## 1jpnea2026001 ## Source details **Canonical URL:** [1jpnea2026001](https://www.imf.org/-/media/files/publications/cr/2026/english/1jpnea2026001.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2026/english/1jpnea2026001.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2026/english/1jpnea2026001.pdf.json) --- ### Outlook and Risks - Growth projection: - 2026 growth projected at 0.8 percent. - Medium-term potential growth: 0.6 percent. - Positive output gap in 2025–2026, projected to close gradually by end-2027. - Private demand: - "Private investment and consumption are expected to remain strong, the latter supported by a gradual rise in real wages as inflation eases and labor shortages persist." - Inflation path: - "Inflation is expected to moderate further in 2026 before converging to the BOJ’s target in 2027." - Core inflation expected to remain more persistent in 2026–27 than previously anticipated. - Risk assessment: - "Risks to the outlook and inflation are broadly balanced." - Selected risks from the Risk Assessment Matrix with likelihood and policy actions: - Geopolitical Tensions — Likelihood: High; Expected Impact: High. Policy: enhance supply chain resilience; BOJ monitor inflationary pressures. - Escalating Protectionism and Trade Disruptions — Likelihood: High; Expected Impact: High. Policy: pursue supply chain resilience and monitor effects on inflation and activity. - Commodity price volatility — Likelihood: High; Expected Impact: Medium. Policy: targeted mitigation for vulnerable groups. - Disorderly AI Correction — Likelihood: High; Expected Impact: High. Policy: strengthen macroprudential buffers; BOJ adjust policy as needed. - Fiscal Vulnerabilities and Higher Interest Rates — Likelihood: High; Expected Impact: High. Policy: advance credible medium-term fiscal consolidation. ### Recent Economic Developments — Key Findings and Key Statistics - Growth and output: - After prolonged low inflation, prices "were growing faster than the BOJ’s 2-percent target for more than three and a half years, before declining to 1.5 percent in January." - Output contraction of 0.2 percent in 2024 due to 2024H1 supply disruptions; growth firmed in 2025H2 and rebounded in 2025H1. - Growth reached 1.1 percent in 2025 (noting Q3 contraction and modest Q4 rebound). - Trade and external developments: - July 2025 US bilateral agreement: capped most US tariffs on Japanese exports at "a flat 15 percent"; included "a substantial Japanese investment pledge of up to $550 billion in key US sectors such as energy, semiconductors, and pharmaceuticals." - Recent tensions with China: "weaker Chinese tourist arrivals, de facto moratorium on exports of seafood to Japan’s largest trade partner," and February 2026 "freezing of the flow of dual use materials to 20 Japanese companies, with another 20 companies put on a watch list." - Exports: "Over the past five years, Japan’s goods exports have maintained around 4 percent global market share." - Current account surplus: 4.8 percent of GDP in 2025 (up from 4.5 percent in 2024). - Net foreign assets: $3.7 trillion as of 2025Q3. - Labor market: - Unemployment: "The unemployment rate has hovered around 2.5 percent." - Labor force participation: "has continued to rise to almost 65 percent (ages 15 and over)." - Foreign workers: "rose by 11.7 percent y/y through October 2025, though they still represent only 3.7 percent of the labor force." - Working-age population decline: "working age population (aged 15-64) peaked in 1995 and has been shrinking by approximately 0.6 percent per year since." - Wages: "scheduled earnings growing just above 2 percent in 2025"; "the average minimum hourly wage rising 6.3 percent from a year earlier." - Inflation: - Headline inflation: "averaged 3.2 percent (y/y) in 2025"; "Headline inflation moderated to 1.5 percent y/y in January 2026." - Food price inflation contributed roughly 1.8 percentage points to headline inflation in 2025; "rice prices rose by more than 100 percent in mid-2025." - Services inflation excluding imputed rents around 2 percent. - Fiscal outcomes: - Primary deficit narrowed to 1.6 percent of GDP in 2024 and estimated to have declined to 0.9 percent of GDP in 2025. - Non-interest revenue strengthened by +2.3 percent of GDP relative to the pre-pandemic average; non-interest expenditure increased by +0.9 percent. - Gross debt ratio declined from 229 percent of GDP at the pandemic height to an estimated 207 percent of GDP as of 2025Q3. - December 2025 measures: extended electricity and gas subsidies (0.1 percent of GDP); increase in basic income tax exemption (0.2 percent of GDP); abolition of provisional gasoline tax rate (0.2 percent of GDP). - Monetary policy normalization and BOJ balance sheet: - Policy rate: "currently 0.75 percent." - BOJ JGB holdings fell from 91 percent of GDP in June 2024 to about 80 percent of GDP in January 2026. - BOJ reduced gross JGB purchases from 3.3 trillion yen per month in December 2025 to 2.1 trillion yen per month by March 2027. - Annual ETF and J-REIT unwind paces: "330 billion yen and 5 billion yen (based on book value), respectively." - BOJ balance sheet reduction path: average pace rises from around 7 percent of GDP in 2025 to close to 9 percent of GDP in 2026; by March 2027 BOJ’s JGB holdings cumulatively decline by around 22 percent of GDP to reach 69 percent of GDP. - Financial conditions and markets: - Equity performance in 2025: "TOPIX up about 23 percent and the Nikkei 225 up 27 percent." - 10-year JGB yield increased by around 100 bps in 2025 to reach 2.1 percent by year-end; peaked at 2.3 percent in January 2026 before retracing. - BOJ ETF and J-REIT holdings constitute around 5 percent and 0.1 percent, respectively, of BOJ total assets in book value. ### JGB Market Linkages, Spillovers, and Exchange Rate Dynamics - JGB market linkages: - Japan’s open capital account, large outstanding government debt, and sizable NIIP create interlinkages with global markets. - Foreign investors play a growing role; staff analysis finds BOJ unconventional policy shocks affecting JGB yields have transmitted to global sovereign yields. - Yen dynamics: - From early 2025 through end-June 2025, yen-dollar appreciated by as much as 9 percent. - Since mid-2025 the yen has steadily depreciated despite the 10-year yield differential narrowing by over 100 bps. - REER at end-2025 was 3.2 percent below its 2024 average and roughly 25 percent below its 2021 average. - Staff analysis: a large portion of yen movements since mid-2025 unexplained by fundamentals; co-moved with positions in the yen futures market. - Authorities (MOF) expressed concern about one-sided and rapid yen depreciation and emphasized decoupling from the narrowing US–Japan yield differential. - External position: - On preliminary basis, Japan’s external position in 2025 assessed as broadly in line with medium-term fundamentals and desired policies. - Current account surplus: 4.8 percent of GDP in 2025. ### Monetary and FX Policy Guidance - Policy normalization: - "BOJ is appropriately withdrawing monetary accommodation; gradual hikes should continue to move the policy rate toward neutral." - Staff’s updated estimate for the neutral nominal rate lies between 1.1 to 2.2 percent (subject to significant uncertainty). - Policy rate expected to reach a neutral stance in 2027 under the baseline. - Flexible, data-dependent approach recommended: - If external shocks weaken activity or global conditions tighten, a slower pace of rate increases could be appropriate. - If inflation surprises on the upside, faster withdrawal of accommodation may be needed. - BOJ independence, credibility, and clear communication are important to avoid sudden repricing and mitigate spillovers. - Exchange rate policy: - Authorities committed to a flexible exchange rate regime. - FX intervention (FXI) should be limited to exceptional circumstances (sharp currency fluctuations due to unhedged exposures, shallow markets, or risk of de-anchoring inflation expectations). ### Fiscal Outlook, Sustainability, and Recommended Adjustments - Near-term fiscal stance and projections: - Fiscal stance expected to turn expansionary in 2026. - Primary deficit expected to rise from 0.9 percent in 2025 to 1.5 percent in 2026 (reflecting a larger December 2025 supplementary budget exceeding 2024 supplementary budget by roughly 1 percent of GDP). - Debt and interest projections: - Nominal growth exceeding effective interest rate helps reduce public debt-to-GDP ratio to 203 percent in 2026 and 193 percent in 2031 under baseline paths presented. - Interest payments projected to rise by about 0.3 percent of GDP per year as debt is rolled over at higher yields. - Interest expenditure: from 1.5 percent of GDP in 2025, projected to double by 2031 and exceed 4 percent of GDP by 2036. - Public expenditure on health and long-term care projected to increase by roughly 1.6 percent of GDP between 2025 and 2040 (government responsible for about 40 percent of this spending). - These pressures will worsen the overall deficit by about 0.4 percent of GDP each year on average over the next decade. - Gross debt will remain elevated—exceeding 190 percent of GDP—and is expected to rise starting in 2035. - Baseline debt projections (selected percent of GDP series): - Public debt: 214.5 (2024); 206.8 (2025); 202.9 (2026); 199.6 (2027); 197.2 (2028); 195.5 (2029); 194.0 (2030); 193.1 (2031); 192.2 (2032); 191.6 (2033); 191.5 (2034). - Primary deficit: 1.6 (2024); 0.9 (2025); 1.5 (2026); 1.7 (2027); 1.9 (2028); 2.0 (2029); 2.2 (2030); 2.3 (2031); 2.5 (2032); 2.7 (2033); 2.8 (2034). - Real GDP growth (memo): -0.2 (2024); 1.1 (2025); 0.8 (2026); 0.6 (2027) … 0.6 (through 2034). - Effective interest rate (percent, memo): 0.7 (2024); 0.7 (2025); 0.8 (2026); 1.0 (2027); 1.2 (2028); 1.4 (2029); 1.5 (2030); 1.7 (2031); 1.8 (2032); 1.9 (2033); 2.0 (2034). - Staff fiscal adjustment recommendation (growth-friendly): - Fiscal adjustment of +0.2 percent of GDP relative to the baseline each year in 2026 and 2027, and +0.3 percent of GDP each year from 2028 onwards. - Under this recommended adjustment, public debt projected to decline to about 176 percent of GDP by 2035, compared to 192 percent of GDP in the baseline. - Revenue mobilization options: - Finalize tax measures to offset higher defense and green transformation spending. - Avoid reducing the consumption tax. - Scope to unify and eventually increase the consumption tax rate; unifying the reduced rate and increasing consumption tax to 15 percent could yield up to 2½ percent of GDP in additional revenues (with targeted transfers). - Additional measures: strengthen financial income taxation for high-income earners; lower exemptions and broaden property tax valuation; streamline pension and employment income deductions while eliminating spouse exemption. - Expenditure rationalization: - Eliminate poorly targeted subsidies including energy subsidies. - Healthcare reforms to contain costs while preserving quality. - Pension reforms such as gradually increasing eligibility age in line with rising life expectancy. - Shift spending composition toward pro-growth investment in education, skills, and innovation. - Medium-term fiscal framework design: - Include a clearly defined fiscal anchor; link annual budgets to medium-term planning; restrict supplementary budgets to large, unexpected shocks; enhance transparency with regular strategy reports and independent evaluation. - Authorities’ stated views: - Cabinet Office projects the primary balance broadly balanced in FY2026 and expects a primary surplus in FY2027. - Authorities considering a two-year suspension of the consumption tax on food and beverages with financing that prevents additional JGB issuance, followed by refundable tax credits. ### Financial Sector Resilience, Market Functioning, and Macroprudential Priorities - Systemic assessment: - "Japan’s financial system remains broadly resilient and systemic risk has not materially changed from the 2025 Article IV consultation, though its sources have shifted." - Major banks: total capital adequacy ratio rose to 17.1 percent as of March 2025 (from 16.5 percent a year earlier). - Domestically active regional banks: total capital adequacy ratio 10.2 percent. - Insurance: well capitalized and profitable; policy surrenders around 6 percent. - Vulnerabilities and stress testing: - Staff stress-test analysis: systemwide CET ratios remain in aggregate above regulatory requirements under a severe "stagflationary" scenario (October 2025 GFSR Global Stress Test), though variation exists across institutions. - Structural vulnerabilities from 2024 FSAP: sizable mark-to-market securities across bank and insurer balance sheets; FX and cross-currency funding exposures; pockets of CRE vulnerability. - Recommendations for supervision and resilience: - Increase resources to monitor regional-bank vulnerabilities. - Empower FSA to adjust capital and liquidity requirements by risk profile. - Strengthen risk-based supervision with forward-looking metrics; expand supervisory staffing; enhance on-site inspections and off-site monitoring for insurers. - Continue follow-up on 2024 FSAP recommendations. - JGB market liquidity and investor positioning: - Weak demand for super-long JGBs has steepened the yield curve. - Life insurers scaled back JGB purchases; market value of their domestic government securities holdings fell by more than 20 percent since 2022. - Foreign investors hold about 13 percent of outstanding JGBs but account for 20–30 percent of trading in medium- to super-long JGBs. - Growing foreign and NBFI participation may increase retrenchment risk during stress. - BOJ and market functioning: - BOJ should closely monitor JGB and repo liquidity and funding distribution across banks and dealers. - Be prepared for exceptional targeted interventions (e.g., temporary JGB purchases) if heightened volatility undermines market liquidity; clearly communicate interventions. - Maintain flexibility to rebalance JGB issuance toward shorter maturities if long-end demand weakens. - Financial safety net and resolution: - Continue expanding ELA eligibility to systemically important NBFIs. - Gradually broaden RRP framework to all banks that could be systemic at point of failure; support with clearer guidance. ### JPY-denominated Stablecoins, Fintech, and AML/CFT Implications - Payment Services Act amendments in June 2022 and June 2025 established a regulatory framework for stablecoins. - Permitted issuers: banks, trust companies, trust banks, and licensed money transfer providers. - Regulatory features: strict reserve, segregation, and redemption requirements. - Market developments: - First JPY-denominated stablecoin issued October 2025 by a Japanese fintech. - A consortium of large banks plans a pilot rollout in 2026. - Risks and supervision: - If stablecoins scale and are issued within fractional-reserve systems, liquidity risks could emerge if redeemable liabilities are backed by newly created bank credit. - Cross-jurisdictional fragmentation and blockchain features may heighten ML/TF risks. - Foreign-issued stablecoins allowed under strict conditions that place primary redemption responsibility on local intermediaries. - Recommendation: FSA should strengthen risk-based AML/CFT supervision and ensure proportionate, dissuasive sanctions. ### Structural Reforms to Boost Growth, Labor Market, and Wages - Wage and productivity context: - From 2022 to 2025, real wages (deflated by the CPI basket) fell by 6 percent. - Since 1996, gap between productivity and wages widened the most in Japan among G7 economies; labor productivity up about 35 percent since 1996. - Policy recommendations to support sustained real wage gains: - Increase labor market flexibility to raise worker mobility; shift from lifetime employment toward job-based employment and merit-based pay. - Support active labor market policies for mobility and AI-related displacement (subsidized training, reskilling). - Remove distortions limiting labor supply for women and seniors (e.g., eliminate income/ hours thresholds that create cliff effects; redesign Health Insurance and Employee Pension Insurance eligibility). - Continue work-style reforms (teleworking, expansion