## _cr04249 — Executive Summary and Staff Report Highlights

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### Macroeconomic outlook and near-term projections
- Recovery has gained pace and broadened; deflation is easing; near-term outlook: continued robust expansion and narrowing deflation (downside risks mainly from external factors).
- Staff projections:
  - GDP growth of about 4½ percent in 2004.
  - GDP growth of 2½ percent in 2005.
  - Staff estimate of potential growth: 1.7 percent per year.
  - y/y CPI deflation expected to ebb to about zero during 2005.
  - Staff’s estimate of the output gap: about 2¼ percentage points as of end-2003.
- Risks:
  - External downside risks: a sharp rise in long-term U.S. interest rates; a slowdown in China (a 10 percentage point fall in China’s imports for domestic use would reduce Japan’s GDP by about ½ percentage point); a sustained 10 percent rise in oil prices could reduce Japan’s GDP by up to ½ percentage point over the long term.
  - Upside risks: stronger-than-expected consumption and business fixed investment if labor market and profits improve faster.

### Monetary policy and exchange rate operations
- BoJ policy stance:
  - Short-term interest rates held at zero under the BoJ’s quantitative easing policy.
  - BoJ clarified conditions for ending quantitative easing: core CPI growth nonnegative for a few months and a majority of Policy Board members forecast positive core CPI inflation.
  - BoJ raised its current-account balance target in October 2003 and January 2004; mission agreed to maintain the quantitative-easing stance until inflation is positive.
- Mission suggestions for transition and communications:
  - Quantify an inflation objective as a desirable medium-term inflation rate (not a binding target for a fixed period).
  - Consider publishing more detailed periodic reports on monetary policy and the inflation outlook.
- Exchange-rate developments and interventions:
  - Interventions: ¥20 trillion in 2003 and ¥15 trillion during January–March 2004.
  - Since June 2003, yen/dollar fluctuated between ¥104 and ¥121 and on balance appreciated by about 9 percent; multilateral: nominal effective appreciated by 3.5 percent and real effective by 2 percent.
  - Staff CGER estimates imply the yen remains substantially undervalued from a medium-run perspective.
  - Mission view: large interventions smoothed short-term volatility and prevented undue tightening; further intervention could be warranted if upward pressure threatened the recovery.

### Financial sector and banking reforms
- Progress:
  - Major banks reduced nonperforming loans and deferred tax assets (DTAs), lifted capital adequacy ratios; on track to attain NPL ratio target of about 4 percent by end-March 2005 for major banks.
  - Insurance companies: improved profits and solvency margins.
  - Banking merger announced: Mitsubishi Tokyo Financial Group and UFJ to merge (announced July 14).
- Remaining vulnerabilities:
  - One major bank remained very weak with high bad loans and large provisions.
  - Regional banks, accounting for 40 percent of bank lending, lag in restructuring and are subject to less demanding regulation than major banks.
  - Bank lending continues to contract; core operating profits remain weak; DTAs still a significant share of regulatory capital.
- Mission recommendations:
  - Further improve recognition of and provisioning for problem loans; promote forward-looking provisioning; allow FSA-required provisions to be tax-deductible.
  - Strengthen bank capital: phase in limits on DTAs in bank capital and raise capital adequacy requirement for all domestic banks to 8 percent.
  - Improve bank governance: enhance roles of outside directors and auditors; exercise government ownership rights where needed.
  - Apply PFR-style measures to regional banks (special inspections, enhanced disclosure, NPL targets); use new capital injection facility for viable regional banks with conditionality to facilitate consolidation.
  - Proceed with planned reduction in deposit insurance coverage on April 1, 2005 as currently planned.

### Corporate sector performance and restructuring
- Aggregate profit indicators improved; profit/sales ratio returned to bubble-era peaks.
- Profit gains initially driven by labor cost cuts and external demand; broadened to SMEs and nonmanufacturers.
- Debt levels remain high and aggregate ROA remains low; further deleveraging and shedding of unproductive assets needed.
- IRCJ involvement: 17 cases as of early June 2004, coordinating large creditor groups and facilitating pro rata haircuts.
- Asset prices and markets:
  - Nikkei gained about 50 percent since 2003 lows.
  - Ten-year JGB yields rose from about 0.45 percent to about 1.8 percent.
  - Average land prices continued to fall, but rate of decline eased in some major urban areas.

### Fiscal policy, public debt, and pension reform
- FY2003 fiscal deficit: 7.9 percent of GDP.
- Cyclically-adjusted structural deficit (including social security but excluding bank support): around 6½ percent of GDP.
- Public debt at end-2003: 166 percent of GDP (gross) and 80 percent of GDP (net).
- Staff projections and stabilization examples:
  - Staff projects a deficit of 3.6 percent of GDP in FY2004 (general government excluding social security).
  - To stabilize public debt at 110 percent of GDP by 2013, an adjustment of 6.9 percent of GDP in the primary balance excluding social security would be needed; even after such adjustment, debt would remain very high—110 percent of GDP.
  - Example primary balance path (in percent of GDP):
    - FY2004: General govt. -4.9; General govt. excluding social security -3.6; Social security -1.3
    - FY2013: General govt. 1.4; General govt. excluding social security 3.3; Social security -1.9
    - Adjustment: General govt. 6.3; General govt. excluding social security 6.9; Social security -0.6
- Medium-term fiscal measures suggested:
  - Further cuts in capital expenditure (capital expenditure was "5½ percent of GDP in 2003").
  - Broaden the personal income tax base by reducing/eliminating allowances and exemptions.
  - Gradually increase the consumption tax rate (staff estimated each 1 percentage point increase would yield 0.5 percent of GDP).
  - Further social security reforms: strengthen enforcement of pension contributions; reform medical and long-term care systems.
- 2004 public pension reform key elements:
  - Contribution rates gradually raised through 2017: by 27 percent in real terms for the NP, and from 13.58 percent of salary to 18.3 percent for the EPI.
  - Pension benefits gradually reduced (not fully indexing to CPI) until EPI benefits for a typical family fall to 50.2 percent of average salary (current level 59.3 percent).
  - Government transfers to NP increase from one-third to one-half of total benefit payments between 2004 and 2009.
  - Pension reserves projected to fall to the level of annual benefit expenditure by 2100 (currently five times annual benefit expenditure).
  - Staff projection: with reform the primary deficit of the public pension system would be 2 percent of GDP in 2050, compared to 5 percent of GDP in the absence of reform.
- Staff cautions: reform relies heavily on contribution increases and government transfers; lacks automatic adjustment mechanisms; may deepen intergenerational inequality.

### Structural reforms, productivity, and trade policy
- Staff estimate: potential to raise productivity and output via deregulation and structural reform.
- Historical declines:
  - Average labor productivity growth fell from "3¾ percent" to "2 percent."
  - Total factor productivity growth fell from "1.6 percent" to "0.2 percent."
- Reform priorities:
  - Enhance labor market flexibility (extend fixed-term contract length to up to three years; clarify dismissal rules; increase pension portability; expand private job placement services which currently account for "1 percent of new hires").
  - Advance regulatory reform (Council for Regulatory Reform; "over 300 special zones were approved" in FY2003).
  - Strengthen competition policy and accelerate public enterprise reform (privatize highway corporations; privatization of Japan Post "is set to begin in 2007").
- Potential gains cited:
  - 1990s studies: structural reforms could boost output level by "around 6 percent."
  - OECD: comprehensive regulatory reforms could reduce producer prices by "5–7 percent" and raise labor productivity and output levels by "5–6 percent."
- Trade policy:
  - Increased reliance on bilateral EPAs; preliminary EPA with Mexico includes commitments on agriculture.
  - Staff view: bilateral steps welcome but multilateral liberalization through WTO would bring more substantial benefits; Japan should play a leadership role in reinvigorating the Doha Round.
  - Japan’s imports from LDCs in 2003: "about 0.5 percent" of its total import bill.
  - Japan’s ODA: currently reported as 0.2 percent of GNI; staff encouraged raising ODA closer toward the UN target of 0.7 percent of GNI.

