and will review it to improve effectiveness. - Enhance crisis preparedness and coordination via an interagency crisis management forum (MoF, Minister for FS, BoJ, JFSA, DICJ). Time Frame: NT - The JFSA has been enhancing crisis management and inter-agency collaboration through regular monitoring practices including information-sharing between authorities. - Establish an orderly resolution regime, following international guidance, for central counterparties and other FMI operators (JFSA). Time Frame: MT - Under consideration by the authorities. - Strengthen framework for the provision of emergency liquidity assistance and tighten preconditions for the use of temporary public funding in resolution (MoF, BoJ). Time Frame: NT - Under consideration by the authorities. ### Financial Intermediation - Continue engaging with banks on implications of macroeconomic and demographic trends and take actions on a timely basis when viability concerns are identified for individual institutions (JFSA). Time Frame: I - The JFSA’s “Providing Better Financial Services in the Era of Transition” (September 2017 and September 2018) analyzed the rapidly ageing society and published an interim report “Financial Services in the Aging Society” in July 2018. - The JFSA will: - Emphasize appropriate planning and implementation of business strategies by managers and effective governance by the Board of Directors for stable revenue base and long-term fiscal soundness. - Encourage management to work on building sustainable business models with timelines in mind. - Conduct on-site and off-site monitoring to secure long-term financial soundness of regional financial institutions and urge those with serious problems to take early responses. - Encourage banks to evolve risk management practices in line with new business activities (JFSA). Time Frame: NT - The JFSA will continue dialogue with banks for improving risk management to maintain financial soundness in both scenarios of continued low interest rate environment and rise of interest rates. - The JFSA will promote prompt response of risk management to changes in global economy and financial market environment through utilizing stress tests in the three megabank groups. - Encourage regional and Shinkin banks to review measures such as cost reduction, consolidation, income diversification, and fee structures to address medium term profitability concerns (JFSA, Gov). Time Frame: NT - The JFSA will conduct on-site and off-site monitoring in an integrated manner and urge regional financial institutions with serious problems to take early responses. - Lower coverage of credit guarantees (SME Agency). Time Frame: MT - Since April 2018, the coverage of credit guarantees to SMEs from Safety Net Program No. 5 was lowered from 100 percent to 80 percent, while a new Safety Net Guarantee program was established for the event of a substantive crisis with 100 percent guarantee. ### Japan — Overall Assessment and External Sector Diagnostics - Foreign asset and liability position and trajectory - Background: - The net international investment position (NIIP) has remained at about 60 percent of GDP over 2013-17, with assets reaching 184 percent and liabilities reaching 124 percent in 2017. - In the medium term the NIIP is projected to rise to about 77 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 36 percent of total). - Assets are diversified geographically and by risk classes. - The NIIP generated net annual investment income of 3.6 percent of GDP in 2017. - Overall Assessment statement preserved from source: - The 2018 external position is projected to be broadly consistent with medium-term fundamentals and desirable policies. - A continued accommodative stance by the Bank of Japanis consistent with the objective of reflating the economy, and needs to be accompanied bybold structural reforms and a credible and specific medium-term fiscal consolidation planto maintain anexternal positionconsistent with medium-term fundamentals. - Potential policy responses (verbatim phrases preserved): - A more forceful and coordinated policy package is needed to raise growth and inflation in a sustainable manner. This includes structuralmeasures to boost wages, increase labor supply, reduce labor market duality, enhance risk capital provision,reduce barriers to entry in some industries,and accelerate agricultural andprofessional services sector deregulation. - Fiscal consolidation should proceed in a gradual manner anchored by a credible medium-term fiscal framework. These ’desirable’ policies are expected to support growth, imports and prices, andmaintainan external positionin line with fundamentals over the medium term. - Current account (CA) — 2018 projections - Background: - The CA surplus has risen since 2013, reaching 4 percent of GDP in 2017, driven mainly by an improvement in the trade balance. - In 2017, the CA surplus