of childcare). - Industrial policy and trade: - IP stepped up since FY2021; FY2025 largest IP expenditure 1.2 trillion yen (0.2 percent of GDP) on clean energy and related industries. - Spending on AI and semiconductors: 0.6 trillion yen (0.1 percent of GDP), about half pooled as state funds. - Recommendation: time-bound IPs with sunset clauses and cost-benefit analysis; narrowly targeted to minimize distortions. - Pursue deeper integration through trade agreements and multilateral cooperation; use security-related trade measures judiciously. ### Boxes and Scenario Summaries - Box 2 — Neutral Interest Rate Estimates: - Nominal neutral rate precision-weighted average lies between 1.1 and 2.2 percent as of 2025Q2. - Nakano, Sugioka, and Yamamoto (2024) survey finds real neutral rate range between -1 percent and 0.5 percent. - Implications: low neutral rate limits conventional easing scope; lowers debt-servicing costs if not driven by lower growth. - Box 3 — Adverse Scenario (concluded): - Key headline indicators (selected): - Nominal GDP: US$ 4,190 Billion (2024) - GDP per capita: US$ 33,820 (2024) - Population: 124 Million (2024) - Real GDP growth (selected): 2024: -0.2; 2025: 1.1; 2026: 0.8; 2027–2031: 0.6 each year. - Selected monetary indicators (Table 1): overnight call rate (end-of-period) 2026: 1.2; 10-year JGB yield (end-of-period) 2026: 2.3. - Current account balance (percent of GDP) series: 2025: 4.8; 2026: 4.6; 2027: 4.5; projection moderates over time. ### Advised Policy Priorities (Consolidated) - Monetary policy: - Continue gradual withdrawal of accommodation toward neutral using a flexible, data-dependent approach. - Maintain clear communication of policy response function to avoid disorderly repricing and mitigate spillovers. - FX policy: - Maintain exchange rate flexibility; limit FXI to exceptional circumstances. - Fiscal policy: - Near-term fiscal policy should refrain from further loosening to preserve fiscal consolidation gains. - Avoid reducing the consumption tax as untargeted measure; support for vulnerable households and firms should be budget neutral, temporary, and targeted. - If a temporary consumption tax suspension on food and beverages is adopted, limit to essential goods, ensure temporariness, and secure financing to avoid additional JGB issuance. - Consider well-designed refundable tax credits as better-targeted support for vulnerable households. - Preserve fiscal buffers to retain capacity to respond to shocks and contribute to stable JGB market conditions. - Financial sector and market functioning: - Strengthen systemic risk monitoring, the macroprudential framework, the financial safety net, and oversight of the financial sector. - Close data gaps on FX derivative positions and investment activities of leveraged foreign investors. - Safeguard JGB market functioning via monitoring liquidity indicators, preparedness for targeted interventions, and consultation on issuance maturity profile. - Structural reforms: - Labor market reforms to translate tightness into sustained real wage gains: increase mobility, reskilling, eliminate cliff effects, expand childcare, and flexible work arrangements. - Time-bound, narrowly targeted industrial policies with rigorous evaluation. *This report reflects data available as of March 2, 2026. Source: 1jpnea2026001.* ### 0.8 percent due to weaker external demand. Private investment and consumption are ### 1jpnea2026001 - 0.8 percent due to weaker external demand. Private investment and consumption are ### Outlook and Risks - Growth projection: "0.8 percent due to weaker external demand." - Private demand: "Private investment and consumption are expected to remain strong, the latter supported by a gradual rise in real wages as inflation eases and labor shortages persist." - Inflation path: "Inflation is expected to moderate further in 2026 before converging to the BOJ’s target in 2027." - Risk assessment: "Risks to the outlook and inflation are broadly balanced." ### Policy lines and Recommendations - Fiscal policy: - "With the output gap positive, fiscal and monetary policies should be calibrated to sustain price and output stability, while rebuilding fiscal buffers." - "Recent fiscal performance has exceeded expectations, but the deficit is expected to widen in 2026 and spending on interest and health and long-term care for the aging population will continue to rise, eventually leading to an increase in the debt-to-GDP ratio from 2035." - Recommendation: "Fiscal prudence is needed, including a plan to keep debt-to-GDP on a firmly downward path." - Monetary policy: - "Monetary policy accommodation is appropriately being withdrawn, and gradual hikes should continue to move the policy rate toward a neutral setting." - Financial sector: - "Japan’s financial system remains broadly resilient and systemic risk has not materially changed from the 2025 Article IV consultation, though its sources have shifted." - Recommendation: "Continued follow-up on implementation of key recommendations from the 2024 FSAP would help strengthen resilience." - Labor market reforms: - "Reforms to the labor market are needed to ensure that labor market tightness translates into sustained real wage gains." ### Recent Economic Developments — Key Findings - Growth and output: - "After three decades of near-zero inflation, prices were growing faster than the BOJ’s 2-percent target for more than three and a half years, before declining to 1.5 percent in January." - "Temporary supply disruptions in 2024H1 led to an output contraction of 0.2 percent in 2024, but growth firmed in the second half and rebounded in 2025H1." - "Following a contraction in Q3 and a modest rebound in Q4, growth reached 1.1 percent in 2025." - Trade and external developments: - July 2025 bilateral agreement with the United States: capped most US tariffs on Japanese exports at "a flat 15 percent"; included "a substantial Japanese investment pledge of up to $550 billion in key US sectors such as energy, semiconductors, and pharmaceuticals." - Recent tensions with China: "weaker Chinese tourist arrivals, de facto moratorium on exports of seafood to Japan’s largest trade partner," and in February 2026 "freezing of the flow of dual use materials to 20 Japanese companies, with another 20 companies put on a watch list." - Exports: "Over the past five years, Japan’s goods exports have maintained around 4 percent global market share." - Labor market: - Unemployment: "The unemployment rate has hovered around 2.5 percent." - Labor force participation: "has continued to rise to almost 65 percent (ages 15 and over)." - Foreign workers: "rose by 11.7 percent y/y through October 2025, though they still represent only 3.7 percent of the labor force." - Working-age population decline: "working age population (aged 15-64) peaked in 1995 and has been shrinking by approximately 0.6 percent per year since." - Wage developments: "scheduled earnings growing just above 2 percent in 2025" and "the average minimum hourly wage rising 6.3 percent from a year earlier." - Inflation: - Headline inflation: "averaged 3.2 percent (y/y) in 2025" and "Headline inflation moderated to 1.5 percent y/y in January 2026." - Food contribution: "food price inflation accounted for more than half of headline inflation in 2025, contributing roughly 1.8 percentage points to headline inflation." - Rice prices: "rose by more than 100 percent in mid-2025." - Services inflation: "services inflation excluding imputed rents has firmed around 2 percent." - Fiscal outcomes: - Primary deficit: "narrowed to 1.6 percent of GDP in 2024 and is estimated to have declined to 0.9 percent of GDP in 2025." - Revenue and expenditure changes: "strengthening of non-interest revenue (+2.3 percent of GDP relative to the pre-pandemic average) that outpaced the increase in non-interest expenditure (+0.9 percent)." - Gross debt ratio: "steady decline in Japan’s gross debt ratio—from 229 percent of GDP at the height of the pandemic to an estimated 207 percent of GDP as of 2025Q3." - December 2025 measures: supplementary budget included "extended electricity and gas subsidies (0.1 percent of GDP)"; tax measures included "an increase in basic income tax exemption (0.2 percent of GDP), and the abolition of the provisional gasoline tax rate (0.2 percent of GDP)." - Monetary policy normalization: - Policy rate: "currently 0.75 percent." - BOJ balance sheet: holdings of JGBs "fallen from 91 percent of GDP in June 2024 to about 80 percent of GDP in January 2026." - BOJ asset unwind: reduced gross JGB purchases "from 3.3 trillion yen per month in December 2025 to 2.1 trillion yen per month by March 2027." - ETF and J-REIT unwind paces: annual paces of "330 billion yen and 5 billion yen (based on book value), respectively." - Financial conditions and markets: - Equity performance: "TOPIX up about 23 percent and the Nikkei 225 up 27 percent" in 2025. - JGB yields: "The 10-year JGB yield increased by around 100 bps in 2025 to reach 2.1 percent by year-end, ... peaked at 2.3 percent in January 2026 before retracing." - BOJ holdings as share of assets: ETF and J-REIT holdings "constitute around 5 percent and 0.1 percent, respectively, of BOJ total assets in book value." ### Fiscal Sustainability and Structural Issues - Long-run pressures: - Aging costs: "spending on interest and health and long-term care for the aging population will continue to rise, eventually leading to an increase in the debt-to-GDP ratio from 2035." - Recommendations: - "A plan to keep debt-to-GDP on a firmly downward path." - Maintain fiscal prudence while rebuilding buffers. ### Financial Sector Resilience - Systemic assessment: - "Japan’s financial system remains broadly resilient and systemic risk has not materially changed from the 2025 Article IV consultation, though its sources have shifted." - Policy follow-up: - "Continued follow-up on implementation of key recommendations from the 2024 FSAP would help strengthen resilience." *This report reflects data available as of March 2, 2026.* ### 15. Developments in the JGB market can potentially spill over to global financial markets. ### 15. Developments in the JGB market can potentially spill over to global financial markets. ### JGB market linkages and spillovers - Japan’s open capital account, large stock of outstanding government debt securities, and sizable net international investment position create interlinkages with global financial markets. - Foreign investors—including mutual funds and hedge funds—have been playing a growing role in the Japanese bond market, providing channels for JGB market conditions to spill over to markets abroad. - Staff analysis finds that BOJ unconventional policy shocks affecting JGB yields have transmitted to global sovereign yields, with estimated spillovers strongest to markets where Japanese investors have larger participation. ### Yen and exchange rate dynamics - From early 2025 through end-June 2025, the yen-dollar exchange rate appreciated by as much as 9 percent. - Since mid-2025 the yen has steadily depreciated despite the 10-year yield differential narrowing by over 100 bps to its lowest level since early 2022. - Staff analysis: a large portion of yen movements since mid-2025 cannot be accounted for by yield differentials or fundamentals (global risk aversion, oil price); the unexplained component co-moved with observed positions in the yen futures market. - The REER at end-2025 was 3.2 percent below its 2024 average and roughly 25 percent below its 2021 average. - Authorities (MOF) expressed concern about one-sided and rapid yen depreciation and emphasized decoupling from the narrowing US–Japan yield differential. ### External position and current account - On a preliminary basis, Japan’s external position in 2025 is assessed as broadly in line with the level implied by medium-term fundamentals and desired policies. - Current account surplus: 4.8 percent of GDP in 2025 (up from 4.5 percent in 2024). - Net foreign assets: $3.7 trillion as of 2025Q3. - Drivers: income balance surplus from large stock of net foreign assets; small trade deficit offset. - Japan’s commitment to invest $550 billion in the US economy is expected to boost outward investment in the United States. ### Outlook (growth, inflation, and balance) - Growth projections: - 2026 growth projected at 0.8 percent. - Medium-term potential growth: 0.6 percent. - Positive output gap in 2025–2026, projected to close gradually by end-2027. - Inflation projections: - Inflation expected to continue moderating in 2026 and converge to the BOJ’s target in 2027. - Core inflation expected to remain more persistent in 2026–27 than previously anticipated. - Tight labor market should support strong nominal wage growth exceeding headline inflation as it converges to target. - Current account outlook: - Surplus expected to remain strong in 2026, driven primarily by income balance on net foreign assets. - Rate of return on external assets expected to normalize over the medium term. ### Fiscal outlook, risks, and key fiscal figures - Near-term fiscal stance: - Fiscal stance expected to turn expansionary in 2026. - Primary deficit expected to rise from 0.9 percent in 2025 to 1.5 percent in 2026 (reflecting a larger supplementary budget approved in December 2025, exceeding the 2024 supplementary budget by roughly 1 percent of GDP). - Debt and interest projections: - Nominal growth exceeding the effective interest rate will help reduce the public debt-to-GDP ratio to 203 percent in 2026 and 193 percent in 2031. - Overall risk of sovereign debt distress assessed as moderate, supported by favorable maturity structure (average residual maturity of 9.5 years), deep domestic investor base, yen’s reserve currency status, and large stock of public sector financial assets. - Medium-to-long-term spending pressures: - Interest payments projected to rise by about 0.3 percent of GDP per year as debt is rolled over at higher yields. - From 1.5 percent of GDP in 2025, interest expenditure is projected to double by 2031 and exceed 4 percent of GDP by 2036. - Public expenditure on health and long-term care projected to increase by roughly 1.6 percent of GDP between 2025 and 2040 (government responsible for about 40 percent of this spending). - These pressures will worsen the overall deficit by about 0.4 percent of GDP each year on average over the next decade. - Gross debt will remain elevated—exceeding 190 percent of GDP—and is expected to rise starting in 2035. ### Monetary and FX policy guidance - Policy normalization: - BOJ is appropriately withdrawing monetary accommodation; gradual hikes should continue to move the policy rate toward neutral. - Staff’s updated estimate for the neutral nominal rate lies between 1.1 to 2.2 percent (subject to significant uncertainty). - Policy rate expected to reach a neutral stance in 2027 under the baseline. - Flexible, data-dependent approach recommended: - If external shocks weaken domestic activity or global financial conditions tighten, a slower pace of rate increases could be appropriate. - If inflation surprises on the upside, a faster withdrawal of accommodation may be needed. - BOJ independence, credibility, and clear communication are important to avoid sudden repricing and mitigate spillovers. - Exchange rate policy: - Authorities remain committed to a flexible exchange rate regime. - Foreign exchange intervention (FXI) should be limited to exceptional circumstances (sharp currency fluctuations due to unhedged exposures, shallow markets, or risk of de-anchoring inflation expectations). ### BOJ balance sheet reduction and market functioning - Balance sheet reduction path: - Average pace of balance sheet reduction will increase from around 7 percent of GDP in 2025 to close to 9 percent of GDP in 2026 under the extended JGB purchasing plan. - Staff estimate the announced pace will raise term premia on JGB yields by approximately 9 bps in 2026. - By March 2027, BOJ’s JGB holdings will have cumulatively declined by around 22 percent of GDP to reach 69 percent of GDP. - Recommendations: - Pace of balance sheet adjustment strikes a balance between improved market functioning and mitigating disruption risks given BOJ’s outsized market participation. - BOJ should be ready to modify pace and maturity profile of purchases if financial conditions become inconsistent with desired monetary policy stance, and should articulate approach for the long-run size and composition of its balance sheet to guide market expectations. ### Policy recommendations and priorities - Monetary policy: - Continue gradual withdrawal of accommodation toward neutral, using a flexible, data-dependent approach. - Maintain clear communication of policy response function to avoid disorderly repricing and mitigate spillovers. - FX policy: - Maintain exchange rate flexibility; limit FXI to exceptional circumstances. - Fiscal policy: - Near-term fiscal policy should refrain from further loosening to preserve fiscal consolidation gains. - Avoid reducing the consumption tax as an untargeted measure that would erode fiscal space. - Support for vulnerable households and firms should be budget neutral, temporary, and targeted. - If a temporary consumption tax suspension on food and beverages is adopted, limit it to essential goods, ensure temporariness, and secure financing to avoid additional JGB issuance. - Consider well-designed refundable tax credits as better-targeted support for vulnerable households. - Preserve fiscal buffers to retain capacity to respond to shocks and contribute to stable JGB market conditions. *Source: 1jpnea2026001 - 15. Developments in the JGB market can potentially spill over to global financial markets.