### Data, statistics, and transparency
- Japan subscribed to the SDDS on July 3, 1996; met SDDS specifications on June 9, 2000.
- National accounts revisions and improvements:
  - 2000 revision to reflect the 1993 SNA; benchmark year revised to 1995; further methodological improvements and more timely preliminary quarterly GDP releases (preliminary estimate about 1½ months after quarter end).
  - ESRI introduced new methods combining supply and demand indicators from Q2 2002.
- Data limitations and recommendations:
  - Some GDP component breakdowns available only with annual data; preliminary income-side estimates limited.
  - Short-term recommendation: improve timeliness and periodicity of fiscal data.
  - Longer-term recommendation: move data production (other than monetary and financial statistics) to a single, independent agency and provide greater detail on quarterly national accounts components.
- Data ROSC: planned to start mid-2005; fiscal ROSC update completed June 2004 welcomed progress but identified needs for better consolidated general government balance reporting and integration of medium-term framework with the budget.

### Selected key statistics (exact figures as reported)
- Nominal GDP: US$4,302 billion (2003).
- Population: 127.6 million (2003).
- GDP per capita: US$33,722 (2003).
- Public debt (calendar year, percent of GDP, end-2003): Gross 166; Net 80 (end-2003 values cited elsewhere: Gross 166 percent, Net 79.6 percent).
- Unemployment: fell to 4.7 percent from record-high 5.5 percent reached in early 2003; annual average unemployment series includes 4.7 for 2003.
- Base money and monetary aggregates (selected):
  - Base money (in trillions of yen, sample series): 68.7 68.0 79.4 94.9 107.5 96.6 102.8 103.6 107.5 108.1 108.8 (table row preserved).
  - M2 + CDs (period average, trillions of yen sample): 616.3 629.3 646.8 668.2 679.6 674.2 681.0 680.2 685.8 685.8 694.0 (table row preserved).
- External sector (selected):
  - Current balance (US$ billion, sample series): 96.6 119.1 114.5 119.6 87.8 112.6 136.2 149.3.
  - Total reserves minus gold (US$ billion sample): 216.6 219.6 215.5 286.9 354.9 395.2 461.2 663.3 807.2.
- Exchange-rate and interest indicators (selected):
  - Yen/dollar rate (period average): 2003: 115.9; Proj. 2004: 111.2.
  - 10-year government bond yield: rose from about 0.45 percent (2003 low) to about 1.8 percent (recent level cited); projection for 2004: 1.86 (table).

### Staff appraisal and policy guidance (summary)
- Monetary policy: current stance appropriate; maintain quantitative easing until inflation firmly positive; consider enhanced BoJ communications and quantification of a medium-term inflation objective as an option.
- Financial sector: continue enhanced regulation of major banks; apply PFR-style measures to regional banks; use capital injection facility with conditionality; improve provisioning, capital, governance, and reduce competition from GFIs.
- Fiscal policy: achieve fiscal savings in FY2004 if recovery remains robust; adopt a specific medium-term primary surplus target (excluding social security) and measures to credibly achieve it; consider further social security reforms, cuts in capital spending, broadening tax base, and gradual consumption tax increases.
- Structural reforms: front-load regulatory reforms; strengthen competition policy; increase labor market flexibility; accelerate public enterprise reforms to raise potential growth.
- Data and transparency: continue national accounts review, conduct data ROSC, reduce fiscal statistics publication lag, and improve consolidated general government reporting.

*Source: _cr04249 - Executive Summary and IMF staff report excerpts (2004 Article IV Consultation).*

### Executive Summary ......................................................................................................

### Executive Summary

### Background
- Recovery, deflation, and sectoral improvements
  - The recovery has gained pace and broadened; deflation is easing; near-term outlook: continued robust expansion and narrowing deflation (downside risks mainly from external factors).
  - Monetary policy supportive: short-term interest rates held at zero under the BoJ’s quantitative easing policy; exchange rate policy has sought to smooth short-term volatility and avoid an undue tightening of monetary conditions.
  - Financial and corporate sector weaknesses are diminishing: declining nonperforming loans and improved profits and deleveraging.
  - Fiscal deficits remain large; public debt has grown rapidly. Authorities aim to achieve a primary surplus (excluding social security) by the early 2010s; recent reforms will improve pension finances.

### Key Issues and Policy Discussions
- Staff recommendations to expand reforms to secure durable medium-term expansion
  - Monetary policy
    - Mission agreed with BoJ policy of keeping short-term interest rates at zero until inflation turns positive.
    - Mission proposed the BoJ enhance communications to stabilize inflation expectations, including quantifying a medium-term inflation objective; the BoJ views this as one possible option for managing the transition to positive inflation.
  - Financial sector
    - Mission proposed expanding on current reforms to more quickly resolve remaining weaknesses—especially for regional banks whose restructuring has lagged.
    - Authorities preferred a more gradual approach.
  - Fiscal policy
    - With the economy stronger than initially envisaged, fiscal savings in FY2004 relative to the budget would be desirable.
    - For the medium term, mission advocated a specific target balance and measures to achieve it to enhance credibility; authorities aim to enhance credibility through concrete progress.
  - Structural reforms
    - Expand reforms to encourage job creation and raise productivity and potential growth.
    - Priorities: strengthen competition policy, increase labor market flexibility, advance regulatory reforms, and further trade liberalization (particularly agriculture).

### I. Introduction (summary of context)
- Key conditions and remaining weaknesses
  - Clear indications that Japan’s longstanding problems have eased: GDP has grown for eight consecutive quarters; labor market conditions improving; deflationary pressures diminished against a narrowing output gap and supportive monetary policy.
  - Remaining weaknesses: mild deflation persists; additional corporate and financial sector restructuring needed; public debt high and rising.
  - Need for accelerated deregulation and structural reform to underpin a strong, durable medium-term expansion.

### II. Signs that Japan’s Longtime Economic Problems have Eased
- Recovery characteristics and drivers
  - Recovery is surprisingly strong and increasingly broad based (Box 1). Output growth in 2003 was about twice the mid-year consensus forecast, and picked up to an annual average rate of about 6¾ percent during the last two quarters.
  - Index-number problems in GDP data may cause measured growth to be overstated; most estimates of the bias are around ¼ to ½ percent per annum; one private study suggests it may be higher; rough STA estimates through 2002 are close to zero.
  - Export rebound (starting early 2002), especially to Asia, was an initial driver; real exports to China increased by about 40 percent in 2003 (China accounts for about 12 percent of Japan’s exports).
  - Business fixed investment grew briskly, supported by robust corporate cashflow and demand to replace aging capital.
  - Consumption has begun to strengthen despite weakness in household income; import growth has firmed.

- Labor market and inflation developments
  - Employment, labor force, and compensation stabilized after declines since 2001; unemployment fell to 4.7 percent from the record-high 5.5 percent reached in early 2003.
  - CPI deflation eased: since January 2003, the y/y fall in the core CPI (excludes fresh food) narrowed; net of transitory factors, underlying trend shows core CPI falling by 0.3 percent.
  - Consensus forecasts: broadly flat CPI over 2004 and 2005.
  - GDP deflator continued to fall more rapidly than the CPI—declining by 2.6 percent y/y in the first quarter of 2004—due to rapid fall in prices of electrical machinery and opposing index-number biases between CPI (Laspeyres, upward bias) and GDP deflator (Paasche, downward bias).

- Monetary, exchange rate, and fiscal positions
  - Monetary policy: short-term interest rates at zero under BoJ quantitative easing; BoJ increased operating target (current account balances), supporting base money growth and ensuring ample funding.
  - Bank lending continues to contract, partly reflecting loan writeoffs amid weak banks and corporate deleveraging.
  - Exchange rate developments: periodic upward pressure on the yen led to record interventions (¥20 trillion in 2003 and ¥15 trillion during January–March 2004); upward pressure and intervention ceased in April 2004.
    - Since June 2003, yen/dollar fluctuated between ¥104 and ¥121 and on balance appreciated by about 9 percent; on a multilateral basis, yen appreciated by 3.5 percent (nominal effective) and 2 percent (real effective).
    - Staff CGER estimates imply the yen remains substantially undervalued from a medium-run perspective.
  - Fiscal outcomes: FY2003 fiscal deficit amounted to 7.9 percent of GDP (slightly lower than in FY2002).
    - On a cyclically-adjusted structural basis (including social security but excluding bank support) the deficit was broadly stable at around 6½ percent of GDP.
    - Public debt at end-2003: 166 percent of GDP (gross) and 80 percent of GDP (net)—the highest among advanced countries by a substantial margin.