increased by 0.1 percent of GDP relative to 2016. - The CA surplus is expected to shrink in 2018 to 3.6 percent of GDP, reflecting smaller income and goods trade balances. - The income balance accounts for most of the current account surplus (90 percent in 2017 and over 95 percent in the first half of 2018). - Assessment and model outputs: - The 2017 CA assessment uses the EBA model: estimated cyclically-adjusted CA of 3.6 percent of GDP is adjusted upward by 0.1 percent to reflect temporary factors. - EBA estimates the 2017 cyclically-adjusted CA norm at 3.2 percent of GDP, with a standard error of 1.3 percent of GDP. - Staff estimates a 2017 CA norm range between 1.9 and 4.5 percent of GDP. - The underlying 2017 CA gap midpoint is assessed to be 0.5 percent of GDP (with CA gap range between -0.8 and 1.8). - Using 2018 projections, the EBA model estimates the 2018 cyclically-adjusted CA norm at 3.3 percent of GDP, with a standard error of 1.2 percent of GDP. - Staff estimates a 2018 CA norm range between 2.0 and 4.5 percent of GDP. - The projected CA gap midpoint in 2018 is assessed to be 0.2 percent of GDP (with CA gap range between -1.1 and 1.4). - However, the large unexplained portion of the EBA CA gap suggests that important bottlenecks to investment and consumption remain. - Projected/model summary line preserved exactly: - Projected CA 3.6 Cycl. Adj. CA 3.5 EBA CA Norm 3.3 EBA CA Gap 0.2 Staff Adj. 0.0 Staff CA Gap 0.2 - Real exchange rate (REER) - Background: - After depreciating substantially during 2013-15, the average REER appreciated substantially during 2016. - In 2017, the average REER weakened by 4.9 percent relative to 2016. - Estimates through September 2018 show that the REER has depreciated by 0.2 percent relative to the 2017 average while it has appreciated by 2.9 percent relative to end-2017. - Assessment: - The EBA REER Index and Level models estimate the 2017 average REER to be 17-18 percent lower than the level consistent with fundamentals and desirable policies. - Using the staff-assessed 2017 CA gap range and a staff-estimated semi-elasticity of 0.14 yields an indicative range for the 2017 REER gap as -13 to 6 percent with a midpoint of -4 percent. - Taking into consideration that this broad REER gap range is due to the low semi-elasticity, the 2017 REER is assessed as in line with the level consistent with fundamentals and desirable policies. - Using projected 2018 CA gap range, the 2018 REER is preliminarily assessed as in line with the level consistent with fundamentals and desirable policies. - Capital and financial accounts: flows and policy measures - Background: - Portfolio outflows continued during most of 2017 – though at a slower pace than in 2016 – as institutional investors continued to diversify overseas and FDI outflows continued. - Net short yen positions have prevailed since Q2 2017, but after end-March net positions are balanced. - Assessment: - Vulnerabilities are limited (inward investment tends to be equity-based and home bias of Japanese investors remains strong). - So far there have been no large spillovers from Yield Curve Control to financial conditions in other economies. - If outflows from Japan 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 25 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. *Source: cr18333 - Annex VI. Progress on 2017 FSAP Key Recommendations.* ### Annex VII. Assessment of Japan ### Annex VII. Assessment of Japan’s External Sector ### Fund Relations and Financial Position - Membership Status: Joined: August 13, 1952; Article VIII. - Quota: 30,820.50 SDR Million (100.00 percent). - IMF's Holdings of Currency (Holdings Rate): 26,505.84 SDR Million (86.00 percent). - Reserve Tranche Position: 4,315.32 SDR Million (14.00 percent). - Net cumulative SDR allocation: 12,284.97 SDR Million (100.00 percent). - Holdings of SDRs: 13,423.80 SDR Million (109.27 percent). - Latest Financial Arrangements (historical): Stand-By Mar 11, 1964–Mar 10, 1965; Amount Approved 305.00 SDR Millions; Stand-By Jan 19, 1962–Jan 18, 1963; Amount Approved 305.00 SDR Millions. - Overdue obligations / projected payments to Fund (charges/interest): 0.20 SDR Million per year for forthcoming 2018–2021 (Total each year 0.20). ### Statistical Issues and Data Transparency - Japan has adhered to the Special Data Dissemination Standard (SDDS) Plus since April 2016 and meets SDDS Plus specifications for coverage, periodicity, and timeliness. - G-20 Data Gaps Initiative (DGI-2) implementation progress: - Started reporting quarterly General Government Gross Debt data in April 2018. - Plans to disseminate General Government Operations in line with SDDS Plus by 2021. - Plans to report global Security Financial Transactions data to the Financial Stability Board by end-2018. - Committed to address limited data availability to compile Securities Statistics and sectoral accounts. - Last data