* ### 34. Growth-friendly fiscal adjustments, underpinned by a robust medium-term ### Growth-friendly fiscal adjustments, underpinned by a robust medium-term framework ### Fiscal adjustment and debt outlook - Staff recommend a fiscal adjustment amounting to +0.2 percent of GDP relative to the baseline each year in 2026 and 2027, and +0.3 percent of GDP each year from 2028 onwards. - Under the recommended adjustment, public debt is projected to decline to about 176 percent of GDP by 2035, compared to 192 percent of GDP in the baseline. - Purpose: offset spending pressures, rebuild fiscal buffers, and keep debt on a firm downward path. ### Revenue mobilization (recommendations and scope) - Tax measures to offset higher defense and green transformation spending should be finalized and implemented swiftly. - Authorities should avoid reducing the consumption tax, as this would weaken the revenue base. - There is scope to unify and eventually increase the consumption tax rate, given that Japan’s consumption tax revenue is among the lowest in G7 countries. - Additional revenue measures could include: - strengthening financial income taxation for high-income earners; - lowering exemptions and broadening the taxable valuation base under the property tax; - streamlining pension and employment income deduction while eliminating exemption for spouses. - Footnote findings referenced: - Unifying the reduced consumption tax rate and increasing the consumption tax rate to 15 percent could yield up to 2½ percent of GDP in additional revenues (with targeted transfers to offset impacts on liquidity-constrained households). ### Expenditure rationalization and efficiency - Current spending remains elevated compared to pre-pandemic levels; need to eliminate poorly targeted subsidies, including energy subsidies. - Social benefit spending—accounting for more than half of total expenditure—is projected to rise further as the population ages. - Scope to enhance efficiency through: - healthcare reforms that contain costs while preserving quality; - pension reforms such as gradually increasing the eligibility age in line with rising life expectancy. - Spending composition should shift toward high-quality, pro-growth investment in education, skills development, and innovation (¶50) to mitigate the growth impact of the recommended fiscal adjustment. - Improving the quality of public investment and strengthening human-capital spending would support long-term growth potential and fiscal sustainability. ### Medium-term fiscal framework (design and resilience) - A credible medium-term fiscal framework should: - include a clearly defined fiscal anchor; - establish a strong link between annual budgets and medium-term planning; - restrict supplementary budgets to large, unexpected shocks that overwhelm automatic stabilizers; - enhance fiscal transparency through regular strategy reports and independent evaluation. - Framework resilience: - Should be robust to adverse scenarios related to fertility, health-care costs, pensions, and macroeconomic shocks. - Long-term fiscal projections should be systematically integrated into annual budget decisions, medium-term adjustment paths, and contingency plans. ### Subnational finances, state funds, and targeting of transfers - Strengthening public expenditure efficiency at the subnational level remains a priority because local governments account for a large share of general government spending. - Governance weaknesses in state funds: - Many funds operate outside regular budgetary controls, can be carried forward without review, and roughly one-third lack explicit termination points. - Recommendation: establish clear exit plans and stronger oversight to enhance accountability and align fund use with fiscal priorities. - Targeting of transfers: - Expansion of the “My Number” digital ID system has strengthened the foundation for targeted support, but limited data sharing across agencies impairs delivery. - International experience suggests integrating tax, social security, and administrative data, enabling automatic eligibility verification, and developing unified beneficiary registries to improve accuracy and reduce leakages. - Linking “My Number” more systematically to public-service delivery—supported by harmonized local IT systems—would allow targeted transfers to be deployed quickly and efficiently in response to shocks. ### Authorities’ views (key points) - Cabinet Office’s latest outlook projects the primary balance to be broadly balanced in FY2026. - Authorities note this would correspond to the smallest deficit since 2001 (when the government adopted the primary balance target) and expect a primary surplus in FY2027. - Authorities are discussing a two-year suspension of the consumption tax on food and beverages, along with financing that would prevent additional JGB issuance, followed by introduction of a system of refundable tax credits. - Fiscal framework review underway to strengthen credibility and predictability, reduce reliance on routine supplementary budgets, and improve multi-year expenditure planning while preserving flexibility to respond to shocks and support growth-enhancing investment. ### Financial sector resilience and vulnerabilities - Banking and insurance sectors remain broadly resilient with robust capital and liquidity positions. - Major banks: total capital adequacy ratio rose to 17.1 percent as of March 2025 (from 16.5 percent a year earlier). - Domestically active regional banks: total capital adequacy ratio was 10.2 percent. - Staff stress-test analysis: systemwide Common Equity Tier ratios remain in aggregate above regulatory requirements under a severe “stagflationary” scenario (October 2025 GFSR Global Stress Test), though results vary across institutions. - Insurance sector: - Well capitalized and profitable; policy surrenders remain low—at around 6 percent. - Transition to the economic value-based solvency regime (ESR) increases sensitivity to interest-rate volatility and supervisory resource needs. - Structural vulnerabilities persist from the 2024 FSAP: sizable mark-to-market securities across bank and insurer balance sheets, FX and cross-currency funding exposures, and pockets of vulnerability in commercial real estate. - Recommendations for supervision: - Increase resources to monitor regional-bank vulnerabilities; - Empower FSA to adjust capital and liquidity requirements by risk profile; - Strengthen risk-based supervision with forward-looking metrics, especially for credit and liquidity risks; - Expand supervisory staffing and enhance on-site inspections and off-site monitoring for insurers. ### Real estate market vulnerabilities - Recent indicators show pockets of vulnerability in real estate markets: - CRE loans have continued to expand. - CRE capitalization rates in major cities have compressed toward historically low levels, leaving the sector more sensitive to interest-rate increases and sentiment shifts. - Loan-to-value ratios around 75 percent—among the highest in major economies—heighten sensitivity to rising borrowing costs and strong credit growth. - Recommendation: assign a formal mandate to the Council for Cooperative Financial System (CCFS) and develop a well-defined macroprudential strategy for timely assessment and calibration of sectoral measures. ### FX exposures and market risks - US dollar exposures for Japanese banks and nonbanks remain large relative to the size of local FX markets, raising potential liquidity-strain risks if global funding conditions tighten. - Hedging costs have fallen from 2022 peaks but remain high by historical standards; institutional investors have reduced hedge ratios further below estimated optimal benchmarks. - Risks from US risk-off episodes: tightened offshore funding conditions, depressed domestic equity prices, and downward pressure on corporate earnings—especially for exporters. - Recommendations: - Strengthen oversight of net open FX positions; - Improve data on derivative exposures; - Closely monitor liquidity coverage ratios by significant currency and consider minimum LCR requirements for domestic banks calibrated by significant currency. ### JGB market liquidity and investor positioning - Increased volatility in yields and shifting investor demand as the BOJ reduces the size of its balance sheet require close monitoring of JGB market liquidity and investor positioning. - Observations: - Weak demand for super-long JGBs has steepened the yield curve. - Life insurers have scaled back purchases of JGBs, with the market value of their domestic government securities holdings falling by more than 20 percent since 2022. - Foreign investors hold about 13 percent of outstanding JGBs but now account for 20–30 percent of trading in medium- to super-long JGBs, which aids market functioning but introduces sensitivity to fiscal news and global developments. - Implication: growing foreign and NBFI participation may increase retrenchment risk during periods of stress. *Source: 1jpnea2026001 - 34. Growth-friendly fiscal adjustments, underpinned by a robust medium-term framework.* ### 43. Given mounting pressures in JGB markets, safeguarding market functioning should ### 1jpnea2026001 - 43. Given mounting pressures in JGB markets, safeguarding market functioning should ### Market functioning and BOJ actions - Finding: Mounting pressures in JGB markets make safeguarding market functioning a priority. - Recommendations for BOJ: - Closely monitor JGB and repo liquidity indicators and the distribution of funding across banks and dealers. - Be prepared to make exceptional targeted interventions—such as temporary JGB purchases—if heightened volatility undermines market liquidity. - Clearly communicate any exceptional targeted interventions to avoid weakening market functioning. - Maintain flexibility to further rebalance JGB issuance toward shorter maturities if demand at the long end weakens further, supported by regular market consultation. - Recommendations for authorities and resolution frameworks: - Continue expanding emergency liquidity assistance (ELA) eligibility to systemically important NBFIs. - Gradually broaden the resolution and recovery planning (RRP) framework to all banks that could be considered systemic at the point of failure. - Support broadened RRP with clearer guidance to strengthen recovery capabilities and address impediments to resolvability. ### JPY-denominated stablecoins, regulation, and risks - Development: The Payment Services Act was amended in June 2022 and June 2025 to establish a regulatory framework for stablecoins. - Permitted issuers under the framework: banks, trust companies, trust banks, and licensed money transfer providers. - Regulatory features: strict reserve, segregation, and redemption requirements. - Market developments: - A Japanese fintech issued the first JPY-denominated stablecoin in October 2025. - A consortium of large banks plans to jointly issue another, targeting a pilot rollout in 2026. - Potential uses: Could support retail and large-value institutional transactions, including T-bill demand, as tokenized finance expands. - Risks and supervisory implications: - If stablecoins achieve significant scale and issuance occurs within a fractional-reserve system, liquidity risks could emerge—especially if redeemable liabilities are backed by newly created bank credit. - Continued supervisory vigilance is warranted as the ecosystem evolves. - Cross-jurisdictional fragmentation and blockchain features (including pseudonymity and disintermediated custody) may leave supervisory gaps and heighten ML/TF risks. - Foreign-issued stablecoins are allowed under strict conditions that place primary redemption responsibility on local intermediaries, resulting in higher balance-sheet burden. - Recommendation: The FSA should continue strengthening risk-based AML/CFT supervision by aligning oversight intensity with updated risk assessments and ensuring proportionate, dissuasive sanctions for non-compliance. ### Authorities’ views on systemic risk and financial resilience - Authorities’ assessment: - Broad concurrence that systemic risk has not materially changed. - BOJ and FSA highlighted continued resilience supported by strong capital and liquidity buffers and the positive impact of higher interest rates on bank profitability. - Credit costs remain low; recent bankruptcies are concentrated among structurally weaker and smaller firms. - Banks’ responses are heterogeneous; regional banks viewed as broadly resilient but more exposed to structural headwinds and gradual deposit pressures. - In insurance, narrowing asset–liability duration gaps ahead of the new solvency framework has helped limit solvency impact of rising interest rates while sustaining JGB demand to match long-term liabilities. - BOJ and FSA concurred on need for continued monitoring of asset valuations, vulnerabilities in parts of the real estate sector, and growing interconnectedness of foreign NBFIs with the Japanese financial system. - Implementation and progress: - Authorities reiterated commitment to advancing implementation of FSAP recommendations while maintaining reservations in certain areas consistent with views reported in the 2025 Article IV consultation. - Reported further progress in areas such as systemic risk monitoring, fintech regulation, insurance and investment funds supervision. ### Reforms to boost growth, labor market, and wages - Finding: Real wage growth remains elusive and is critical for supporting domestic consumption in staff’s baseline forecast. - Historical change: From 2022 to 2025, real wages (deflated by the CPI basket) have fallen by 6 percent. - Structural context: - Since 1996, the gap between productivity and wages has widened the most in Japan among G7 economies. - Labor productivity (output per hour worked) has increased by about 35 percent since 1996. - A falling labor share of income likely reflects strong investment in labor-saving automation and potentially limited worker bargaining power due to long-term employment contracts. - Private savings shifted from households to corporates as profits increased. - Policy recommendations to stabilize divergence and boost wages: - Increase labor market flexibility to raise worker mobility; shift from lifetime employment toward job-based employment and merit-based pay. - Support active labor market policies to help mobility and address AI-related displacement, including subsidized training programs to reskill and upskill the workforce. - Remove policy distortions that limit labor supply, particularly those affecting women and senior citizens: - Example distortion: income threshold for exemption from social security contributions leads dependent spouses to limit hours worked. - Suggestion: Eliminate thresholds in