- Financial and corporate sector progress and remaining vulnerabilities
  - Major banks (FY2003): cut bad loans, reduced deferred tax assets (DTAs) and equity holdings, and lifted capital adequacy ratios amid recovery, stock market rebound, and tighter regulation under the Program for Financial Revival (PFR).
  - Insurance companies: improved profits and solvency margins.
  - Remaining bank issues: one major bank had high bad loans, increased provisions, and marked down earnings; DTAs still accounted for a substantial part of regulatory capital; core operating profits remained weak; financial strength ratings (excluding government support) stayed low.
  - Regional banks: account for 40 percent of bank lending, are subject to less demanding regulation than major banks, are not covered by the PFR, and have lagged in reducing bad loans.
    - A large regional bank failed and was nationalized through share acquisition in late 2003, indicating persistent weaknesses among regional banks.

- Box 1 (summary): Is the Japanese Recovery for Real?
  - Reasons the current recovery is likely more durable than prior 1990s recoveries:
    - It is more broadly based with firmer private domestic demand; strong investment supported by corporate profits and demand to upgrade aging capital; consumption strengthening despite falling public spending.
    - Corporate restructuring has fostered structural gains in profitability, with firms paring excess leverage and labor costs.
    - Corporate and financial sectors have become more resilient: firms deleveraged; banks shed nonperforming loans and equity holdings, reducing vulnerability to shocks.

*Source: _cr04249 - Executive Summary_*

### 12.      The corporate sector has made

### 12.      The corporate sector has made substantial progress in restructuring.

### Corporate sector performance and restructuring
- Aggregate profit indicators have improved; the profit/sales ratio has returned to bubble-era peaks.
- Profit gains initially driven by labor cost cuts and strong external demand, led by large export-oriented manufacturers; recently broadened to SMEs and nonmanufacturers.
- Debt levels remain high and aggregate ROA is still low by historical standards, indicating further deleveraging and shedding of unproductive assets is needed.
- The Industrial Revitalization Corporation of Japan (IRCJ) was involved in 17 cases as of early June 2004, coordinating large numbers of creditors (over 100 in one case) and facilitating pro rata haircuts.

### Recent financial-market and asset-price developments
- Since their lows in 2003:
  - The Nikkei has gained about 50 percent.
  - Ten-year JGB yields have risen from about 0.45 percent to about 1.8 percent.
- Average land prices have continued to fall, but the rate of decline seems to have eased in a few major urban areas.

### Near-term outlook and staff projections
- Baseline near-term outlook: continued expansion with mild deflation, assuming supportive external environment and firmer domestic demand.
- Staff projections:
  - GDP growth of about 4½ percent in 2004.
  - GDP growth of 2½ percent in 2005.
- y/y CPI deflation expected to ebb to about zero during 2005.
- Staff’s estimate of the output gap is about 2¼ percentage points as of end-2003.

### Risks to the near-term outlook
- Downside risks (mainly external):
  - A sharp rise in long-term U.S. interest rates that could spark global portfolio rebalancing and volatility in international capital markets.
  - A slowdown in China that could dampen its demand for Japan’s exports.
    - Staff estimate: a 10 percentage point fall relative to baseline in China’s imports for domestic use, caused by slowing Chinese domestic demand, would reduce Japan’s GDP by about ½ percentage point.
  - A supply shock in oil markets that could foster a sustained oil price increase and reduce partner country growth.
    - Staff estimate: a sustained 10 percent rise in oil prices could reduce Japan’s GDP by up to ½ percentage point over the long term (near-term effects would be considerably smaller).
  - Geopolitical shocks that could deteriorate business and consumer confidence.
- Upside risks:
  - Consumption and business fixed investment could show further surprising strength if labor market conditions and corporate profits improve more rapidly than anticipated.

### Medium-term outlook and potential
- Staff estimate of potential growth: 1.7 percent per year.
- This estimate assumes productivity growth continues at around current rates.
- Additional structural reforms (deregulation of labor and product markets, continued progress in financial and corporate sector restructuring) could boost productivity, raise economic potential, and foster more rapid job creation.

### Monetary policy: commitment and transition
- BoJ actions and stance:
  - BoJ clarified conditions for ending quantitative easing: that core CPI growth be nonnegative for a few months, and that a majority of Policy Board members forecast positive core CPI inflation; it also raised its current-account balance target in October 2003 and January 2004.
  - Authorities and mission agreed to maintain the current quantitative-easing stance and strategy until inflation is positive.
- Mission suggestions for transition and communication:
  - Quantify an inflation objective, set high enough to limit the risk of returning to deflation, account for upward bias in CPI inflation, and facilitate relative price adjustments given downward price rigidities.
  - Specify the objective as the BoJ’s view on a desirable medium-term inflation rate, not as a binding target with a specified time commitment.
  - Consider issuing more detailed periodic reports on monetary policy and the inflation outlook.
- BoJ officials’ views:
  - Consider current quantitative easing a more effective commitment than inflation targeting for the immediate future; inflation targeting considered an option for the medium term if announced as a medium- to long-term objective.

### Exchange rate policy
- Authorities’ approach: aim to smooth excessive short-term volatility in the yen.
- Interventions during 2003–early 2004 described as “extraordinary measures to deal with extraordinary circumstances” and judged to have smoothed sharp short-term fluctuations.
- Mission concurred that past sizeable interventions had prevented undue tightening of monetary conditions and that further intervention could be warranted if upward pressure on the yen threatened to stall the recovery and heighten deflationary pressures.

### Financial and corporate sectors: completing revitalization
- Authorities’ strategy for banking weaknesses:
  - Continue enhanced regulation of major banks and measures to promote restructuring of regional banks and their borrowers.
  - Implement PFR regulatory measures (e.g., forward-looking provisioning for selected loans) aiming to reduce major banks’ bad loan ratios to around 4 percent by end-March 2005.
  - New facility (passed the Diet in June 2004) to offer regional banks precautionary capital injections, available in principle to any bank but intended for regional banks; injections provided only to viable banks indispensable for regional economies, with management accountable for restructuring plans.
  - Action Program for Enhancement of Relationship Banking Functions to encourage regional banks to help borrowers restructure.
- Mission’s recommendations (in line with the 2003 FSAP):
  - Further improve recognition of and provisioning for problem loans; encourage banks to make more extensive use of forward-looking provisioning; allow provisions required by the FSA to be recognized as a cost for tax purposes.
  - Strengthen bank capital: phase in limits on DTAs in bank capital, and raise the capital adequacy requirement for all domestic banks to 8 percent.
  - Enhance the environment for profitability: front load and flesh out plans to reduce competition from Japan Post and government financial institutions (GFIs), more rapidly phase out their preferences, and clarify the timetable for shrinking their operations.
  - Improve bank governance: urge banks to enhance roles of outside directors and auditors; exercise government ownership rights in any major bank that does not meet the end-March 2005 NPL target to make management improvements.
  - Encourage more rapid strengthening and restructuring of regional banks: subject them to measures that succeeded with major banks under the PFR (special inspections, enhanced disclosure about DTAs, targets for NPL reductions); use the capital injection facility, with appropriate conditionality, to facilitate consolidation.
- Differences of view between authorities and mission:
  - FSA considered regional banks’ Action Program progress acceptable and preferred more time for it to work; concerned that raising capital adequacy requirements for all banks could adversely affect regional banks’ lending.
  - Government considering phased rules on DTAs with liberalized tax-deductibility of provisions; discussion on GFIs to resume in 2005 on halving the sector’s balance sheet as a proportion of GDP.

### Corporate governance and restructuring enablers
- Revisions to the Commercial Code to ensure outside directors are fully independent from corporate management could improve incentives for financial and operational restructuring.
- Continued official efforts to promote mergers and acquisitions have helped foster revitalization.

### Fiscal policy: strategy to stabilize public debt
- Authorities’ medium-term fiscal adjustment strategy aims to stabilize public debt.
  - For the general government excluding social security: aim to achieve a primary surplus by the early 2010s.
    - Staff projects a deficit of 3.6 percent of GDP in FY2004.
    - Authorities intend to keep government expenditure at or below its current level as a percent of GDP through FY2006, then continue limiting expenditure and introduce revenue-enhancing measures.
  - For social security: periodic reviews of pension and medical insurance schemes; pension reform that passed the Diet in June 2004 features gradual increases in contributions and government transfers and reductions in pension benefits, which together would significantly reduce the system’s long-term deficit.