ROSC (Observance of Standards and Codes) mission: 2005; report published March 2006. - Selected Common Indicators (latest observations as of October 19, 2018) include: - Exchange Rates: Oct. 2018 (daily). - International Reserve Assets and Reserve Liabilities: Sept. 2018 (monthly). - International Investment Position: 2018Q2 (quarterly). - GDP/GNP: 2018Q2 (quarterly). - External Current Account Balance: Aug. 2018 (monthly). - Stocks of Central Government and Central Government-Guaranteed Debt: 2018Q2 (quarterly). ### Recent Economic Developments, Outlook, and Risks - Q3 2018 GDP and shocks: - IMF staff preliminary estimate (released Nov 14): real GDP growth for Q3 (July–September) at -1.2 percent (annualized), down from 3.0 percent in Q2. Main causes: several natural disasters (typhoons in the Osaka area, earthquake in Hokkaido) that disrupted supply chains, private investment, exports, and private consumption (including disaster-driven surge in fresh food prices). - Revised preliminary estimate for third quarter growth to be released on December 10 (date preserved as in source). - Authorities’ (first preliminary) quarterly estimate for July–September 2018: -0.3% (quarter-to-quarter). Authorities consider the economy continues on a steadily growing trend despite temporary drop in private consumption and decline in exports. - Supplementary budget and fiscal timing: - Supplementary budget passed on November 7: ¥0.9 trillion (about 0.2 percent of GDP), mostly for disaster recovery expenditure. Staff expects the supplementary budget will have an effect next year, supporting 2019 growth. - Inflation: - Headline CPI inflation: 1.2 percent (year-on-year) in September, supported by energy and food prices. - Core CPI inflation (excluding fresh food and energy): 0.4 percent (year-on-year) in September. - External sector and markets: - External current account (CA) surplus recovered in Q3, with a balance about US$50 billion, equal to the average CA balance over first half of 2018; driven by a larger income balance due to lower income debits. - Trade balance turned to deficit in Q3, mainly due to increased goods imports and lower exports (typhoon- and earthquake-related disruptions). - Yen has appreciated (in real effective terms) by almost 2 percent as of September 2018, relative to end-2017. - Since the beginning of 2018, equity markets have fallen by 4.2 percent. - The 10-year government bond yield increased by 7 basis points to 0.11 percent. ### Policy Mix, Structural Reforms, and Labor Market - Policy stance: - Authorities emphasize mutually-supportive policies under Abenomics: aggressive monetary policy, flexible fiscal policy, and growth strategy including structural reform. - Basic principle on fiscal consolidation: "without economic revitalization, there can be no fiscal consolidation" under the New Plan to Advance Economic and Fiscal Revitalization (formulated in June). - Authorities will accelerate and expand three-pillar reform: overcoming deflation and revitalizing the economy, expenditure reforms, and revenue reforms. - Growth strategy and structural reforms (priorities and actions): - Central focus on mitigating adverse effects of demographic changes (aging and shrinking population). - Core reform areas described in Basic Policy 2018 ("Realizing Sustainable Economic Growth by Overcoming the Decreasing Birth Rate and Aging Population") and Growth Strategy 2018. - Supply-side measures to raise potential growth: - Greater labor participation of female and older workers. - Investment in human resources and free early childhood education ("human resources development revolution"). - Measures to enhance productivity: promotion of AI, robots, IoT; strengthening corporate governance; “realization and expansion of Supply System Innovation.” - Spread benefits of growth from urban to rural areas and from large companies to SMEs. - Labor market reforms (top priority per staff and authorities): - Work Style Reform Bills enacted in June (year preserved as in source). Key elements: - Establishment of a limit on overtime work with introduction of penalty in case of breach. - Elimination of the irrational gap of the working conditions between regular and non-regular workers (“equal pay for equal work”). - Complementary measures noted by authorities and staff: develop guidelines, strengthen training for non-regular workers, introduce job descriptions, and ensure effective implementation of the bills. - Labor market outcomes and participation: - Unemployment rate: 2.3% (record 25-year low cited by authorities). - Active job openings-to-applicants ratio: reached a 44-year record-high level and "have exceeded one in every 2 prefecture for two years" (text preserved as in source). - Labor force participation rates: - Female (15–64 years old): 69.4%. - Older workers: 23.5%. ### Trade Policy and International Agreements - Trade agreements and