hours or income and redesign Health Insurance and Employee Pension Insurance eligibility to avoid cliff effects. - Continue work-style reforms (teleworking, expansion of childcare) to provide flexible arrangements and improve career prospects and incomes of women. - Evidence of change: Early evidence that labor mobility is starting to pick up, with job switching rising most among younger cohorts and part-time workers. ### Industrial policy, trade, and fiscal/monetary appraisal - Industrial policy (IP): - Japan stepped up IP since FY2021 to strengthen resilience of supply chains and spur innovation. - FY2025 largest expenditure: 1.2 trillion yen (0.2 percent of GDP) on clean energy and related industries. - Spending on AI and semiconductors: 0.6 trillion yen (0.1 percent of GDP), about half pooled as state funds. - Recommendation: IPs should be time-bound with clear sunset clauses and subject to thorough cost-benefit analysis; remain narrowly targeted to minimize distortions. - Trade and multilateral cooperation: - Recommendation: Pursue deeper integration through trade agreements and multilateral cooperation; use trade/investment measures for security reasons judiciously and narrowly to limit negative spillovers. - Staff appraisal and macro recommendations: - Japan’s economy shows impressive resilience; domestic demand expected to remain strong, particularly non-residential investment. - Inflation: After being high for three and a half years, inflation is moderating and expected to moderate further in 2026, falling below the BOJ’s 2-percent target, before converging back to target next year. - Output: A positive output gap is expected to close as monetary and fiscal policies become neutral in 2027. - Monetary policy: As underlying inflation converges to target, monetary accommodation is being appropriately withdrawn; policy rate should continue to rise gradually towards neutral if the baseline materializes. - Fiscal policy: Continued fiscal prudence and growth-friendly fiscal adjustment needed to meet spending pressures while preserving fiscal sustainability; debt-to-GDP ratio remains very high. - Recommendation: Fiscal restraint and a credible medium-term plan to keep the debt-to-GDP ratio on a firm downward path are crucial to preserve market confidence and stable JGB market conditions. - Financial sector: Strengthen systemic risk monitoring, the macroprudential framework, the financial safety net, and oversight of the financial sector; close data gaps on FX derivative positions and investment activities of leveraged foreign investors. - Consultation timing: It is recommended that the next Article IV consultation take place on the standard 12-month cycle. *Source: IMF staff chapter text as provided in the content unit.* ### Box 2. Neutral Interest Rate Estimates ### Box 2. Neutral Interest Rate Estimates ### Definition and estimation methods - The neutral rate of interest is defined as the real interest rate consistent with output at potential and stable inflation. - Estimates for Japan are derived using several complementary methodologies: - Holston, Laubach, and Williams (2023, HLW) - Del Negro and others (2017, DGGT) - The long-run real rate implied from Consensus Forecasts - Each approach has strengths and limitations, contributing to substantial uncertainty surrounding the level of the neutral rate. ### 2025Q2 estimates and measurement uncertainty - A precision-weighted average of the estimates suggests the nominal neutral rate lies between 1.1 and 2.2 percent as of 2025Q2. - The DGGT estimate and Consensus expectations broadly coincide, while the HLW model yields a point estimate that is substantially higher than the other two methods, with a very wide confidence band. - Japan’s prolonged period of policy rates at or near the effective lower bound subjects estimations of the neutral rate to significant uncertainty. - Given Japan’s long-run inflation expectations have only recently shown signs of re-aligning with the BOJ’s target, the nominal neutral interest rate is subject to additional uncertainty. - If inflation expectations were to fall significantly below 2 percent, the nominal neutral rate may move commensurately lower. ### Historical drivers and macroeconomic implications - Over the past three decades, Japan’s neutral rate of interest has steadily declined. - Chapter 2 of April 2023 World Economic Outlook (Platzer and Peruffo 2022) finds the downward trend in neutral rates for Japan has been driven by: - population aging, and - slower productivity growth, - with these forces having been partly offset by Japan’s large stock of public debt. - Implications of a low neutral rate: - For monetary policy: it limits the scope for conventional easing in downturns. - For fiscal policy: it lowers debt-servicing costs and helps sustain fiscal space to the extent that the decline in neutral rates is not driven by lower economic growth. - Maintaining long-term debt sustainability will require that potential growth continues to exceed the real interest rate. ### Supporting note and comparison of estimates - Nakano, Sugioka, and Yamamoto (2024) survey several estimation methods of the neutral rate for Japan and finds the real neutral rate to range between -1 percent and 0.5 percent.1 *Prepared by Ken Teoh (APD).* ### Box 3. Adverse Scenario (Concluded) ### Box 3. Adverse Scenario (Concluded) ### Recent economic developments and growth outlook - Growth since 2024 has been supported by consumption; net exports have fluctuated. - Private consumption remained firm following supply disruptions in early 2024. - Real wage growth has remained weak. - Business investment has steadily strengthened; residential investment has been weaker. - Public consumption remained relatively flat; public investment weakened. - Real exports weakened in the second half (motor vehicles, capital, and intermediate goods). - Key headline indicators (from Table 1, selected): - Nominal GDP: US$ 4,190 Billion (2024) - GDP per capita: US$ 33,820 (2024) - Population: 124 Million (2024) - Real GDP growth: 2022: 1.3; 2023: 0.7; 2024: -0.2; 2025: 1.1; 2026: 0.8; 2027: 0.6; 2028: 0.6; 2029: 0.6; 2030: 0.6; 2031: 0.6 - Domestic demand growth: 2024: -0.2; 2025: 1.3; 2026: 1.1 - Private consumption: 2024: -0.6; 2025: 1.4; 2026: 1.1 - Business investment: 2024: -0.2; 2025: 1.5; 2026: 1.1 - Output gap: 2024: 0.0; 2025: 0.3; 2026: 0.5 ### Inflation dynamics and expectations - Headline and BOJ core inflation remained above BOJ’s headline inflation target for an extended period; headline inflation dipped below target in January. - Elevated inflation was primarily boosted by high food price inflation. - In 2025, export and import prices eased before rebounding in recent months; corporate goods and services producer price indices have been rising. - Surveys of firms’ inflation expectations remain above BOJ’s headline inflation target; professional forecasters’ and market-implied expectations have gradually converged towards target. - Selected inflation figures (Table 1): - Headline CPI: 2022: 2.5; 2023: 3.2; 2024: 2.7; 2025: 3.2; 2026: 1.9; 2027: 2.1; 2028: 2.0; 2029: 2.0; 2030: 2.0 - Core CPI (ex. fresh food & energy): 2022: 1.1; 2023: 3.9; 2024: 2.4; 2025: 3.0; 2026: 2.4; 2027: 2.1; 2028: 2.0; 2029: 2.0; 2030: 2.0 ### Monetary policy, JGB yields, and credit conditions - JGB yields have continued to rise, particularly at the long-end. - The rise in yields since 2022 has been driven by higher term premia as well as higher risk-free rates. - Higher yields are transmitting to higher lending rates; growth in lending remains strong. - Firms continue to perceive bank lending as accommodative; corporate bond spreads have remained stable amid strong corporate earnings. - Since June 2024, the BOJ has steadily reduced the size of its balance sheet by slowing purchases of JGBs, accompanied by a reduction of bank reserves. - The BOJ has gradually reduced JGB holdings across maturities and begun unwinding holdings of ETFs and REITs in January 2026. - The withdrawal of monetary accommodation has contributed to a shrinking monetary base. - Selected monetary and interest-rate indicators (Table 1): - Overnight call rate, uncollateralized (end-of-period): 2024: 0.2; 2025: 0.7; 2026: 1.2; 2027: 1.5; 2028: 1.5; 2029: 1.5; 2030: 1.5 - 10-year JGB yield (end-of-period): 2022: 0.4; 2023: 0.6; 2024: 1.1; 2025: 2.1; 2026: 2.3; 2027: 2.4; 2028: 2.5; 2029: 2.6; 2030: 2.7; 2031: 2.7 - Base money (y/y percent change): 2022: -5.6; 2023: 6.4; 2024: -1.9; 2025: 2.1; 2026: 2.2; 2027: 2.3 ### Financial market developments and external funding - The yen has continued to weaken since 2022, driven by structural outflows and persistent carry-trade demand, despite narrowing interest rate differentials. - USD funding costs for Japanese institutions remain elevated amid tighter global liquidity and higher offshore dollar rates. - Net commercial yen futures contracts have moved towards a balanced position. - The April tariff shock briefly lifted the yen as a safe haven, but it weakened as financial uncertainty eased. - Equity markets have risen on strong earnings and steady foreign inflows, with gains broad-based across the Nikkei and TOPIX. - External sector highlights (Table 3, selected): - Current account balance (in billions of USD): 2022: 89.9; 2023: 156.2; 2024: 189.2; 2025: 214.2; 2026: 203.3; 2027: 205.0; 2028: 206.4; 2029: 206.6; 2030: 212.5; 2031: 214.3 - Current account balance (percent of GDP): 2022: 2.0; 2023: 3.6; 2024: 4.5; 2025: 4.8; 2026: 4.6; 2027: 4.5; 2028: 4.4; 2029: 4.3; 2030: 4.3; 2031: 4.2 - Trade balance (goods, in billions of USD): 2022: -115.8; 2023: -49.0; 2024: -24.5; 2025: -5.1; 2026: -15.8; 2027: -17.8; 2028: -19.8; 2029: -23.7; 2030: -23.8; 2031: -27.0 - Exports of goods (in billions of USD): 2024: 693.8; 2025: 720.5; 2026: 704.7 - Imports of goods (in billions of USD): 2024: 718.4; 2025: 725.5; 2026: 720.5 - Oil prices (US$/barrel): 2022: 96.4; 2023: 80.6; 2024: 79.2; 2025: 67.7; 2026: 64.7 ### Labor market and wages - Female labor force participation has increased substantially over the past decade. - Labor market tightness persists: unemployment rates near historic lows; vacancy and job opening rates elevated; continued labor shortages. - Mild uptick in regular employment driven by part-time employee increases, which has reversed; growth rate of wages stabilized in 2025. - Memorandum indicators (Table 1): - Real GDP per Capita Growth: 2022: 1.7; 2023: 1.2; 2024: 0.2; 2025: 1.6; 2026: 1.3; 2027: 1.2; 2028: 1.2; 2029: 1.2; 2030: 1.2 - Unemployment (implied context): unemployment rates hovering near historic lows (no exact series provided in source text) ### Fiscal developments and sustainability - Post-pandemic fiscal consolidation has been underpinned by strong revenues and spending restraint. - Health and long-term care spending is projected to rise due to an aging population. - Favorable r-g dynamics over the next few years lead to a decline in public debt. - BOJ’s holdings of JGBs have started to shrink following its decision to reduce asset purchases. - Relative to peers, Japan’s share of non-social security spending is low; room exists for further revenue mobilization. - General government aggregates (Table 4, selected): - Total revenue (percent of GDP): 2024: 35.6; 2025: 35.8; 2026: 35.5; 2027: 35.5 - Total expenditure (percent of GDP): 2024: 37.3; 2025: 36.9; 2026: 37.3; 2027: 37.8 - Overall balance (percent of GDP): 2024: -1.7; 2025: -1.1; 2026: -1.8; 2027: -2.3 - Primary balance (percent of GDP): 2024: -1.6; 2025: -0.9; 2026: -1.5; 2027: -1.7 - Gross public debt (percent of GDP): 2022: 227.8; 2023: 220.3; 2024: 214.5; 2025: 206.5; 2026: 203.1; 2027: 199.8; 2028: 197.3; 2029: 195.5; 2030: 194.0; 2031: 192.9 - Net public debt (percent of GDP): 2022: 159.6; 2023: 149.5; 2024: 141.7; 2025: 136.5; 2026: 133.0; 2027: 129.7 ### Financial soundness and banking sector indicators - Selected financial soundness indicators (Table 5, Q1 series): - Regulatory capital to risk-weighted assets: 2019: 17.2; 2020: 16.4; 2021: 16.6; 2022: 15.4; 2023: 14.9; 2024: 16.4; 2025: 16.7 - Regulatory tier 1 capital to risk-weighted assets: 2019: 15.1; 2020: 14.3; 2021: 14.6; 2022: 13.8; 2023: 13.4; 2024: 14.9; 2025: 15.2 - Non-performing loans (NPL) to total loans ratio: 2019: 1.1; 2020: 1.1; 2021: 1.2; 2022: 1.3; 2023: 1.2; 2024: 1.3; 2025: 1.1 - Return on assets: 2019: 0.1; 2020: -0.1; 2021: 0.1; 2022: 0.1; 2023: 0.2; 2024: 0.2; 2025: 0.2 - Return on equity: 2019: 2.3; 2020: -1.3; 2021: 3.5; 2022: 2.6; 2023: 5.8; 2024: 4.7; 2025: 6.2 - Liquid assets to total assets: 2019: 29.4; 2020: 29.5; 2021: 34.4; 2022: 35.8; 2023: 33.3; 2024: 32.5; 2025: 32.9 - Gross derivative asset to capital: 2019: 35.2; 2020: 55.8; 2021: 43.3; 2022: 57.1; 2023: 76.2; 2024: 81.1; 2025: 77.2 *Source: IMF staff calculations. This box was prepared by Parisa Kamali (APD) and Dirk Muir (RES).* ### References ### References ### Bibliographic entries - Adler, Gustavo, Cían Allen, Giovanni Ganelli, and Daniel Leigh, 2024. “An Updated Action-based Dataset of Fiscal Consolidation,” IMF Working Paper 2024/210. International Monetary Fund: Washington, DC. - Adrian, Tobias, Parma Bains, Marianne Bechara, Eugenio Cerutti, Stephanie Forte, Federico Grinberg, Alessandro Gullo, Martina Hengge, Agnija Jekabsone, Kathleen Kao, Tommaso Mancini Griffoli, Soledad Martinez Peria, Marcello Miccoli, Marco Reuter, and Nobuyasu Sugimoto, 2025. “Understanding Stablecoins,” IMF Departmental Paper 2025/009. International Monetary Fund: Washington, DC. - Ahir, Hites, Nicholas Bloom, and Davide Furceri, 2022, “The World Uncertainty Index”, NBER Working Paper 29763. doi: 10.3386/w29763 - Aruoba, Borağan, 2020. “Term Structures of Inflation Expectations and Real Interest Rates,” Journal of Business and Economic Statistics 38(3): 542-553. doi: 10.1080/07350015.2018.1529599 - Asao, Kohei, Haruki Seitani, Ara Stepanyan, and Teng Xu. “The Impact of Aging and AI on Japan's Labor Market Challenges and Opportunities,” IMF Working Paper 2025/184. International Monetary Fund: Washington, DC. - Asao, Kohei, Purva Khera, and Vasishth, 2024. “Why Such Few Women in Leadership Positions in Japan?” IMF Selected Issues Paper 2024/024. International Monetary Fund: Washington, DC. - Bird, Nicolò, and Emine Hanedar, 202 . “Expanding and Improving Social Safety Nets Through Digitalization: Conceptual Framework and Review of Country Experiences,” IMF Note 2023/007. International Monetary Fund: Washington, DC. - Carrière-Swallow, Yan, Gene Kindberg-Hanlon, and Danila Smirnov, 2025. “Macroeconomic Effects and Spillovers from Bank of Japan Unconventional Monetary Policy,” IMF Working Paper 2025/227. International Monetary Fund: Washington, DC. - Chien, ili, Wenxin Du, and Hanno Lustig, 2025. “Japan’s Debt Puzzle Sovereign Wealth Fund from Borrowed Money,” Journal of Economic Perspectives 39(4): 3-26. doi: 10.1257/jep.20251452 - Del Negro, Marco, Domenico Giannone, Marc P. Giannoni, and Andrea Tambalotti, 2017. “Safety, Liquidity, and the Natural Rate of Interest,” Brookings Papers on Economic Activity Spring: 235-316. - Evenett, Simon, Adam Jakubik, Fernando Martín, and Michele Ruta, 2024. “The Return of Industrial Policy in Data,” IMF Working Paper 2024/001. International Monetary Fund: Washington, DC. - Evenett, Simon, Adam Jakubik, Jaden Kim, Fernando Martín, Samuel Pienknagura, Michele Ruta, Sandra Baquie, Yueling Huang, and Rafael Machado Parente, 2025. “Industrial Policy Since the Great Financial Crisis,” IMF Working Paper 2025/222. International Monetary Fund: Washington, DC. - Gopinath, Gita, Pierre-Olivier Gourinchas, Andrea Presbitero, Petia Topalova, 2025. “Changing global linkages A new Cold War?” Journal of International Economics, 153: 104042. doi: 10.1016/j.jinteco.2024.104042 - Holston, Kathryn, Thomas Laubach, and John C. Williams, 2023. “Measuring the Natural Rate of Interest After Covid-19,” Staff Reports No. 1063. Federal Reserve Bank of New York: New York, NY. - Ikeda, Shuichiro, Ushio Kawano, Yoshibumi Makabe, Kohei Takata, and Tomoyuki Yagi, 2025. “Effects of Demographic Change on Labor Market and Wage Developments,” BOJ Review 2025-E-2. Bank of Japan: Tokyo. - Kashiwase, Kenichiro, Masahiro Nozaki, and Kiichi Tokuoka, 2012. “Pension Reforms in