*Source: IMF staff report text from the provided content unit.*

### 33.      The mission and the authorities broadly agreed that the stronger economy

### _cr04249 - 33.      The mission and the authorities broadly agreed that the stronger economy

### Near-term fiscal stance
- With growth "much higher than initially envisaged," the mission recommended a tighter near-term fiscal stance and that "any stronger than expected revenues should be saved" while exploring "the scope for expenditure savings."
- Authorities agreed on the revenue side but considered it "too early in the fiscal year (which began only in April) to consider expenditure measures" and judged it unclear whether the recovery was sufficiently robust to step up discretionary spending cuts.
- The government was contemplating reforms of the fiscal relationship between the central and local governments to decentralize decision-making and "achieve fiscal consolidation at the local and central government levels."

### Medium-term fiscal adjustment and debt stabilization
- The mission assessed that an adjustment of 6.9 percent of GDP in the primary balance excluding social security would be needed to stabilize public debt relative to GDP by 2013 (the authorities’ target period).
- Even after such an adjustment, debt would remain very high—110 percent of GDP.
- The consolidation effort would likely require a mix of spending cuts and revenue-boosting measures, including:
  - Further cuts in capital expenditure, which is high at "5½ percent of GDP in 2003" (compared with an average of "3 percent" in other G-7 countries) and includes some inefficient public works spending.
  - Additional measures to broaden the personal income tax base by reducing or eliminating various allowances and exemptions.
  - An increase in the consumption tax rate, "introduced gradually over several years"; staff estimated that "each 1 percentage point increase would yield 0.5 percent of GDP."
  - Social security reforms beyond the 2004 pension reform, including strengthened enforcement of pension contributions and reforms of the medical and long-term care systems. Future pension reviews should consider both long-term finances and adverse effects on growth when weighing contribution hikes against benefit cuts.
- The mission recommended measures to enhance the plan’s credibility by specifying a primary surplus target and measures to achieve it, to help prevent a rise in real interest rates.

- Primary Balance Adjustment (in percent of GDP):
  - FY2004: General govt. -4.9; General govt. excluding social security -3.6; Social security -1.3
  - FY2013: General govt. 1.4; General govt. excluding social security 3.3; Social security -1.9
  - Adjustment: General govt. 6.3; General govt. excluding social security 6.9; Social security -0.6

- Primary Balance (Excluding Social Security) required to stabilize net debt (debt stabilized at 110 percent of GDP; social security primary deficit in 2013 estimated at 1.9 percent of GDP): table entries as presented:
  - Real interest rate/real GDP growth rate:
    - Row: 0.7 → 3.3 → 4.4 → 5.5
    - Row: 1.7 → 2.2 → 3.3 → 4.4
    - Row: 2.7 → 1.2 → 2.2 → 3.3
  - (Source: Fund Staff estimates.)

### Public pension reform (Box 2) — description, impacts, and critiques
- Demographic challenge:
  - "The elderly dependency ratio is expected to increase from about 30 percent currently to more than 70 percent in 2050."
  - Social security expenditure has been "the fastest growing component of public expenditure and is set to continue outpacing GDP growth in the future."
- Structure of the public system:
  - National Pension (NP): covers all people and pays flat-rate benefits.
  - Employee Pension Insurance (EPI): covers private sector employees and pays wage-related benefits.
  - Mutual pension schemes: cover public sector employees and have structures similar to the EPI.
- Key elements of the 2004 public pension reform:
  - "Contribution rates would be gradually raised through 2017: by 27 percent in real terms for the NP, and from 13.58 percent of salary to 18.3 percent for the EPI."
  - "Pension benefits would be gradually reduced (by not fully indexing them to the CPI), but the reductions would stop once the EPI benefits for a typical family fall to 50.2 percent of average salary (the current level is 59.3 percent)."
  - "Government transfers to the NP would increase gradually from one-third to one-half of total benefit payments between 2004 and 2009."
  - "The reserves of the pension system would fall to the level of annual benefit expenditure by 2100 (currently the reserves are five times annual benefit expenditure)."
- Projected fiscal impact:
  - Staff projections suggest that with the reform "the primary deficit of the public pension system would be 2 percent of GDP in 2050, compared to 5 percent of GDP in the absence of reform."
- Criticisms of the reform:
  - (i) It "relies heavily on increases in contribution rates and government transfers," which are likely to affect economic growth negatively (the latter because it would require higher taxes).
  - (ii) It "does not include an automatic mechanism to lower benefits or increase contributions" if current assumptions prove too optimistic.
  - (iii) It "deepens intergenerational inequality as the younger generations would bear most of the burden of the reform."

### Structural reforms (Box 3) — goals, measures, and potential gains
- Objective: reverse the secular decline in growth and productivity and enhance private sector activity and employment.
- Historical productivity changes:
  - Average labor productivity growth declined from "3¾ percent" to "2 percent."
  - Total factor productivity growth declined from "1.6 percent" to "0.2 percent."
- Main elements of the reform agenda:
  - Enhancing labor market flexibility: allowing temporary workers on fixed-term contracts up to three years (up from one), clarifying dismissal rules, increasing pension portability via defined-contribution plans (subject to a low contribution limit), expanding private job placement services (currently account for "1 percent of new hires"), and improving public job training effectiveness.
  - Advancing regulatory reform: Council for Regulatory Reform guiding removal of obstacles to private sector involvement in social sectors and establishing "special structural reform zones"; in FY2003 "over 300 special zones were approved."
  - Strengthening competition policy: steps to strengthen the Fair Trade Commission's independence and resources; temporarily reducing minimum capital required to start a new business.
  - Accelerating public enterprise reform: privatizing highway and postal corporations (the four highway corporations to be transformed into six private corporations; privatization of Japan Post "is set to begin in 2007").
- Possible gains from reforms (cited studies):
  - Studies in the 1990s suggested structural reforms could boost the level of output by "around 6 percent."
  - An OECD study estimated comprehensive regulatory reforms could reduce producer prices by "5–7 percent" and raise labor productivity and output levels by "5–6 percent."

### Trade policy and external openness
- Increased reliance on bilateral Economic Partnership Agreements (EPAs), with the preliminary EPA with Mexico highlighted for including commitments on agriculture.
- Staff view:
  - Steps toward liberalization welcome, but broad-based liberalization through the WTO would bring more substantial benefits and demonstrate support for the multilateral trading system.
  - Highlighted risks of trade diversion and proliferation of trade rules complicating trade administration.
- Authorities’ stance:
  - WTO and the Doha Development Agenda remain the centerpieces of Japan’s trade policy; pursuit of bilateral agreements is not a shift away from multilateral support but a response to regional agreements by other countries.
  - EPAs create opportunities to pursue objectives stalled in the Doha Round.
- WTO Ministerial in Cancun:
  - Authorities regarded the outcome as reflecting a deep-seated lack of consensus—principally on agriculture and the Singapore Issues.
  - Mission suggested Japan should play a leadership role in reinvigorating the Round.
- Agricultural support and LDCs:
  - Mission reiterated concerns that Japan’s continued high agricultural support unduly burdens Japanese consumers.
  - Japan’s imports from LDCs in 2003 accounted for "about 0.5 percent" of its total import bill.
  - Mission welcomed expanded product coverage for tariff- and quota-free imports from LDCs under Japan’s GSP and emphasized the importance of further lowering barriers to LDC exports.

### Other areas: statistics, transparency, and fiscal reporting
- The authorities were reviewing national-accounts methodology and considering a shift to a chain-weighted methodology; a data ROSC was intended to start in mid-2005.
- A fiscal ROSC update completed in June 2004 "welcomed the progress achieved in improving transparency and identified areas where further efforts were needed."
- Areas for further effort included:
  - Providing timely information on the consolidated general government balance.
  - Better integrating the medium term framework with the budget process.
  - Analyzing the financial implications of the Fiscal Investment and Loan Program (FILP); reforms initiated in 2001 had "significantly reduced its size," and the use of supplementary budgets had been minimized.