timing: - Japan-EU Economic Partnership Agreement: - Cabinet submitted legislation to ratify the free trade agreement to the Diet on November 6; aims to bring the pact into force by February 1, 2019. - The agreement would create a bloc covering about 28 percent of global GDP. - Comprehensive and Progressive Agreement for Trans-Pacific Partnership (TPP11): - Australia became the sixth country (after Japan, Mexico, Singapore, New Zealand and Canada) to ratify on October 31. - The Agreement will come into force on December 30. - Authorities commit to promote open, rule-based, multilateral trade and investment systems, and to proceed with negotiations in mega agreements including TPP11, Japan-EU EPA, and RECEP. ### Risks and Monitoring - Authorities and staff highlight external risks requiring continued attention: - Trade tensions. - Developments in the Chinese economy. - Vulnerabilities in Emerging Markets. - Geopolitical tensions. - Domestic policy risk noted: - Potential demand fluctuations caused by the consumption tax rate hike from 8% to 10%; authorities recognize importance of taking all possible measures to contain such fluctuations to stabilize the economy. _Italic: Source: "Annex VII. Assessment of Japan" — Staff Report for the 2018 Article IV Consultation (as presented in the provided content)._ ### 14. For fiscal consolidation, the GOJ aimed to achieve the primary surplus of the ### cr18333 - 14. For fiscal consolidation, the GOJ aimed to achieve the primary surplus of the ### Fiscal consolidation and primary surplus target - GOJ aimed to achieve the primary surplus of the central and local governments by FY 2020 under the Plan to Advance Economic and Fiscal Revitalization developed in 2015. - Improvements of the primary balance were delayed because of: - more moderate growth of tax revenues, and - the impact of the postponement of the consumption tax rate from 8% to 10%. - The GOJ changed the use of revenues from the consumption tax rate hike to preserve stable financial resources for the “human resources development revolution,” making the FY 2020 target difficult to achieve. - Public debt to GDP ratio rise has been moderate but has not yet reached steady reduction. - Revised target: - GOJ now aims for the primary surplus of the central and local governments by FY 2025 under the New Plan to Advance Economic and Fiscal Revitalization formulated in this June. - Social security reforms are considered imperative to achieve the new fiscal consolidation target. - GOJ will comprehensively review progress focusing mainly on the social security reforms in FY 2020 and specify policy measures in social security, including modalities to balance between benefits and burdens. - GOJ will start actions, including scheduling and implementation of reforms, within FY 2019 – FY 2021. - Credibility and projections: - Staff emphasizes importance of specification of fiscal consolidation measures to enhance credibility. - GOJ considers realistic macro-fiscal projections can be delivered via the Council on Economic and Fiscal Policy (CEFP) and the Fiscal System Council (FSC) without creating an independent fiscal institution. - Following input from CEFP, the GOJ revised Economic and Fiscal Projections for Medium to Long Term Analysis in this January with more realistic assumptions based on previous economic performances. ### Consumption tax hike, mitigation, and use of revenues - Consumption tax rate scheduled increase: - From 8% to 10% on October 1, 2019 as stipulated by law. - The upcoming hike is 2%, smaller than the last one. - Mitigating measures and supports: - GOJ will mobilize a wide range of measures and make every effort to contain demand fluctuations before and after the tax rate increase, along with supports for low-income households. - GOJ will take temporal and special measures in the initial budgets for FY 2019 and FY 2020. - Announced measures include: - introduction of reduced tax rate, - enhanced relief of long-term care insurance premiums for the low-income elderly, - provision of supporting benefits for pensioners, - provision of greater supports for child-rearing generations by modifying use of the revenues generated by the consumption tax rate hike. - GOJ will take tax and budgetary measures to create advantages for purchases of consumer durable goods, including automobiles and housing, after October 1, 2019. - Process and communication: - GOJ will specify and show specific mitigating measures for FY 2019 soon, since Draft of initial budget is usually decided in December each year. - Specific size and items of mitigating measures will be determined in the process of formulating budgets. - GOJ will clearly communicate with public on the necessity of the consumption tax rate hike and mitigating measures. - Historical reference: - Based on previous experience with the 3% consumption tax rate increase in 2014. ### Monetary