Japan,” IMF Working Paper 2012/285. International Monetary Fund: Washington, DC. - Kim, Seho, Pablo Lopez-Murphy, and Rui Xu, 2023. “Drivers of Corporate Cash Holdings in Japan,” IMF Selected Issues Paper 2023/029. International Monetary Fund: Washington, DC. - Kitao, Sagiri and Minamo Mikoshiba, 2022. “Why Women Work the Way They Do in Japan: Roles of Fiscal Policies.” RIETI Discussion Paper Series 22-E-016. - Nakano, Shogo, u Sugioka, and Hiroki amamoto, 2024. “Recent Developments in Measuring the Natural Rate of Interest.” Bank of Japan Working Paper Series No. 24-E-12. - Nozaki, Masahiro, Kenichiro Kashiwase, and Ikuo Saito, 2017. “Health spending in Japan: Macro-fiscal implications and reform options,” The Journal of the Economics of Ageing, Vol. (9), 159-171. doi: 10.1016/j.jeoa.2016.11.002 - Platzer, Josef and Marcel Peruffo, 2022. “Secular Drivers of the Natural Rate of Interest in the United States A uantitative Evaluation,” IMF Working Paper 2022/030. International Monetary Fund: Washington, DC. - Xu, Rui and Kaustubh Chahande 2023. “Structural Barriers to Wage Income Growth in Japan,” IMF Selected Issues Paper 2023/031. International Monetary Fund: Washington, DC. ### Annex I. External Sector Assessment — Overall assessment and policy priorities - Overall Assessment: - On a preliminary basis, the external position in 2025 is assessed as broadly in line with the level implied by medium-term fundamentals and desirable policies. - The final assessment will be provided in the 2026 External Sector Report. - The CA surplus increased to 4.8 percent of GDP in 2025 from 4.5 percent in 2024. - The increase reflected a largely unchanged primary income balance and a comparatively larger shrinking of the trade deficit. - The primary income surplus arises from a large positive NIIP and a high rate of return on net foreign assets. - Though Japan’s CA surplus is expected to continue over the medium term, it moderates in size, mainly driven by a reduction in its primary income surplus. - Potential Policy Responses: - Policies focused on structural reforms and fiscal sustainability are needed to maintain an external position consistent with medium-term fundamentals and desirable policies. - Shift drivers of the economy to the private sector and raise Japan’s potential growth over the medium term. - Priority: labor market policies and fiscal reforms that support robust wage growth, improve mobility of labor, and raise potential growth. - Fiscal sustainability requires a credible and specific medium-term fiscal consolidation plan. - Industrial policies should be narrowly targeted to specific objectives where externalities or market failures prevent effective market solutions and aim to minimize trade and investment distortions. - Japan’s global leadership role to promote more open, stable, and transparent trade policies in regional/multilateral trade agreements should be prioritized. ### Annex I. External Sector Assessment — Foreign asset and liability position and trajectory - Background: - On a provisional basis, Japan’s NIIP stood at 82 percent of GDP in Q3-2025, unchanged from end-2024 and sharply higher than the pre-pandemic (2016–19) average of 59 percent. - Drivers: increase in net FDI outflows and positive valuation effects from yen depreciation. - Portfolio flows: inflows in 2022 followed by outflows, before reverting to net inflows in 2025, resulting in a limited net impact on NIIP. - Japan holds one of the world’s largest stock of net foreign assets, valued at $3.7 trillion in Q3-2025. - Major global shocks that lead to sustained movements in the yen would affect income earned from Japan’s large net foreign asset position. - Assessment: - Foreign asset holdings are well diversified by geography and risk classes. - As of Q3-2025, gross foreign assets largely comprised portfolio investment accounting for about 43 percent of the total, followed by FDI with 21 percent. - Of that portfolio investment, about 19 percent was yen denominated and 60 percent was dollar denominated. - A large yen appreciation against the dollar poses the risk of negative valuation effects. - Vulnerabilities associated with liabilities are contained; equity and direct investment account for about 37 percent of gross foreign liabilities. - The NIIP is projected to generate a net annual investment income return of about 7.5 percent in 2025, larger than the pre-pandemic historical (2015–19) average of 6.3 percent. - Improved return is partly driven by the increasing share of FDI in external assets, which has a higher average return. - Japan’s large positive NIIP is partly related to asset accumulation for old-age consumption; gradual decumulation of such assets is expected over the long term. - Key statistics (Q3-2025, % GDP): - NIIP: 82 - Gross Assets: 259 - Debt Assets: 85 - Gross Liab.: 177 - Debt Liab.: 101 ### Annex I. External Sector Assessment — Current account - Background: - Japan’s CA surplus mainly reflects a large income balance owing to its large net foreign asset position. - The CA surplus increased to 4.8 percent of GDP in 2025 from 4.5 percent in 2024. - The income balance was unchanged in 2025 at 6.3 percent of GDP from 2024. - The goods trade deficit declined to -0.1 percent of GDP from -0.6 percent last year. - Front loading of both exports and imports in the first half of the year followed significant trade policy changes announced by the US starting in April. - A moderation in the post-COVID surge in imported fuel cost helped improve the trade balance. - The services balance remained broadly unchanged in 2025. - Medium-term CA balance is projected to be 4.2 percent, below current levels, partly reflecting moderation in the high return on net foreign assets. - From a savings-investment perspective, the change between 2025 and 2024 is attributable to an increase in public savings; the projected medium-term decline of the CA surplus largely reflects the expected decline in public savings. - Assessment: - 2025 cyclically adjusted CA is 4.9 percent of GDP. - Cyclically adjusted CA norm is 4.9 percent of GDP (with a range between 3.7 and 6.1 percent of GDP). - 2025 CA gap midpoint is assessed at 0 percent of GDP, with a range between −1.2 and 1.2 percent of GDP. - The EBA-identified policy gaps reflect a positive credit gap, though it has been shrinking steadily over the years. - Fiscal consolidation in 2025 relative to 2024 has closed the fiscal policy gap from last year. - The unexplained residual of the assessment potentially reflects structural impediments and country-specific factors not included in the model, such as investment bottlenecks, including entrepreneurship entry barriers and corporate savings distortions. - Key statistics (2025, % GDP): - CA: 4.8 - Cycl. Adj. CA: 4.9 - EBA Norm: 4.9 - EBA Gap: 0.0 - Staff Adjustors: 0.0 - Staff Gap: 0.0 ### Annex I. External Sector Assessment — Real exchange rate - Background: - REER appreciation that started in the second half of 2024 continued into the first half of 2025, reflecting in part the broad dollar depreciation during the first half of 2025. - This was more than offset by depreciation that followed in the second half of 2025. - Pattern reflects changes in yen’s nominal value against major currencies, diverging from trend of narrowing interest rate differentials in the second half of 2025. - Assessment: - IMF staff CA gap implies a REER gap of 0.1 percent in 2025 (with an estimated elasticity of 0.18 applied). - The EBA REER index and level models deliver gaps of −36.4 and −32.1 percent, respectively. - Consistent with the IMF staff CA gap, the REER gap is assessed to be in the range of -6.7 to 6.7 percent, with a midpoint of 0.1 percent. ### Annex I. External Sector Assessment — Capital and financial accounts: flows and policy measures - Background: - The financial account recorded net outflows in 2025, mirroring the CA surplus, and increased to 4.6 percent of GDP in 2025 from 4.0 percent in 2024. - Net FDI outflows of 3.9 percent of GDP are primarily driven by outward FDI flows to Asia, Europe, and North America. - Portfolio investment is expected to record net inflows of 2.4 percent of GDP, as opposed to net outflows of 2.2 percent in 2024. - Net inflows reflect substantial net inflow into domestic securities, with large debt inflows following the U.S. tariff announcement in April and large equity inflows after the LDP presidential election in October. - Assessment: - Vulnerabilities are limited. - Inward investment tends to be equity based, and the home bias of Japanese investors is strong. - So far, outward spillovers from Japan’s policies to financial conditions in other economies—interest rates, credit growth—are contained. ### Annex I. External Sector Assessment — FX intervention and reserves level - Background: - Reserves stood at $1.3 trillion, or about 30 percent of GDP, in Q3-2025. - This amount was little changed since end-2024. - Assessment: - The exchange rate is free floating; FX interventions have not occurred in 2025. - FX interventions should be isolated and limited to addressing disorderly market conditions. --- ### Annex II. Risk Assessment Matrix (RAM) — Overview - Note: The RAM shows events that could materially alter the baseline. Likelihood reflects staff’s subjective assessment: “low” below 0 percent , “medium” (10- 0 percent , and “high” (30-50 percent). The RAM captures staff views on the source of risks and overall concern as of the time of discussions with the authorities. - Selected risks, likelihood, expected impact, and recommended policy actions: - Geopolitical Tensions and Intensification of Conflicts - Likelihood: High - Source: External - Expected Impact: High - Recommended Policy Actions: - Continue to enhance supply chain resilience. - BOJ to carefully monitor inflationary pressures from geopolitical shocks and adjust monetary policy as needed to keep inflation expectations anchored. - Fiscal policy should cushion vulnerable households and firms when needed. - Escalating Protectionism and Trade Disruptions - Likelihood: High - Source: External - Expected Impact: High - Recommended Policy Actions: - Pursue policies to enhance supply chain resilience. - BOJ to monitor effects of weaker external demand and rising cost pressures from trade restrictions and depreciation and respond as appropriate to achieve its inflation target. - Commodity price volatility - Likelihood: High - Source: External - Expected Impact: Medium - Recommended Policy Actions: - Allow pass-through of commodity prices while mitigating the impact on the most vulnerable with targeted policies and monitoring second-round effects to ensure inflation expectations do not de-anchor. - Disorderly AI Correction - Likelihood: High - Source: External - Expected Impact: High - Recommended Policy Actions: - BOJ to adjust monetary policy in line with achieving its inflation target and strengthen macroprudential buffers to reduce stress on domestic banks. - Provide temporary and targeted support to affected financial institutions if needed, with safeguards to mitigate moral hazard. - Fiscal Vulnerabilities and Higher Interest Rates - Likelihood: High - Source: External - Expected Impact: High - Recommended Policy Actions: - Provide temporary and targeted support to affected financial institutions, with safeguards to mitigate moral hazard, while advancing credible medium-term fiscal consolidation to reduce fiscal vulnerabilities and contain upward pressure on long-term interest rates. - Cyberthreats - Likelihood: High - Source: External - Expected Impact: High - Recommended Policy Actions: - Take pre-emptive measures to prevent cyberattacks and do contingent planning to build resilience if there is an attack. - Climate Change - Likelihood: Medium - Source: External - Expected Impact: High - Recommended Policy Actions: - Strengthen climate adaptation and mitigation efforts and provide targeted relief to affected households. - Labor shortages constrain activity - Likelihood: Medium - Source: Domestic - Expected Impact: Medium - Recommended Policy Actions: - Strengthen policies to further support female labor force participation, improve visa access and promote other supportive policies for migrant workers. - Consumption recovery is not sustained - Likelihood: Medium - Source: Domestic - Expected Impact: Medium - Recommended Policy Actions: - Targeted fiscal measures and monetary easing to support domestic demand, complemented by structural reforms—such as measures to improve labor mobility and strengthen wage-setting mechanisms—to sustain real wage growth. - Bond market stress from a reassessment of sovereign risk - Likelihood: Medium - Source: Domestic - Expected Impact: High - Recommended Policy Actions: - Adopt a credible medium-term fiscal consolidation to put debt on a downward path. --- ### Annex III. Sovereign Risk and Debt Sustainability Analysis — Key findings - Public debt trajectory and risks: - Public debt is projected to gradually decline over the next decade, reflecting favorable interest-growth dynamics driven in part by higher inflation. - Over the long term, debt is projected to rise due to spending pressures from an aging population and increased debt servicing costs. - Gross financing needs are elevated, but the risks of debt distress are moderate, as rollover risks are mitigated by the large domestic investor base and the debt profile. - A credible medium-term fiscal adjustment is needed to keep public debt firmly on a downward path. - Background context: - Japan’s economy displayed resilience amid global shocks. - Headline inflation has reached levels not seen in three decades, with prices growing faster than the BOJ’s 2-percent target for more than three years. - After exceptional fiscal support for COVID-19 and spillovers from the war in Ukraine, fiscal policy has tightened, leaving the 2025 primary deficit smaller than its pre-pandemic level and among the lowest in the G7. - Elevated global interest rates, normalization of domestic monetary policy, and rising perceptions of fiscal risk pushed up sovereign borrowing costs. - 10-year JGB yields increased by about 100 basis points in 2025 to around 2.1 percent. - The yen-dollar exchange rate had generally tracked the US-Japan yield differential in recent years, but has consistently decoupled since mid-2025. - From early 2025 through the end of June, the yen-dollar exchange rate appreciated by as much as 9 percent, reflecting broad dollar depreciation across major currencies. - Since then, while other major currencies broadly held their value against the dollar, the yen steadily depreciated despite the 10-year yield differential narrowing by over 100 bps to its lowest level since early 2022. *IMF staff compilation as presented in the source content.