*Source: IMF staff report content unit _cr04249 - 33.*

### 43.      An AML/CFT ROSC completed in June 2004 (IMF Country Report No. 04/187)

### 43.      An AML/CFT ROSC completed in June 2004 (IMF Country Report No. 04/187)

### AML/CFT assessment
- An AML/CFT ROSC completed in June 2004 noted that important progress has been made towards achieving a high level of compliance with the FATF Recommendations.
- A comprehensive legal and institutional framework is in place.
- Remaining weaknesses noted:
  - international cooperation;
  - staffing resources for financial supervision (including of Japan Post);
  - staffing resources for the financial intelligence unit.

### Official Development Assistance (ODA)
- Japan remained the second largest provider of ODA despite a cut in ODA.
- Japan’s ODA was becoming more focused, targeted and prioritized to promote infrastructure development in Asia and Africa.
- Current ODA level reported as 0.2 percent of GNI, virtually the same as the weighted average in G-7 countries.
- Staff encouraged the authorities to raise ODA closer towards the UN target of 0.7 percent of GNI.

### Staff appraisal — overview
- The economic recovery, together with policy measures, has fostered progress in addressing longstanding economic problems.
- Deflationary pressures have eased amid a narrowing output gap and supportive monetary policy.
- Financial and corporate sector restructuring have continued, aided by enhancements to bank regulation and the framework for corporate revitalization.
- Risks to the outlook remain, stemming mainly from the external environment.

### Monetary policy
- The current monetary policy stance and strategy are appropriate for the present deflationary environment and should be maintained until inflation is firmly positive.
- Recent increases in the current-account target and steps to spell out necessary conditions for ending the quantitative easing framework have clarified the commitment to maintain zero-short term interest rates until deflation ends.
- With liquidity ample, further increases in the current account target could be considered if needed to signal commitment to the quantitative easing framework.
- Large-scale currency market interventions no longer seem necessary to prevent an undue tightening of monetary conditions; however, interventions could be used if significant upward pressures on the yen reemerged and threatened the recovery or heightened deflationary pressures.
- As the onset of inflation draws nearer, enhancements to the BoJ’s communications strategy could help stabilize inflation expectations:
  - quantifying the BoJ’s inflation objective as a desirable medium-term inflation rate (not a binding target for a fixed period);
  - publishing more details of the BoJ’s views on monetary policy and the inflation outlook.

### Financial sector and banking reforms
- Progress:
  - Economic recovery and strengthened regulation have fostered progress in resolving balance-sheet problems.
  - Major banks have reduced NPLs and DTAs and are on track to attain the NPL ratio target of about 4 percent by end-March 2005.
  - No signs of strain in the run-up to the cutback in deposit insurance coverage; it would be desirable to reduce deposit insurance coverage on April 1, 2005 as currently planned.
- Remaining weaknesses:
  - one major bank is very weak;
  - regional banks have made less progress in reducing NPLs;
  - core profits remain low;
  - DTAs are still a significant share of regulatory capital.
- Policy recommendations:
  - For major banks: further improve recognition of and provisioning for problem loans; strengthen bank capital; bolster bank governance.
  - For regional banks: introduce measures similar to those for major banks to catch up on NPL reduction; hold regional banks to the same rigorous minimum capital standard as major banks, introduced gradually in light of regional weaknesses.
  - Use the new capital injection facility, with appropriate conditionality, to facilitate consolidation among numerous regional institutions.
  - Implement soon plans to scale back government financial institutions in areas where they compete with private institutions to enhance profitability.
- Corporate restructuring:
  - A strengthened banking system would facilitate additional corporate restructuring.
  - Revisions to the Commercial Code to ensure that outside directors are fully independent from corporate management could improve incentives for corporations to restructure.
  - The IRCJ can continue to facilitate market-based restructuring, particularly where it has an advantage coordinating creditors.

### Fiscal situation and recommendations
- Public debt is already at very high levels; population aging will pose major fiscal challenges over the medium term.
- Staff regards the official goal to achieve a primary surplus (excluding social security) by the early 2010s and the recent adoption of public pension reforms as steps in the right direction.
- Given the need to begin fiscal consolidation and the favorable economic environment, achieving savings in FY2004 relative to the budget would be desirable.
  - It would be useful to explore scope for expenditure savings this year, which (together with any stronger than expected revenues) should be used to reduce the deficit.
- Medium-term consolidation options to stabilize the debt even at a very high level could include:
  - further social security reforms (in addition to recently adopted pension measures, reforms of the medical and long-term care elements);
  - further cutting capital spending;
  - broadening the personal income tax base;
  - (in the medium term) raising the consumption tax.
- Early consolidation steps could bolster credibility of the government’s medium-term fiscal plan and reduce the risk of a harmful rise in real interest rates.
- Credibility could also be enhanced by adopting a specific medium term primary surplus target and explicit measures to achieve it, while retaining flexibility to adapt to short-term economic fluctuations.

### Structural reforms and growth
- Accelerating the government’s structural reform program would raise potential growth.
- Recommended measures:
  - Front-loaded regulatory reforms;
  - Strengthen competition policy;
  - Further increase labor market flexibility;
  - Public enterprise reforms.
- These steps are especially important given rapid population aging.

### Trade policy
- Market opening under the preliminary EPA between Japan and Mexico is welcome.
- Multilateral liberalization under the WTO framework should remain the centerpiece of Japan’s trade policy regime.
- Authorities should work with other industrial countries to ensure achievement of the Doha Round’s development objectives; flexibility on agriculture will be essential.
- Concern remains about the high level of agricultural support; more cost-effective and less distortionary means of addressing non-trade concerns might be sought.
- The expansion of coverage for LDC exports under Japan’s generalized system of preferences in 2003 is commendable; authorities should work to make further progress.

### Data and statistics
- The review of the national accounts methodology is welcome.
- The staff encourages authorities to make needed improvements to national accounts data and notes the intention to conduct a data ROSC starting in mid-2005.
- Reducing the publications lag for fiscal statistics would ease analysis in this critically important area.

*IMF Country Report No. 04/187 — AML/CFT ROSC completed in June 2004*

### 58.       It is recommended that the next Article IV consultation take place on the

### _cr04249 - 58. It is recommended that the next Article IV consultation take place on the

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

### Executive Board / Article IV consultation findings and policy guidance
- The 2003 Article IV Consultation discussions: held during May 22–June 4, 2003; Executive Board concluded the consultation on August 20, 2003.
- Executive Directors:
  - welcomed recent signs of improvement in the economic situation and outlook;
  - welcomed progress in tackling major economic challenges facing Japan;
  - stressed that serious and interrelated problems remained;
  - agreed that a more comprehensive and integrated policy approach was needed to:
    - revitalize the corporate and financial sectors;
    - tackle deflation;
    - address fiscal imbalances.
- Publication: staff report, staff statement, FSSA and PIN were all published.

### Key macroeconomic indicators and projections (selected exact figures as reported)
- Nominal GDP: US$4,302 billion (2003)
- Population: 127.6 million (2003)
- GDP per capita: US$33,722 (2003)
- Quota: SDR 13,312.8 million

- Real GDP (Growth, percent change) 1997–2005 (row as reported):
  - Real GDP 1.8-1.20.22.80.4-0.32.54.52.4

- Domestic demand and components (row formatting preserved):
  - Domestic demand 0.8-1.50.32.31.2-1.01.83.72.0
  - Private consumption 1.00.00.20.81.80.90.83.21.8
  - Residential investment -11.7-14.5-0.10.7-5.3-4.2-0.82.02.0
  - Business investment 11.1-2.3-3.99.70.9-7.19.611.16.2
  - Government consumption 1.02.04.64.93.02.41.01.51.1
  - Public investment -10.5-2.26.7-10.0-4.5-4.7-10.5-10.2-7.5
  - Stockbuilding 2/ -0.1-0.6-0.40.30.0-0.20.30.2-0.1
- Net exports and trade components:
  - Net exports 2/ 1.00.3-0.10.5-0.70.70.70.90.5
  - Exports of goods and services 11.5-2.41.412.5-6.17.910.113.47.6
  - Imports of goods and services 1.0-6.63.39.30.21.95.08.25.1

- Saving–Investment (percent of GDP):
  - Gross national saving 30.929.828.628.827.826.727.227.727.8
  - Gross domestic investment 28.726.826.026.325.723.924.024.424.5