policy - Bank of Japan (BOJ) measures: - BOJ decided to strengthen commitment to achieving the price stability target by introducing forward guidance for policy rates, and to enhance sustainability of “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control” in this July. - Forward guidance: publicly made clear to maintain current extremely low levels of short- and long-term interest rates for an extended period, taking into account uncertainties including effects of the consumption tax hike scheduled in October 2019. - BOJ decided to conduct market operations and asset purchases in a more flexible manner to enhance sustainability of QQE with Yield Curve Control. - Target level of long-term yields maintained at around zero percent, but BOJ clarified actual yields might move upward and downward to some extent depending on developments in economic activity and prices. - Since the policy decision, the degree of market functioning has improved with BOJ conducting JGB purchases in a flexible manner. - Policy intent: - BOJ will continue with QQE with Yield Curve Control, aiming to achieve the price stability target of 2 percent, as long as necessary for maintaining that target in a stable manner. - BOJ will examine the risks most relevant to monetary policy and conduct policy appropriately, taking account of developments in economic activity and prices as well as financial conditions. ### Financial sector stability and supervision - Staff finds Japan’s financial sector remains stable; authorities will closely monitor financial risks while continuously improving supervisory approaches. - Implementation progress on FSAP recommendations: - Authorities state progress has been made on macroprudential policies and resolution (paragraph 28 referenced). - Examples of actions: - Expanded coverage of intensive monitoring of stress testing exercises to some D-SIBs and other large banks in addition to Japanese G-SIBs (three megabanks). - Expanded scope of requirements on Total Loss Absorbing Capacity (TLAC) requirement to one D-SIB. - Support for regional financial institutions: - JFSA set priorities: responding to acceleration of digitalization, promoting long-term personal asset building, vitalizing capital market and securing market integrity and transparency, and securing effective financial intermediation and financial stability. - For regional institutions, JFSA formed and sent expert teams to local finance bureau to better capture regional economies through deep dialogues and to improve financial intermediation function. ### External sector and EBA/REER concerns - Global imbalances: - Reducing excess global imbalances is critical to sustain global economic growth. - Important for the Fund to continuously refine EBA methodology, a multilateral monitoring tool to assess individual countries’ CA balances; GOJ welcomes efforts on EBA methodological update this year. - Current account (CA) assessment: - GOJ agrees with staff’s assessment that the 2017 CA balance and the projected 2018 CA balance are broadly in line with fundamentals and desired policies. - Authorities will promote fiscal consolidation and structural reforms, including labor market reforms. - Staff did not apply the adjustor related to increased energy imports due to shut downs of nuclear power reactors for the preliminary 2018 CA external assessment. - REER and methodological concerns: - Authorities are concerned about REER assessment using the CA gap from EBA methodology: - Exchange rates are determined by capital transactions rather than trade balance; linking CA assessment with REER assessment causes problems especially where income balance dominates CA balances. - Developments of global value chains have weakened linkage between trade balance and REER. - Recommendation: - The Fund should not pursue identifying appropriate level of REER for free-floating currencies, especially when income balances dominate CA balances (case of Japanese yen). - EBA should be used to identify appropriate level of CA, find structural problems contributing to CA gaps, and recommend structural policies to solve them. - GOJ requests continuation of discussions on this point. ### Supply-side of corruption - GOJ acknowledges importance of supply-side issues to address corruption and volunteered to have its legal and institutional framework assessed in the Article IV Consultation. - Japan is the first case of this initiative, together with the United Kingdom which was discussed earlier this week. - OECD Phase 3 recommendations in the OECD Working Group on Bribery pointed out several points regarding enforcement of foreign bribery offences; GOJ has steadily implemented the above recommendations as the staff report shows. *Source: cr18333 - 14. For fiscal consolidation, the GOJ aimed to achieve the primary surplus of the* --- _Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18333.pdf_