* ### 2. Baseline. Under the baseline—which incorporates the 2025 supplementary budget and ### 2. Baseline. ### Baseline projections - The baseline incorporates the 2025 supplementary budget and assumes the continuation of the practice of supplementary budgets in subsequent years. - The primary deficit is projected to worsen in 2026 and continue deteriorating thereafter, driven mainly by age-related spending pressures and higher borrowing costs. - While near- and medium-term debt dynamics are favorable, supported by strong GDP growth and inflation at the BOJ’s 2-percent target (which generate a favorable interest-growth differential), the public debt trajectory is projected to worsen over the longer term. - Gross public debt: - 215 percent of GDP in 2024 - projected to fall to 191 percent of GDP in 2034, before rising subsequently. - Figure 4 baseline table highlights (percent of GDP unless otherwise indicated): - Public debt: 214.5 (2024); 206.8 (2025); 202.9 (2026); 199.6 (2027); 197.2 (2028); 195.5 (2029); 194.0 (2030); 193.1 (2031); 192.2 (2032); 191.6 (2033); 191.5 (2034). - Change in public debt: -5.8 (2024); -7.7 (2025); -3.9 (2026); -3.3 (2027); -2.4 (2028); -1.7 (2029); -1.5 (2030); -0.9 (2031); -1.0 (2032); -0.5 (2033); -0.2 (2034). - Primary deficit: 1.6 (2024); 0.9 (2025); 1.5 (2026); 1.7 (2027); 1.9 (2028); 2.0 (2029); 2.2 (2030); 2.3 (2031); 2.5 (2032); 2.7 (2033); 2.8 (2034). - Noninterest revenues: 34.3 (2024); 34.5 (2025); 34.1 (2026); 34.1 (2027); 34.0 (2028) … 34.0 (through 2034). - Noninterest expenditures: 35.9 (2024); 35.3 (2025); 35.7 (2026); 35.8 (2027); 35.9 (2028); 36.0 (2029); 36.1 (2030); 36.3 (2031); 36.5 (2032); 36.7 (2033); 36.8 (2034). - Automatic debt dynamics: -4.9 (2024); -7.7 (2025); -4.1 (2026); -3.6 (2027); -2.9 (2028); -2.4 (2029); -2.3 (2030); -1.8 (2031); -2.1 (2032); -1.8 (2033); -1.6 (2034). - Real interest rate and relative inflation: -5.4 (2024); -5.5 (2025); -2.4 (2026); -2.3 (2027); -1.6 (2028); -1.3 (2029); -1.1 (2030); -0.7 (2031); -1.0 (2032); -0.8 (2033); -0.5 (2034). - Real GDP growth (percent, memo): -0.2 (2024); 1.1 (2025); 0.8 (2026); 0.6 (2027); 0.6 (2028); 0.6 (2029); 0.6 (2030); 0.6 (2031); 0.6 (2032); 0.6 (2033); 0.6 (2034). - Inflation (GDP deflator; percent, memo): 3.2 (2024); 3.4 (2025); 2.0 (2026); 2.2 (2027); 2.1 (2028); 2.0 (2029); 2.1 (2030); 2.0 (2031); 2.3 (2032); 2.3 (2033); 2.3 (2034). - Nominal GDP growth (percent, memo): 3.0 (2024); 4.5 (2025); 2.9 (2026); 2.9 (2027); 2.7 (2028); 2.6 (2029); 2.7 (2030); 2.6 (2031); 2.9 (2032); 2.9 (2033); 2.9 (2034). - Effective interest rate (percent, memo): 0.7 (2024); 0.7 (2025); 0.8 (2026); 1.0 (2027); 1.2 (2028); 1.4 (2029); 1.5 (2030); 1.7 (2031); 1.8 (2032); 1.9 (2033); 2.0 (2034). - Gross financing needs: 31.8 (2024); 29.4 (2025); 39.0 (2026); 40.9 (2027); 39.1 (2028); 37.9 (2029); 40.6 (2030); 39.6 (2031); 39.9 (2032); 40.7 (2033); 40.1 (2034). - Debt service (of which): 31.6 (2024); 29.8 (2025); 38.9 (2026); 40.6 (2027); 38.6 (2028); 37.2 (2029); 39.8 (2030); 38.7 (2031); 38.8 (2032); 39.4 (2033); 38.6 (2034). ### Realism of projections - Historical outcomes point to some pessimism in staff’s projections for the primary deficit and public debt. - This pessimism is explained by: - Unwinding of exceptional support measures after the pandemic. - Sharp rise in inflation and its unexpected persistence. - Strong growth in recent years. - The recent rapid reduction of the debt-to-GDP ratio was caused by still low effective borrowing costs amid high inflation and the reduction in the post-pandemic fiscal deficit—these were exceptional circumstances of the last few years. - While the projected 3-year debt reduction marginally exceeds the maximum historical 3-year reduction in public debt, it remains less than the debt reduction achieved over the three years prior to 2025Q3 (which is not yet included in the historical assessment of the realism tool). ### Risks and mitigating factors - Risks: - High and persistent debt levels and a deteriorating primary balance hinder rebuilding fiscal buffers under the baseline. - Debt-to-GDP could rise sharply if growth slumps. - Debt-to-GDP could increase gradually but persistently if interest rates exceed staff’s projections. - Mitigating factors: - Japan’s public debt has a long average maturity, limiting pass-through from higher yields to effective interest rates. - A large domestic investor base: domestic creditors held 87 percent of public debt in 2024. - General government debt is denominated in yen—a major reserve currency—reducing rollover and currency risks. - The general government holds a large stock of financial assets: - 70 percent of GDP as of 2025Q3 (or 118 percent of GDP when equity holdings are included), bringing net debt to 137 percent of GDP and providing an additional buffer against long-term fiscal risks. - However, most general government financial assets are encumbered and managed by agencies with operational independence. - The Japanese legal framework limits the government’s ability to use these assets to finance general expenditures, particularly in the short term. ### Long-term risks and demographic pressures - Japan’s aging population will place increasing pressure on GFN and debt over the long term, particularly if healthcare costs rise faster than anticipated. - These risks remain manageable given their long horizon but underscore: - The need for credible medium-term fiscal consolidation. - The importance of structural reforms to contain age-related spending and policies to raise labor force participation. - Long-term pressures are partially mitigated by pension system assets: - Pension system assets amount to 43 percent of GDP in 2025. - Automatic adjustment of pension benefits following the 2004 pension reforms helps align benefits with demographic and economic developments and supports long-term sustainability. ### Medium-term risk assessment and stress indicators - Staff's assessment of medium-term risk of sovereign stress: moderate against a mechanical signal of moderate (the fanchart produces a mechanical signal of high due to elevated debt level at the end of the projection horizon and historically low nominal GDP growth relative to projected nominal growth rates). - Risks are mitigated by the large domestic investor base, debt profile, and Japan acting as a global reserve currency issuer. - Debt coverage and disclosures: - Debt coverage in the DSA: general government. - Subsector inclusion in the baseline: Budgetary central government (Yes); Extra budgetary funds (EBFs) (No); Social security funds (SSFs) (Yes); State governments (Yes); Local governments (Yes); Public nonfinancial corporations (No); Central bank (No); Other public financial corporations (No). - Public debt structure indicators: - The Bank of Japan’s holdings increased from 12 percent in 2012 to 45 percent in 2024. - All public debt is governed by domestic law. - Debt is mostly long term, with an average residual maturity above 9 years (residual maturity: 9.5 years, projection noted). ### Final diagnostics from staff analysis - Debt fanchart module: - Debt fanchart index (DFI): 2.2 - Fanchart width: 63.9 (percent of GDP) - Probability of debt non-stabilization: 42.2 (percent) - Terminal debt-to-GDP x institutions index: 40.0 - Risk signal: High - Gross financing needs (GFN) module: - Average baseline GFN: 37.8 (percent of GDP) - GFN financeability index (GFI): 16.2 - Risk signal: Moderate - Medium-term index: Final assessment—moderate risk. - Prob. of missed crisis, 2025-2030, if stress not predicted: 45.5 pct. - Prob. of false alarms, 2025-2030, if stress predicted: 10.2 pct. ### Key policy implications - Credible medium-term fiscal consolidation is needed to address long-term deterioration in the public debt trajectory. - Structural reforms are important to contain age-related spending and to raise labor force participation. - The constrained usability of large general government financial assets (due to encumbrance and agency management) limits short-term fiscal maneuverability and should inform policy design. *Source: IMF staff.* ### Annex IV. Progress on Past Recommendations ### Annex IV. Progress on Past Recommendations ### Fiscal policy and consolidation - Recommendation: A clear consolidation plan is needed to offset rising fiscal pressures, ensure debt sustainability, and increase fiscal space; staff recommend additional 0.2 percent of GDP fiscal consolidation in 2025 by ending energy subsidies while leveraging the FY2025 primary balance target as a fiscal anchor. - Actions taken / Status: - No comprehensive consolidation plan has been introduced. - The primary deficit is projected to have narrowed to 0.9 percent of GDP in 2025. - Improvement reflects strong revenues supported by buoyant tax collection and spending restraint. - Energy subsidies have been extended through the beginning of 2026. ### Budgetary governance - Recommendation: Reserve the use of supplementary budgets for exceptional circumstances (such as responding to large, unexpected shocks that overwhelm automatic stabilizers). - Actions taken / Status: - The government announced a supplementary budget for FY2025 that exceeds the size of last year’s supplementary budget, without adequate justification that exceptional circumstances warranted the additional outlays. ### Monetary policy - Recommendation: If the baseline inflation forecast bears out, the BOJ should continue to gradually raise the policy rate. - Actions taken / Status: - The BOJ raised the policy rate from 0.25 to 0.5 percent in January 2025; and to 0.75 percent in December 2025. - The BOJ has expressed its intention to continue gradual rate hikes if its baseline forecast materializes. ### Labor market and human capital - Recommendations and recommended measures: - Further support women’s labor force participation: expanding childcare facilities and resources, facilitating fathers’ contribution to home/childcare, and further encouraging the use of flexible working arrangements. - Leverage AI and minimize displacement: training programs on IT and AI-related skills, improving labor market mobility and reducing barriers to job changes, subsidized occupation-oriented on-the-job training programs to reskill and upskill workers. - Attract foreign workers to help alleviate labor shortages. - Actions taken / Status: - Tomoiku Project: public awareness initiative to promote dual-income families and shared parenting; FY 2025 budget allocation of JPY 130,000,000. - Support measures for re-skilling by MHLW include: - free training for the unemployed and employer-attended training; - part of tuition subsidized by the ministry when an employee completes a course; - subsidies to employers covering training expenses and part of wages for employees undertaking vocational training. ### Anti-corruption and beneficial ownership - Recommendation: Address risks of transnational aspects of corruption, implement OECD Phase 4 recommendations, and require all companies created in Japan to file necessary information with the beneficial ownership registry introduced in 2022. - Actions taken / Status: - Japan continues efforts to address those risks. - 2025 amendments to further enhance whistleblower protection from disadvantageous treatment by business operators will take effect in December 2026. - Several trainings on foreign bribery enforcement for prosecutors and police officers have been conducted. - International cooperation strengthened through various initiatives and partnerships. - The AML/CFT/CPF Action Plan sets out planned measures through the end of March 2027. - Authorities should continue to implement measures in the Action Plan to improve and increase the effectiveness of the Beneficial Ownership (BO) framework and ensure reporting entities comply with requirements to hold adequate, accurate, and up-to-date BO information. --- ### Annex V. Progress on Recommendations from 2024 FSAP ### Cross-cutting issue: staffing and skills - Recommendation: Increase staffing resources significantly and strengthen skills to enhance supervision and resolution of financial institutions and supervision of cybersecurity risks (Government, FSA; ¶66-67, ¶83). Timeline: ST - Implementation status: - FSA allocated additional resources to enhance on-site monitoring of investment funds, banking supervision, resolution processes, and cybersecurity. - Resources reallocated for a senior position in insurance supervision; further restructuring under deliberation. - FSA provides cross-cutting and comprehensive training in bank supervision, insurance company supervision, market oversight and digital activities including IT and cyber risk; initiatives are continuously updated. ### Systemic risk monitoring and macroprudential framework - Recommendation: Broaden and deepen systemic risk analysis with more forward-looking and comprehensive monitoring and stronger interagency collaboration (FSA, BOJ; ¶68-69). Timeline: C - Implementation status: - FSA expanded data collection and systemic risk analysis by incorporating external corporate and market data; publishes "FSA Analytical Notes". - FSA initiated bottom-up stress tests for major securities firms. - BOJ developed a satellite module to assess global CRE market vulnerabilities during periods of stress and improved its credit cost module using granular loan-level data from the Common Data Platform. - BOJ strengthened monitoring of NBFIs and incorporated implications into stress testing. - FSA and BOJ regularly collaborate on systemic risk analysis via the Common Data Platform launched in March 2025. - FSA and BOJ, with major banks, conducted scenario analysis for climate risk; FSA conducted climate risk scenario analysis with non-life insurers and the General Insurance Rating Organization of Japan. ### Governance of macroprudential decision-making - Recommendation: Strengthen governance by assigning a formal mandate to the CCFS (FSA, BOJ; ¶63). Timeline: ST - Implementation status: - CCFS continues to operate without a clear, formal mandate. - CCFS has been held regularly twice each year since 2014; a quarterly liaison meeting complements CCFS and results are reported semi-annually. - Semi-annual Financial Monitoring Council and periodic working-level meetings continue to strengthen cooperation in monitoring and data collection frameworks. ### Macroprudential toolkit - Recommendation: Expand the macroprudential policy toolkit with targeted borrower-based tools (FSA, BOJ; ¶64). Timeline: MT - Implementation status: - Targeted borrower-based tools (LTV, loan-to-income, debt-to-income, DSTI caps) have not been implemented. - FSA focuses on monitoring risk accumulation and addresses issues via reports, guidance, inspections, and reviews on areas such as LBO and real estate finance. - FSA and BOJ monitor risks using loan-level data from the Common Data Platform and engage closely with financial institutions. ### Banking sector regulation and supervision - Recommendation: Strengthen risk-based supervision and develop the Early Warning System with more forward-looking metrics, especially for credit and liquidity risks (FSA; ¶44). Timeline: I - Implementation status: - FSA continues efforts but no significant changes to the Early Warning System framework. - FSA encourages banks to take improvement measures through in-depth supervisory dialogues; may issue orders under Article 24 of the Banking Act if necessary. - Recommendation: Make explicit provision in the law to ensure the priority of financial safety and stability in the mandate of the FSA (Government; ¶45). Timeline: ST - Implementation status: - No changes to the FSA's mandate in law; the "JFSA’s Approaches to Prudential Supervision" Discussion Paper states interdependence of financial stability and effective intermediation. - Recommendation: Provide the FSA with power to set and adjust individual bank capital ratios above minimums in response to a bank’s risk profile (Government; ¶46). Timeline: ST - Implementation status: - FSA's Pillar 2 powers remain unchanged; no authority to set risk-based capital ratios above regulatory minimums. - FSA addresses soundness concerns through supervisory discussions and may issue orders under Articles 24 or 26 of the Banking Act if necessary. - Recommendation: Establish a minimum liquidity requirement for domestic banks (FSA; ¶47). Timeline: ST - Implementation status: - Minimum liquidity requirements have not been set. - FSA monitors individual banks' liquidity risks through the Early Warning System. ### Insurance sector regulation and supervision - Recommendation: Reform insurance supervision by establishing a comprehensive risk-based, proactive supervisory framework using regular on-site inspections and off-site monitoring (FSA; ¶50). Timeline: ST - Implementation status: - Insurance Business Act amended in May 2025 to require specified large-sized shared non-life insurance agencies to strengthen internal control systems related to solicitation. - Negotiations with HR authorities to secure additional staffing for insurance supervision are in progress. - Risk-based initiatives under consideration include revising the Early Warning System and intensifying monitoring of insurers' management systems, profitability, and specific insurance types prone to losses such as corporate fire insurance. - Recommendation: Ensure suitability requirements apply to all key persons and set explicit expectations on establishment and adequacy of all control functions (FSA; ¶50). Timeline: ST - Implementation status: - Deliberations conducted to comprehensively apply suitability requirements and establish clear expectations for control functions. - Amendments introduced suitability requirements for intermediaries to appoint