- Inflation (annual average):
  - CPI (SA) 1.70.6-0.3-0.9-0.8-0.9-0.2-0.10.0
  - GDP deflator 0.3-0.1-1.5-2.0-1.5-1.2-2.5-2.2-1.1

- Unemployment rate (annual average):
  - 3.44.14.74.75.05.45.34.74.4

### Government finance (fiscal year basis, percent of GDP)
- General government (selected lines, 1999–2004, fiscal year rows preserved):
  - Total revenue 28.829.329.728.328.428.5
  - Taxes and fines 16.617.317.215.916.216.3
  - Social security premiums 9.79.810.310.410.410.5
  - Total expenditure 36.536.036.436.436.235.2
  - Current 29.129.230.430.730.930.9
  - Interest paid 3.43.33.13.03.13.2
  - Balance -7.7-6.6-6.7-8.1-7.9-6.7
  - Balance excluding social security -8.6-7.0-6.6-8.0-7.3-6.2
  - Primary balance 2/ -5.7-4.6-5.2-6.8-5.8-4.9
  - Structural balance (excluding support for banks) -6.1-5.5-5.0-6.5-6.5-6.5
- Debt (calendar year, percent of GDP):
  - Gross 131.0139.3148.9158.4166.2168.9
  - Net 53.559.165.171.479.684.8

### Monetary and financial indicators (selected)
- Monetary aggregates (end-period and percent change rows preserved from Table 2):
  - Base money (in trillions of yen, sample column) 68.768.079.494.9107.596.6102.8103.6107.5108.1108.8
  - M1 (period average, trillions of yen) 213.2230.6250.1319.2345.5341.2346.6345.6354.0354.9363.0
  - M2 + CDs (period average, trillions of yen) 616.3629.3646.8668.2679.6674.2681.0680.2685.8685.8694.0
  - Bank lending (end-period, trillions of yen) 478.4460.4440.5419.6398.1417.3403.7399.9398.1397.5389.0
  - Year-on-year percent change, base money 14.2-1.116.919.513.210.920.320.913.211.97.4
  - Year-on-year percent change, M2 + CDs 3.72.12.83.31.71.71.81.81.51.72.0
  - Year-on-year percent change, Bank lending -5.9-3.8-4.3-4.8-5.1-4.5-4.6-5.0-5.1-4.8-4.1

- Interest rates (selected):
  - Three-month CD rate (annual average) 0.50.60.10.20.090.070.090.059
  - Official discount rate (end-period) 0.50.50.50.50.100.100.100.109

- Financial sector risk indicators (selected, percent)
  - General government gross debt (percent of GDP, end-year series) 99.3105.9117.8131.1139.4148.9158.4166.3
  - Total loans to assets 52.550.949.947.344.339.638.234.6
  - Total loans to deposits 107.6107.0105.198.997.893.487.381.9
  - Share of non-performing loans in total loans (end-fiscal year, major banks) 4.95.56.15.45.38.47.25.2
  - Risk-weighted capital ratio (end-fiscal year, major banks) 9.09.511.611.811.710.410.2

### External sector and balance of payments (selected exact figures)
- Balance of payments (in billions of U.S. dollars, 1997–2004 rows preserved):
  - Current balance 96.6119.1114.5119.687.8112.6136.2149.3
  - Trade balance 101.5122.7123.4116.770.293.9106.4129.1
  - Exports, f.o.b. 409.2374.4403.9459.6383.5395.7449.2525.2
  - Imports, f.o.b. 307.8251.6280.5342.8313.3301.8342.8396.1
  - Reserve assets changes (selected) -6.97.4-77.3-49.3-41.1-46.7-188.1-57.4
- External indicators and vulnerability metrics:
  - Total reserves minus gold (US$ billion) 216.6219.6215.5286.9354.9395.2461.2663.3807.2
  - In months of imports of goods and services 6.06.37.49.19.611.714.017.9
  - Broad money (M2 + CDs) to reserves ratio 2.32.12.11.91.61.31.10.90.8
  - Net international investment position (US$ billion) 891.0958.71,153.6829.11,157.91,249.11,598.51,721.9

### Fund relations and administrative facts (as of April 30, 2004)
- Membership: Joined 8/13/52; Article VIII.
- General Resources Account (SDR Million and % Quota):
  - Quota 13,312.80 (100.00)
  - Fund holdings of currency 8,312.97 (62.44)
  - Reserve position in Fund 5,000.58 (37.56)
- SDR Department:
  - Net cumulative allocation 891.69 (100.00)
  - Holdings 1,842.56 (206.64)
- Outstanding Purchases and Loans: None
- Financial Arrangements: None
- Projected Obligations to Fund: None
- Exchange rate arrangement:
  - Japan maintains a floating exchange rate regime.
  - The exchange system is free of restrictions on the making of payments and transfers for current international transactions, with the exceptions of restrictions maintained against Taliban, Al-Qaida, and other terrorists, pursuant to UN Security Council Resolutions 1267, 1333, 1390 and 1373 (notified to the Fund EBD/02/52).
  - Japan also maintains exchange restrictions against the former Iraqi regime that have not yet been notified to and approved by the Fund under Decision 144–(52/51).

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04249.pdf*

### 1.  Japan subscribed to the Special Data Dissemination Standard (SDDS) on July 3, 1996

### Japan subscribed to the Special Data Dissemination Standard (SDDS) on July 3, 1996

### SDDS subscription and data adequacy
- Japan subscribed to the Special Data Dissemination Standard (SDDS) on July 3, 1996.
- Met the SDDS specifications for the coverage, periodicity, and timeliness of data and for dissemination of advance release calendars on June 9, 2000.
- Economic and financial data provided to the Fund are considered adequate for surveillance purposes.

### National accounts and real sector statistics
- The Japanese National Accounts were revised in 2000 by the Economic and Social Research Institute (ESRI) to reflect the 1993 System of National Accounts (1993 SNA).
  - Revisions included: inclusion of spending on computer software in investment expenditure; depreciation on social capital in government consumption; revision of the benchmark year to 1995.
  - Improved seasonal adjustment methods introduced to take account of leap year and other shift factors.
  - Data revisions from 1980 onwards described in ESRI’s publication System of National Accounts 1993 in Japan (April 2001).
- Quarterly GDP estimates:
  - ESRI releases preliminary estimates of quarterly GDP.
  - Starting with data from Q2 2002, a new method combines supply and demand side indicators to reduce statistical discrepancy between production and expenditure measures.
  - ESRI now releases the preliminary estimate about 1½ months after the end of the quarter, approximately a month earlier than before.
  - More frequent backward revisions and concurrent seasonal adjustment methods were introduced.
  - More complete annual national accounts data are only available with a lag of nine months.
- Price and production indices:
  - Bank of Japan (BoJ) revised the Wholesale Price Index (WPI): base year updated from 1995 to 2000; changed commodities released as index series; increased sample prices; renamed index to Corporate Goods Price Index (CGPI).
  - Industrial production series improved in April 2003: base year updated from 1995 to 2000; component weights and seasonal adjustment factors updated; increased weight on the electrical machinery sector; revised seasonal adjustments may smooth recent history.
- Other national accounts improvements:
  - November 2002: improved methods for estimating pension fund output; part of expenditure on mobile telecommunication devices reclassified to consumption; changes incorporated back to 1980.
  - Family Income and Expenditure Survey (FIES) volatility addressed: January 2002 modest sample expansion to about 9,000 households; reclassification to better reflect IT product expenditures; new durable goods expenditures survey covering about 30,000 households introduced in October 2001.
- Data limitations and practices:
  - GDP breakdowns for some key components of demand are available only with the annual data (trade flows into goods and services; business investment into structures and equipment; private consumption into durables and nondurables).
  - Preliminary estimates for the income side of the national accounts (except compensation of employees) are not provided; profits estimates are based on imputed quarterly patterns for annual data.
  - ESRI relies on other agencies/organizations to compile source data and coordinates with data providers on survey and administrative collection design.
  - GDP deflator and corresponding volume series are re-based every five years; current base year is 1995.

### Fiscal statistics and public sector accounts
- Fiscal accounts structure:
  - Distinguish between general (ordinary) accounts for core government functions and special accounts, some partly financed through borrowing from the Fiscal Loan Fund (main part of FILP).
  - Information on the central government general account is readily available, but published consolidated accounts (which incorporate special accounts) are insufficient to calculate a consolidated deficit.
- Subnational government data:
  - More than 3,000 independent prefectures and municipalities; their finances are consolidated with a delay of about one year.
- Timing and availability:
  - Data on general government operations—including disaggregation by major government sector—are available with the release of the annual national accounts data.
  - Government annual balance sheet published since October 2000; estimates from FY1998 to FY2001 available.
  - Relationship between balance sheet and national accounts flow data is unclear because the balance sheet consolidates the FILP whereas flow data do not.
- Reporting gaps:
  - Authorities have not reported fiscal data for publication in the GFS Yearbook since 1994; STA attempts to initiate reporting were unsuccessful.
  - Japan country page was dropped from the 2003 GFS Yearbook.
  - No fiscal data are reported for publication in IFS.

### External sector statistics
- Monthly merchandise trade and balance of payments data are released on a timely basis.
- Financial account issue:
  - Proceeds from sale of loans during 1997–2000 may be overstated because sales were not recorded at market prices.
  - BoJ recorded corresponding large debit entries as capital transfers in the capital account.

### Monetary and financial sector statistics
- Banking sector data dissemination:
  - Money stocks and total credit are disseminated 6–8 business days after the end of the reference month.
  - Banking sector data on the external position and breakdown of credit to government and private sector are usually disseminated 6–7 weeks after the end of the reference month (as “The Monetary Survey” in BoJ’s Financial and Economic Statistics Monthly).
  - Only money stocks and total credit meet the one-month SDDS timeliness requirement for Analytical Accounts of the Banking sector (AAB); Japan uses a timeliness flexibility option for other AAB components on grounds of an extensive branch banking system.

### Recommendations for data improvements
- Short term:
  - Improve the timeliness and periodicity of fiscal data (particularly given the importance of monitoring fiscal consolidation efforts on a comprehensive basis).
- Longer term:
  - Move data production (other than monetary and financial statistics) to a single, independent agency staffed with professional statisticians.
  - Provide greater detail on the quarterly components of national accounts.

### Public debt sustainability: baseline, projections, and stress tests
- Baseline assumptions and policy intent:
  - Analysis centered on a baseline scenario broadly based on publicly announced medium term fiscal goals.
  - Authorities aim to move from a primary deficit to a primary surplus in the accounts of the general government excluding social security by the early 2010s.
  - For this analysis, a primary balance of zero is assumed to be achieved by 2013 through tax increases and capital expenditure reductions.
  - Projections for social security incorporate the favorable impact of the 2004 pension reform, but rising deficits remain owing to rapidly increasing medical costs (health care contribution rates are assumed to remain fixed).
  - Assumptions consistent with a reduction in the overall primary deficit to about 3 percent by 2009.
- Baseline debt path and risks:
  - Under the baseline, public debt will grow rapidly over the next 5 years.
  - By 2009, net debt will reach 106 percent of GDP (compared to 80 percent of GDP at end-2003).
  - Debt would accumulate more rapidly if contingent liabilities (e.g., bank recapitalization or default on guaranteed loans) need to be met.
  - Standard stress tests illustrate sensitivity to shocks.
- Stabilization requirements:
  - Stabilizing the debt-to-GDP ratio requires substantial consolidation beyond the baseline.
  - Example: stabilizing net debt at 110 percent of GDP by 2013 would require achieving a general government primary surplus of 1.4 percent of GDP.
  - Reaching that surplus requires an adjustment of 6.3 percent of GDP in the overall primary balance (6.9 percent of GDP in the primary balance excluding social security), compared with an adjustment of 3.6 percent in the baseline.
  - Even with that adjustment, net debt-to-GDP would be very high by international standards; further consolidation may be desirable.
- Policy implications:
  - Urgent need to address fiscal challenges from rapid population aging and high public indebtedness.
  - Consolidation at local and central government levels requires significant efforts to control expenditure and increase revenue.
  - Adjustment in social security should involve reform of the health care system to address rapidly rising costs.
  - Importance of limiting reliance on revenue measures in social security reforms because the tax burden is already bound to increase significantly in the next two decades.
- Selected projection table highlights (net general government debt, percent of GDP):
  - 1998: 45.8
  - 1999: 53.5
  - 2000: 59.1
  - 2001: 65.1
  - 2002: 71.4
  - 2003: 79.6
  - 2004: 84.8
  - 2005: 89.9
  - 2006: 94.7
  - 2007: 98.9
  - 2008: 102.7
  - 2009: 106.1
- Key macro-fiscal assumptions used in projections:
  - Real potential GDP growth assumed at 1.7 percent (used in a stabilization example).
  - Long-term real interest rate assumed at 3 percent beyond 2009 (used in a stabilization example).
  - Historical and projection assumptions shown for: Real GDP growth, Average nominal interest rate on public debt, Average real interest rate, Inflation rate (GDP deflator), Growth of real primary spending, Primary deficit.
- Stress test outcomes (selected scenarios, net debt percent of GDP in later years):
  - Baseline 2003: 79.6
  - A1 (key variables at historical averages in 2004–08): 119.9 (by 2009 in that scenario table)
  - B1 (real interest rate shock): 113.8 (last year shown)
  - B2 (real GDP growth shock): 136.6 (last year shown)
  - B3 (primary balance shock): 111.6 (last year shown)
  - B4 (combination of 1–3 using one standard deviation shocks): 120.2 (last year shown)
  - B5 (10 percent of GDP increase in other debt-creating flows in 2004): 116.4 (last year shown)

### Supplementary information and recent developments (as of July 23, 2004)
- Economic indicators and near-term outlook:
  - Recent indicators suggest the economic recovery continues apace.
  - During Q2, the Tankan index of business conditions rose to its highest level in a decade.
  - Machinery orders on a solid uptrend; private investment strength implied.
  - Household spending rose 5.6 percent (y/y) in May.
  - Unemployment rate fell to 4.6 percent.
  - Tankan survey data indicate a further easing of deflationary pressures; consumer price inflation remains slightly negative.
  - Near-term risks may be tilted to the upside for business fixed investment and private consumption.
  - Government raised its forecast for FY2004 GDP growth to 3.5 percent (up from 1.8 percent released in January).
  - July consensus forecast for CY2004 is 4.2 percent; staff forecast is 4.5 percent.
- Political developments:
  - July 11 upper house elections: ruling coalition retained a majority; LDP and New Komeito hold combined 139 seats (of 242), same as before; Democratic Party of Japan (DPJ) increased to 82 seats from 70.
  - Ruling coalition also controls majority in the lower house.
- Pension reform discussion:
  - Post-election, discussion of pension reforms regained momentum.
  - DPJ called for repeal of the pension reform act; government plans to implement it as scheduled.
  - Government plans to establish a council (including business and labor representatives) to consider fundamental reforms to pensions, medical care, and long-term care.

*Source: International Monetary Fund, Staff Report for the 2004 Article IV Consultation — Supplementary Information (Prepared by the Asia and Pacific Department, Approved July 23, 2004).*

### 6.      On July 14, two major banks announced plans to merge and form the largest

### On July 14, two major banks announced plans to merge and form the largest bank in the world.

### Banking merger and banking-sector developments
- Merger partners: Mitsubishi Tokyo Financial Group (MTFG) (lowest ratio of nonperforming loans (NPL) to total loans among the major banks) and UFJ (much higher ratio).
- Observers’ assessment:
  - Operational integration could be complex and time-consuming.
  - Successful strengthening of the merged bank’s management culture and realization of synergies across business lines would yield a strong and profitable bank.
  - MTFG’s strong capital position could allow UFJ to write off NPLs more quickly.
- Market reaction: Financial markets reacted favorably; bank stocks rose after the announcement.
- Banking-sector trends noted in FY2003:
  - Nonperforming loans at major banks declined to about 5 percent of loans (target: about 4 percent by end-FY2004).
  - Regional banks account for 40 percent of bank lending and lag in NPL reduction and capital strengthening.
  - Major banks increased profits and capital adequacy ratios, but core profits and quality of capital remained weak.
- Policy implications and recommendations:
  - Improve recognition of, and provisioning for, problem loans; strengthen bank capital; bolster bank governance for major banks.
  - Scale back competition of government financial institutions with private institutions to improve prospects for bank profitability.
  - Apply similar restructuring measures to regional banks; use the new capital injection facility, with appropriate conditionality, to facilitate consolidation among regional banks.
  - Proceed with planned reduction in deposit insurance coverage by the end of the fiscal year (welcomed in light of banking progress).