compliance officers and for insurers to designate officers responsible for assessing intermediaries’ compliance. - Effective March 31, 2026, FSA plans to introduce suitability requirements for staff verifying ESR calculations and insurance liabilities, alongside independence requirements for ESR-related control functions; supervisory practices to be enhanced through off-site monitoring. - Recommendation: Delegate licensing powers to the Commissioner of the FSA and review whether government can provide increased independence to the FSA for its expenditure budget and financing (Government, FSA; ¶51). Timeline: ST - Implementation status: - No changes to the structure and powers of the FSA or inter-agency coordination. - FSA deliberated the recommendation, taking note of governmental structure. ### Cyber resilience and FMIs - Recommendation: Enhance regulatory framework and supervisory processes for cybersecurity by updating supervisory guidelines, methodologies, and tools (FSA; ¶71). Timeline: MT - Implementation status: - In 2024, FSA issued cybersecurity-related amendments to the "Comprehensive Guidelines for Supervision of Major Banks, etc." and other guidelines, and the "Guidelines on Cybersecurity for the Financial Sector"; these took immediate effect and apply to all supervised financial entities including FMIs. - FSA actions to implement a structured, risk-based approach include clarifying risk-based application, using Guidelines in off-site monitoring and on-site inspections, and conducting the Cybersecurity-Self Assessment (CSSA) questionnaire in 2025. - Draft partial amendments to strengthen authentication requirements for internet transactions and enhance fraud-prevention are under public consultation. - FSA continues to conduct the Delta Wall cybersecurity exercise; Delta Wall 2025 included a dedicated scenario for cryptoasset exchange service providers. - Recommendation: Enhance cyber supervision/oversight of FMIs (FSA, BOJ; ¶71). Timeline: ST - Implementation status: - FSA and BOJ initiated an annual supervisory review of cybersecurity posture of major FMIs; to continue regularly. - BOJ utilizing CPMI-IOSCO Cyber Guidance to assess cyber risks in overseen FMIs, including those it operates. - BOJ and FSA collaborate on annual reviews to enhance supervisory approach; BOJ enhancing overseers' expertise through cyber risk assessment training. ### Regulation and supervision of investment funds - Recommendation: Enhance onsite supervisory approach by broadening its scope to include more firms, including larger asset managers and self-regulatory organizations (SESC; ¶54). Timeline: ST - Implementation status: - SESC increased risk-based on-site supervisions focused on areas identified by off-site monitoring. - FSA established a new Asset Management Business Division for off-site monitoring, coordinating with on-site supervision. - Data collection scheme targeting large investment funds introduced and conducted annually after a pilot since FY 2023 to identify liquidity and leverage risks. - FSA and SESC increased staffing resources; senior position dedicated to supervising the asset management industry created. - Planned merger between Investment Trusts Association and Japan Investment Advisers Association includes planned on-site visits to oversee the new association. ### Regulation and supervision of fintech industry - Recommendation: Intensify monitoring of FTSPs and PPI issuers / consider reviewing regulatory framework to ensure adequate coverage of any new risks (FSA; ¶56). Timeline: I / ST - Implementation status: - June 2025 amendment to the Payment Services Act extends funds transfer requirements to cross-border receiving agent services and diversifies methods for returning users’ funds in bankruptcy. - Amendment introduces onshore asset-retention requirements for crypto-asset exchange service providers and greater flexibility in reserve assets management for stablecoins issued as trust-beneficiary rights. - FSA coordinated meetings to improve management control and risk monitoring. - Enhanced oversight and regulations under consideration for FTSPs expanding into B-to-B transactions and revisions to supervisory guidelines for stablecoin issuers. - No changes to the current coverage ratio; FSA continues to monitor PPI coverage adequacy and engage in international discussions and dialogues with major FTSPs and PPI issuers. ### Climate-related oversight - Recommendation: Develop and publicize a clear plan towards formalizing supervision of climate-related risks considering international bodies’ work (FSA; ¶73). Timeline: MT - Implementation status: - FSA established “the Office for Climate-related Financial Risk Monitoring Hub” to coordinate climate-related financial risk monitoring based on “Supervisory Guidance on Climate-related Risk Management and Client Engagement (July 2022)”. - FSA surveyed major financial institutions on risk management and client engagement and conducted further hearings; a report summarizing survey findings was published in 2025. - Further hearings ongoing with a focus on physical risks. ### Financial safety net and crisis preparedness - Recommendation: Protect the financial soundness of the BOJ to cover potential losses with additional safeguards and mitigate moral hazard from ELA operations (BOJ, MOF, FSA; ¶76). Timeline: C - Implementation status: - No changes have been made to the BOJ’s ELA framework. - Recommendation: Expand ELA eligibility to some NBFIs that could be systemically important, prioritizing CCPs (BOJ; ¶77). Timeline: MT - Implementation status: - No changes have been made to expand scope of institutions eligible to receive ELA. - Recommendation: Gradually expand RRP to all banks that could be deemed systemic at the time of failure, supported by planning guidance to improve recovery capabilities and resolvability (FSA; ¶79). Timeline: ST - Implementation status: - Authorities are considering an expansion of RRP to other systemically important banks while setting priorities among potentially in-scope banks. - Recommendation: Operationalize, codify, and regularly review/update individual and collective crisis readiness, resolution regimes, and supporting decision-making structures and information flows (All; ¶80). Timeline: C - Implementation status: - FSA conducts internal seminars where the RRP team informs BAU monitoring teams on Japan's Orderly Resolution framework and resolvability monitoring. - FSA conducts seminars among domestic resolution authorities; FSA, BOJ, and Deposit Insurance Corporation of Japan are codifying practical issues on Orderly Resolution to ensure shared understanding and institutional knowledge, focusing on timelines, home/host coordination, and actions with financial institutions. - Recommendation: Execute a multi-year interagency crisis simulations program for diverse failure scenarios, including fast-fail resolutions of systemic and midsize banks and concurrent failures (All; ¶81). Timeline: C - Implementation status: - FSA, BOJ, and Deposit Insurance Corporation of Japan focused on defining and formalizing operational roles and timelines and sharing codified outputs. - No further changes to implement multi-year interagency crisis simulations; measures to examine operational capabilities are under consideration. - Recommendation: Ensure effective recovery and resolution planning regime for insurers and CCPs consistent with international standards and guidance (FSA, Government; ¶82). Timeline: MT - Implementation status: - FSA continues to consider a resolution framework for FMIs based on existing frameworks and individual FMI risk profiles. - FSA requires five IAIGs to develop recovery plans, reflecting the new IAIG designation of one insurer in July 2024. - In response to IAIS revisions to ICP and ComFrame on recovery and resolution, FSA is advancing considerations for developing resolution plans and updating supervisory guidelines to align with international standards. *Information in this summary is drawn from the Annex IV and Annex V content provided in the source PDF.* ### Annex VI. Data Issues ### Annex VI. Data Issues ### Data adequacy and dissemination - Japan adheres to the Special Data Dissemination Standard (SDDS) Plus since April 2016 and publishes the data on its National Summary Data Page. - The latest SDDS Plus Annual Observance Report is available on the Dissemination Standards Bulletin Board (https://dsbb.imf.org/). ### Japan: Data Adequacy Assessment and data standards - Table 1. Japan: Data Adequacy Assessment for Surveillance (rating table referenced). - Table 2. Japan: Data Standards Initiatives (table referenced). - Table 3. Japan: Table of Common Indicators Required for Surveillance (table referenced). *Prepared material references SDDS Plus reporting and Cabinet Office data availability.* --- ### Annex VII. Japan’s general government balance sheet ### Key context and accounting treatment - The report revises the accounting treatment of gross debt to present general government gross debt on a consolidated basis and at face value, consistent with PSDS guidance where possible. - Consolidation nets out intra-government holdings (notably Social Security Funds’ holdings of JGBs) and measures liabilities to the rest of the economy and the world. - Face value of consolidated gross debt is used in this report due to limitations in availability of nominal value data, as reported by the Cabinet Office of Japan under SDDS Plus. ### Major findings and magnitudes (exact figures preserved) - Face value of consolidated gross debt: 207 percent of GDP as of 2025Q3. - On a market-value basis, general government financial assets amounted to about 70 percent of GDP in 2025Q3, implying net debt of roughly 137 percent of GDP in 2025Q3. - Net debt (highly liquid) measure (nets out only currency and deposits): 186 percent of GDP in 2025Q3. - A broader balance-sheet view including equity positions: general government asset holdings 118 percent of GDP on a consolidated basis as of 2025Q3, yielding general government net debt of 89 percent of GDP as of 2025Q3. - The share of financial assets (excluding domestic equities) held by the social security fund as a percent of total financial assets of the general government: 46 percent as of end-FY-2024 (estimate based on non-consolidated assets data). ### Measurement and valuation issues - Market-value vs. face/nominal-value: market value reflects prevailing market prices (informative from a creditor’s perspective); nominal/face value is the amount owed (relevant from a debtor’s perspective). - Rising yields have recently lowered the market value of outstanding JGBs, pushing market value below face value over the past two years. - Accrued future pension obligations of social security schemes are not recorded in the government debt statistics (per PSDS Guide ¶2.80 and 2008 SNA ¶17.192); staff model these obligations in the debt sustainability analysis and long-term fiscal risk assessment. ### Asset composition and encumbrance - A sizeable share of government financial assets is invested in foreign securities and domestic equities; central and local government assets have increasingly been allocated towards foreign securities while maintaining sizeable holdings of domestic equities. - Most general government financial assets are encumbered and managed by agencies with operational independence, limiting the government’s ability to use these assets to finance general expenditures, particularly in the short term. - Social Security Funds’ domestic equity and outward-investment positions have risen sharply over the past two decades, financed largely through social security contributions. --- ### Annex VIII. Trade Barriers and Policy Uncertainty: Implications for Japanese Outward FDI ### Stylized facts on Japan’s FDI, trade barriers, and policy uncertainty - Japan’s outward FDI stock has surged while exports have stagnated; outward FDI stock grew fastest among peer G7 economies over the past two decades. - Outward FDI stocks remain largest in finance and insurance and in wholesale and retail; services and real estate have grown fastest in recent years from smaller bases. - Manufacturing heterogeneity: pharmaceuticals expanded strongly; autos retain a large but slower-growing position; general machinery outpaced electronics. - Global trade environment: tariffs on Japan’s manufacturing exports generally fell over the past two decades (notably in China and the EU around 2019–20), but non-tariff measures (NTMs) increased since the US–China trade war and the pandemic; 2025 tariff developments add further headwinds (but are outside the empirical analysis scope). - Destination reorientation: outward FDI reoriented away from China toward advanced economies, particularly the US and Europe, with declining investment in Eastern bloc (including China) and rising flows to Western-aligned economies. ### Empirical framework (data and variables) - Data: BoJ outward FDI flow data from 2005 to 2023, destination country and industry-level. - Trade barriers: trade‑weighted tariff rates on Japan’s exports (UNCTAD‑TRAINS, 2005–2023) and number of newly announced NTMs from Global Trade Alert (2009–2023). - Uncertainty: country‑level overall uncertainty index following Ahir et al. (2022), capturing macroeconomic, political, and regulatory uncertainty. - Extensive margin: logit model for probability of positive Japanese investment in destination–industry pairs with controls for destination-market size, destination growth rate, labor regulation index, real effective exchange rate, and lagged FDI flows; country, industry, and year fixed effects included. - Intensive margin: conditional model of FDI magnitude given positive entry (exponential specification). ### Empirical results — extensive margin (entry probability) - Tariffs: higher tariffs are associated with a greater probability of Japanese outward FDI entry (positive and statistically significant tariff coefficient across baseline specifications), consistent with tariff-jumping behavior. - NTMs and uncertainty: coefficients of NTM and policy uncertainty indices do not robustly influence entry decisions in baseline specifications. - Market-size interactions: tariffs and NTMs raise the probability of entry in larger markets but reduce it in smaller ones (tariff-jumping and market-access motives stronger where demand is larger). - Geopolitical heterogeneity: higher uncertainty is linked to lower entry probabilities in Eastern bloc destinations (interaction between uncertainty index and Eastern bloc is negative and statistically significant); effects elsewhere are muted or statistically insignificant. - Robustness: exclusion of China from the destination sample does not overturn the main findings. ### Empirical results — intensive margin (investment scale conditional on entry) - Tariffs: higher tariffs are associated with larger Japanese outward FDI positions conditional on entry (tariff coefficient positive and statistically significant). - NTMs: NTM coefficients and interactions with GDP are not significant, suggesting limited systematic effect of NTMs on investment scale. - Uncertainty: reduces investment intensity in geopolitically distant markets; uncertainty does not have a significant effect within Western-aligned economies. - Interactions: tariff × destination GDP and NTM × GDP interactions generally insignificant for intensive margin. ### Strategy-specific heterogeneity - FDI classified into horizontal (market-seeking), vertical (production fragmentation/cost-driven), and export-platform strategies using METI’s Basic Survey on Overseas Business Activities. - Industry patterns: - Pharmaceuticals: primarily market-seeking (horizontal). - Autos: operate largely as export platforms. - Electronics: more vertically integrated, with affiliates in Asia and China exporting back to Japan. - Regional patterns: - Affiliates in the US: more horizontal. - Europe: stronger export-platform role. - Locations close to Japan: more integrated into vertical production networks. - Tariff effects by strategy: - Strongest entry response for horizontal FDI in larger markets. - Smaller effects for export-platform and vertical strategies. - NTMs show no systematic impact by strategy. - Conditional on entry, tariffs matter across strategies (higher tariffs associated with larger investment volumes); interactions with market size and NTMs are insignificant. ### Synthesis and implications - Higher tariffs encourage FDI entry in large markets and are associated with larger investment positions once established; NTMs play a more limited role. - Uncertainty mainly dampens investment in geopolitically distant destinations and hurts entry into Eastern bloc markets. - Japanese firms are reconfiguring their global footprint—tilting toward large advanced economies and non-manufacturing sectors—balancing market access, geopolitical alignment, and resilience amid rising trade barriers and uncertainty. *Annex material prepared by IMF staff (Annex VII prepared by Shujaat Ali Khan (APD)); data sources include Cabinet Office of Japan, BoJ, UNCTAD‑TRAINS, Global Trade Alert, METI, and IMF staff calculations.