### Macroeconomic outlook and growth
- Recent performance:
  - 2003 GDP growth: 2½ percent.
  - Q1 2004 growth: about 6 percent on an annualized basis.
  - Recovery drivers: initially business fixed investment and net exports; more recently private consumption as labor market conditions improved.
  - Current account surplus widened to 3¼ percent of GDP.
- Projections:
  - Real GDP projected to expand by 4½ percent in 2004 and 2½ percent in 2005.
  - Beyond near term, growth envisaged to slow to around potential, estimated by staff at around 1.7 percent per year.
  - CPI deflation expected to ebb to zero by the end of this period.
- Risks: Potential sharp rise in global interest rates or a slowdown in key trading partners could threaten the outlook.
- Structural reforms: Additional structural economic reforms and continued progress in financial and corporate sector restructuring could raise Japan’s economic potential.

### Monetary policy and exchange rates
- BoJ policy stance:
  - Short-term interest rates maintained at zero under the Bank of Japan’s quantitative easing framework.
  - Increases in the BoJ’s target for current account balances supported base money growth and financial stability.
  - Quantitative easing maintained at least until core CPI growth is nonnegative for a few months and positive inflation is expected.
- Directors’ views:
  - Current accommodative stance is appropriate.
  - Further increases in the current account operating target could be used if needed to reinforce commitment.
  - As deflation ends, enhancements to BoJ communication could help stabilize inflation expectations.
  - Some Directors supported quantification of a medium-term inflation objective and eventual shift to inflation targeting; others viewed that as premature.
- Exchange-rate interventions:
  - Authorities intervened to counter upward pressure on the yen: ¥20 trillion in 2003 and ¥15 trillion in Q1 2004.
  - Since June 2003, yen/dollar rate appreciated by about 9 percent; on a multilateral basis yen appreciated only moderately.
  - Nearly all Directors observed that sizeable past interventions prevented undue tightening of monetary conditions, but with exchange rate risks more balanced interventions were not seen as desirable. Many Directors would permit intervention if significant upward pressures reemerged; others warned against exacerbating global imbalances and urged market-determined rates.

### Fiscal position and social policy
- FY2003 fiscal outcomes:
  - Government recorded a fiscal deficit of 7.9 percent of GDP.
  - Structural stance (including social security but excluding bank support): around 6½ percent of GDP.
  - Public debt estimated at 166 percent of GDP on a gross basis (80 percent on a net basis) at end-2003.
- Pension reform (noted in staff report footnote):
  - Pension reform act passed in June stipulates a rise in premiums from 13.58 percent this year to 18.30 percent in 2017; this would entail annual premium increases of about 1/3 of a percentage point.
- Directors’ recommendations for medium-term fiscal consolidation:
  - Achieve savings relative to the budget in fiscal year 2004 if the recovery remains robust by saving stronger-than-expected revenues and seeking expenditure reductions.
  - Substantial medium-term fiscal adjustment needed to put public debt on a sustainable trajectory.
  - Welcome to pension reforms; further social security reforms needed in medical and long-term care systems.
  - Scope to broaden the personal income tax base, increase the consumption tax rate over time, and further reduce public investment.
  - Consider defining a more specific goal for the primary balance and supporting measures to achieve it, while retaining flexibility.
  - Reform local finances: reduce transfers from the central government and increase tax autonomy to improve subnational fiscal positions.

### Corporate sector and structural reforms
- Corporate restructuring:
  - Restructuring expanded from large export-oriented manufacturers to SMEs and nonmanufacturers.
  - Debt levels remain high but profit indicators improved driven by labor cost reductions, strong external demand, and buoyant sales.
  - Improvement in corporate profits contributed to stock-price rebound: Nikkei Index gained about 50 percent since 2003 lows.
- Policy recommendations:
  - Strengthening the banking system would facilitate additional corporate restructuring.
  - Industrial Revitalization Corporation of Japan could continue to coordinate creditors and facilitate market-based restructuring.
  - Accelerate implementation of structural reforms to raise long-term economic potential: improve labor market flexibility, relax business regulation, strengthen competition policy, and reform public enterprises.

### Executive Board assessment—summary of priorities
- Directors welcomed broadening recovery, easing deflationary pressures, and ongoing restructuring.
- Key priorities identified:
  - Broader financial and corporate sector restructuring.
  - Medium-term fiscal consolidation.
  - Continued structural reforms to raise potential growth.
- Additional points:
  - Support for further enhancement of Bank of Japan communication.
  - Need for more analysis of exchange rate policies in future Article IV reports.
  - Commendation for high compliance with international standards to combat money laundering and terrorism financing, with encouragement to address remaining weaknesses.
  - Support for Japan raising Official Development Assistance toward the UN target of 0.7 percent of GNI.

### Key economic indicators (selected values from Japan: Selected Economic Indicators)
- GDP growth rates:
  - 2000: 2.8
  - 2001: 0.4
  - 2002: -0.3
  - 2003: 2.5
  - Proj. 2004: 4.5
- Components (selected):
  - Private consumption: 2000: 0.8; 2001: 1.8; 2002: 0.9; 2003: 0.8; Proj. 2004: 3.2
  - Nonresidential investment: 2000: 9.7; 2001: 0.9; 2002: -7.1; 2003: 9.6; Proj. 2004: 11.1
  - Exports of goods and services: 2000: 12.5; 2001: -6.1; 2002: 7.9; 2003: 10.1; Proj. 2004: 13.4
- Inflation:
  - GDP deflator: 2000: -2.0; 2001: -1.5; 2002: -1.2; 2003: -2.5; Proj. 2004: -2.2
  - CPI: 2000: -0.9; 2001: -0.8; 2002: -0.9; 2003: -0.2; Proj. 2004: -0.1
- Unemployment rate (period average, percent):
  - 2000: 4.7; 2001: 5.0; 2002: 5.4; 2003: 5.3; Proj. 2004: 4.7
- Current account balance:
  - Billions of U.S. dollars: 2000: 119.6; 2001: 87.8; 2002: 112.6; 2003: 136.2; Proj. 2004: 149.3
  - Percent of GDP: 2000: 2.5; 2001: 2.1; 2002: 2.8; 2003: 3.2; Proj. 2004: 3.2
- General government balances (percent of GDP, FY):
  - Balance including social security: 2000: -6.6; 2001: -6.7; 2002: -8.1; 2003: -7.9; Proj. 2004: -6.7
  - Balance excluding social security: 2000: -7.0; 2001: -6.6; 2002: -8.0; 2003: -7.3; Proj. 2004: -6.2
  - Structural balance: 2000: -5.5; 2001: -5.0; 2002: -6.5; 2003: -6.5; Proj. 2004: -6.5
- Monetary and credit (12-month growth rate; end period):
  - Base money: 2000: -1.1; 2001: 16.9; 2002: 19.5; 2003: 13.2; Proj. 2004: 4.4 3/
  - M2 + CDs (period average): 2000: 2.1; 2001: 2.8; 2002: 3.3; 2003: 1.7; Proj. 2004: 1.8 3/
  - Bank lending: 2000: -3.8; 2001: -4.3; 2002: -4.8; 2003: -5.1; Proj. 2004: -4.2 3/
- Exchange and interest rates (period average):
  - Yen/dollar rate: 2000: 107.8; 2001: 121.5; 2002: 125.4; 2003: 115.9; Proj. 2004: 111.2 5/
  - Real effective exchange rate (1990 = 100): 2000: 136.6; 2001: 120.8; 2002: 110.0; 2003: 107.3; Proj. 2004: 108.0 3/
  - 3-month CD rate: 2000: 0.20; 2001: 0.09; 2002: 0.07; 2003: 0.09; Proj. 2004: 0.05 5/
  - 10-year government bond yield: 2000: 1.74; 2001: 1.33; 2002: 1.28; 2003: 1.00; Proj. 2004: 1.86 5/

*Public Information Notice (PIN) No. 04/88 — IMF Concludes 2004 Article IV Consultation with Japan; August 11, 2004.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04249.pdf_