* ### Annex IX. Japan’s ousehold Consumption Behavior ### Annex IX. Japan’s ousehold Consumption Behavior ### Background - Private consumption is a pivotal driver of Japan’s growth; understanding consumption behavior informs policy targeting given demographic aging, precautionary saving motives, and labor market structural features. - The study combines household-level evidence and cohort-level time-series evidence: - Micro data: Japan Household Panel Survey/Keio Household Panel Survey (JHPS/KHPS; Keio University, 2004–2023), tracking same households over time to identify within-household changes in consumption, income, and balance-sheet positions. - Macro data: Family Income and Expenditure Survey (FIES; January 2000–June 2025), providing monthly cohort-level measures of expenditures and income components. ### Micro Analysis — key findings and estimation approach - Aggregate trends: - Household expenditure has declined in aggregate terms since 2005, reflecting falling average household size; per-capita spending has been relatively stable. - Household saving rate rose sharply during the pandemic and eased thereafter. - Heterogeneity in propensity to consume: - Low-income households exhibit the highest propensities to consume, consistent with liquidity constraints and limited buffer-stock savings. - Older-headed households may show higher spending sensitivity to income changes when fixed expenses rise or portfolio income volatility increases. - Estimation strategy: - Panel regressions exploit within-household variation with household fixed effects and time fixed effects; fiscal shocks taken from Adler and others (2024) narrative identification of discretionary changes in taxes and government spending. - Baseline specification: real per-capita household consumption regressed on household disposable income per capita (log), with interactions between common fiscal consolidation shocks and household characteristics (indebtedness, age profile, education). Time fixed effects capture common macro shocks. - Note: time fixed effects’ collinearity with fiscal shocks precludes estimation of the average impact of fiscal shocks on household consumption; the regressions identify differential responses via interactions. - Differential short-term consumption response to fiscal consolidation (percent): - Fiscal shock * Group interaction: - Highly Indebted: -1.96 (p-value 0.022) - High LTV: -5.68 (p-value 0) - Old Age: -1.38 (p-value 0.092) - Low Education: -0.36 (p-value 0.676) - Disposable income per capita (log) coefficient (same across specifications): - 22.71 (p-value 0) for most columns; 22.69 (p-value 0) reported once. - Note: Dependent variable is log of real consumption per capita. Fiscal shocks are expressed in percent of GDP and disposable income per capita enters in log-terms as a regressor. - Interpretation: - Highly indebted households and households with high loan-to-value ratios experience larger consumption declines in response to fiscal consolidation—consistent with balance-sheet and liquidity constraint channels. - Differential effect for older households is negative but only marginally significant; no statistically meaningful difference for lower-education households. - Across groups, disposable income per capita is a strong and significant driver of consumption. ### Macro Analysis — ARDL results and cohort patterns - Model and data: - An autoregressive distributed lag (ARDL) model estimated using monthly FIES cohort data for 2003-2025. - Variables (deviations from trend): ĉt,i = log real per capita consumption for time t and age-income cohort i; relative food inflation; overall inflation (inft); policy shocks vector (including unconventional monetary policy shocks identified for Japan by Carrière-Swallow and others (2025)); controls: employment income, bonuses, rental income, social security and pension benefits, change in VAT rate, and deleveraging. Lagged dependent and explanatory variables included. - Controls are real values in log except deleveraging (not in log because it has negative values). - Narrative fiscal shocks from the micro section are not included here due to lower frequency. - Inflation: - On average, consumer spending per capita does not show a statistically significant relationship with inflation—consistent with consumption smoothing per permanent income and life-cycle hypotheses. - Younger employed cohorts (under 34) tend to reduce spending when inflation rises; effect is not statistically significant and may reflect liquidity constraints or shorter planning horizons. - Deleveraging: - Debt deleveraging is strongly and negatively associated with consumption per capita for employed households, driven mainly by mid- and high-income groups and households with middle-aged heads—indicative of reallocating resources from consumption to balance-sheet repair. - Among households with unemployed heads, the deleveraging effect on consumption is even stronger for the wealthiest and oldest cohorts. - Employment income and saving: - Employment income is the key driver of household saving behavior, with the largest and most broad-based association with saving rates. - The employment-income–saving link is slightly stronger for wealthy households, consistent with greater capacity to allocate surplus income to savings. - Deleveraging does not show a statistically significant relationship with saving rates on average, though for some wealthier cohorts reducing debt appears to lower savings. ### Visual/empirical patterns highlighted - Average Real Expenditure per Capita (2000 prices) plotted for 2003–2021 indicates stable per-capita spending despite aggregate decline. - Average Propensity to Consume by income quartiles shows higher propensity for Q1 (lowest income) relative to Q4 (highest income). - Short-term impact charts: - Headline inflation: small negative average impact on consumption per capita; variation by age cohorts (up to 34, 40–49, 50–59, 60–69). - Deleveraging per capita: negative short-term impact on consumption per capita, stronger for higher income groups and older cohorts. - Short-term impact on saving rate: positive response to employment income per capita, larger for higher income groups. ### Conclusion — policy implications - Consumption responses vary markedly across income, age, and leverage groups; aggregate measures can obscure important distributional effects relevant for policy transmission. - Constrained households (highly indebted, high LTV) tend to adjust more to fiscal consolidation; income gains are not uniformly translated into higher spending when precautionary saving and deleveraging motives are strong. - Policy recommendations implied by the findings: - Design fiscal measures that are carefully targeted toward households with higher propensities to consume to support consumption and growth. - Complement demand-side policies with measures that reduce balance-sheet constraints (e.g., addressing indebtedness and liquidity constraints) to strengthen transmission. - Consider heterogeneity in incidence when evaluating fiscal consolidation impacts to avoid disproportionate consumption declines among constrained households. *Source: Annex IX. Japan’s household Consumption Behavior (staff-prepared annex, JHPS/KHPS 2004–2023; FIES January 2000–June 2025).* ### 1. Recent data releases continue to point to the resilience of the Japanese economy. ### 1. Recent data releases continue to point to the resilience of the Japanese economy. ### Recent data and near-term growth - Revised national accounts: 2025Q4 GDP growth revised up to 0.3 percent q/q (from 0.1 percent in the first statistical release). - Resulting annual growth revision: 2025 growth revised up to 1.2 percent (from 1.1 percent). - Drivers of the upward revision: stronger domestic demand, particularly business investment and private consumption. - Balance of payments (January 2026): large improvement in goods and services trade balance driven by a narrower goods trade deficit. - Goods exports: 20.3 percent increase (year on year). - Goods imports: 7.7 percent decline (year on year). - Income balance remained the largest contributor to the current account surplus. ### External shock — Middle East conflict and market impact - Energy import dependence: in 2025, oil and LNG together accounted for about 17 percent of total goods imports. - Trade composition: most oil imports come from the Middle East; LNG imports are more diversified. - Market and financial impacts since conflict: - Yen depreciation: 1.8 percent. - Equity declines: Nikkei by -12.5 percent; Topix by -11.5 percent. - Higher yields: 10-year JGB yield rising by 19bps. ### Government measures and fiscal implications - Measures announced: - March 16: lowered mandatory private petroleum stockpiles by 15 days and released one month’s worth of national oil reserves. - March 19: cap of 170 yen per liter on the retail price of gasoline effective March 19. - Estimated fiscal cost (preliminary): around 0.2 percent of GDP in 2026, potentially financed using contingency funds. - Policy design guidance from staff: measures to mitigate the effect of the shock should be budget neutral, temporary, and targeted to the most affected households and firms. ### Monetary policy response - Bank of Japan (BOJ) action: policy rate kept unchanged at its monetary policy meeting on March 19, 2026. - BOJ stance: closely monitoring impact of the conflict on underlying inflation; assessment of risk to outlook to be updated at each policy meeting. - Staff view on policy path: with limited impact on underlying inflation in the baseline, gradual hikes should continue to move the policy rate toward neutral; BOJ’s flexible and data-dependent approach remains appropriate. - Role of exchange rate: exchange rate flexibility will help absorb the external shock and support monetary policy’s focus on price stability. ### Staff projections and baseline scenario (under assumption that global oil and natural gas prices normalize gradually) - Trade and current account impacts in 2026 (relative to pre-conflict baseline): - Goods trade deficit expected to widen by 0.7 percent of GDP in 2026. - Current account surplus declining by 0.8 percent to 3.8 percent of GDP in 2026, before increasing to 3.9 percent of GDP in 2027 as global prices moderate. - Inflation impacts (relative to pre-conflict baseline): - Headline inflation higher by 0.3 pp in 2026 and 0.2 pp in 2027, to 2.2 and 2.3 percent respectively. - Second-round effects expected to remain modest due to medium-term inflation expectations realigning with the target from below. - Support measures partly reduce pass-through to inflation. - GDP growth projections (relative to pre-conflict baseline): - Growth projected to remain unchanged at 0.8 percent in 2026 and 0.6 percent in 2027. - Higher-than-expected 2025Q4 growth provides additional momentum into 2026, largely offsetting drag from higher oil and gas prices. - Uncertainty and risks: impacts are preliminary and may be revised for the April 2026 World Economic Outlook; risks include further intensification or a more protracted conflict that could keep oil and gas prices elevated for longer. ### Staff policy advice (reiterated under the revised baseline) - Monetary policy: - Continue gradual hikes to move policy rate toward neutral given limited baseline impact on underlying inflation. - Maintain a flexible, data-dependent approach amid heightened uncertainty. - Fiscal policy: - Neutral fiscal stance remains appropriate to preserve fiscal buffers and capacity to respond to large shocks, given the economy operating above potential. - Support measures should be budget neutral, temporary, and targeted. - Exchange rate: - Allow exchange rate flexibility to absorb the external shock. - Overall appraisal: the thrust of staff appraisal remains unchanged. ### Key points from the Japanese authorities’ statement (March 27, 2026) - Authorities’ view on recent performance: - Real GDP growth reached 1.2 percent in 2025, supported by private consumption and corporate investment. - Inflation expected to move toward the BOJ’s price stability target of 2 percent; recent crude oil price rise warrants attention. - Cabinet Office outlook: - Envisages growth of 1.3 percent in FY2026 (April 2026-March 2027), led by private consumption and corporate investment supported by strategic fiscal measures. - Preliminary annual spring wage negotiations (announced March 18): wage increases have remained at a high level, exceeding 5 percent. - Cabinet Office expects real wage growth to continue improving in FY2025 and to rise to around 1 percent in FY2026 as inflation gradually moderates. - Monetary policy developments noted by authorities: - BOJ raised policy interest rate to around 0.75 percent in December 2025 (following a policy rate hike in January 2025). - BOJ’s balance sheet reduction and market operations: new reduction plan for JGB purchases decided in June 2025; moderation of reduction pace from April 2026; decision in September 2025 to begin selling ETFs and J-REITs holdings to market in a manner that avoids destabilizing effects. - BOJ will continue data-dependent policy and raise policy interest rate if outlook is realized. - External and fiscal policy priorities: - Commitment to market-determined exchange rates while monitoring and addressing excessive volatility and disorderly movements. - FY2026 budget under discussion features the lowest Bond Dependence Ratio (24.2 percent); primary balance turned into a surplus for the first time in 28 years. - Fiscal reforms in expenditure and revenue, including reviewing tax expenditures through a newly established Office for Reviewing Tax Expenditures and Subsidies. - Consideration of suspension of the consumption tax limited to food and beverage items for a period of two years as a measure until a refundable tax credit system is introduced—without relying on issuance of deficit-financing bonds. - Medium- to long-term strategy to reduce outstanding government debt-to-GDP ratio by keeping the rate of government debt expansion not exceeding growth. - Financial sector and structural reform priorities: - Financial system viewed as resilient; credit costs low; gradual rise in interest rates has supported bank profitability. - Vigilance on vulnerabilities: structural challenges for some regional banks, valuation risks in parts of the real estate sector, and growing interconnectedness of foreign nonbank financial institutions. - FSA “Regional Financial Power Enhancement Plan” to support regional financial institutions. - Progress on implementing the 2024 FSAP recommendations, including stronger systemic risk monitoring and supervisory oversight in fintech, insurance, and investment funds. - Structural reform focus: boost labor participation, support childcare, prioritize investments in AI, semiconductors, shipbuilding, and resilience (economic security, food security, energy and resource security, health and medical care security, national resilience, cybersecurity). - Commitment to multilateral cooperation and avoiding geoeconomic fragmentation; support for CPTPP expansion and dialogue with EU and ASEAN. *1jpnea2026001 - 1. Recent data releases continue to point to the resilience of the Japanese economy.* --- _Source: https://www.imf.org/-/media/files/publications/cr/2026/english/1jpnea2026001.pdf_