## _cr06275

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---

### Executive summary — main findings
- Post-bubble adjustment essentially complete; economic activity expanding robustly driven by domestic demand; downside risks mainly external, upside risks to private consumption and investment.
- Financial and corporate sectors strengthening: nonperforming loans continue to fall and bank lending is reviving; core profits remain low; corporate restructuring spurring productivity gains and record profits.
- Monetary policy normalizing: core CPI positive y/y for a few months; in March the Bank of Japan shifted from targeting reserves to targeting the overnight policy interest rate (which remains at zero) and introduced a new post-deflation framework.
- Fiscal consolidation proceeding but imbalances remain large: authorities project achieving a primary balance excluding social security in 2011; the corresponding (estimated) deficit fell 1 percent of GDP in FY2005; net debt ratio high by advanced-country standards and rising.
- External surplus narrowing: trade balance fell in 2005; yen recently strengthened but in effective terms remains relatively weak compared with the past.
- Reforms (deregulation, product and labor market liberalization) intended to lift productivity and medium-term growth prospects.

### Economic and financial backdrop
- Growth and inflation
  - 2005 GDP growth was over 2½ percent; GDP grew at a seasonally adjusted annual rate of about 3 percent in Q1 2006.
  - Core inflation (CPI excluding fresh food) positive since November 2005; year-on-year core inflation was ½ percent in April 2006 and 0.6 percent in May 2006.
  - GDP deflator continues to decline; implicit deflator for domestic demand rising marginally.
  - Land prices in major cities rebounding after a fifteen-year slide.
- Labor market and corporate sector
  - Unemployment around an eight-year low at 4.1 percent; labor shortages emerging; wages and bonuses risen though unit labor costs still falling.
  - Major banks’ NPL ratios fell to below 2 percent in March 2006; regional banks’ NPLs at 4½ percent of total loans.
  - Corporate debt-to-sales ratios at lowest level since the bubble for all firms; lowest in 25 years for manufacturers.
  - Bank lending (adjusted for provisions and write-offs) trending up since mid-2005 after about eight years of contraction.
- External sector and exchange rate
  - Trade balance fell in 2005 by ¾ percent of GDP despite real effective yen depreciation.
  - Current account declined more modestly as factor income surged.
  - Yen depreciated nearly 15 percent against the U.S. dollar in 2005; since then appreciated modestly, but nominal and real effective terms remain about 6¼ percent weaker than a year ago; real effective yen about as weak as at the time of the 1985 Plaza Accord.
  - No foreign exchange intervention since March 2004.

### Outlook and risks
- Baseline: GDP growth projected at nearly 3 percent in 2006 (output gap expected to turn positive for the first time since 1992) and just above 2 percent in 2007; current account surplus would hover around 3½ percent of GDP.
- Downside risks: volatile oil prices, rising long-term interest rates, global slowdown; low inflation raises possibility of renewed deflation in adverse scenarios.
- Upside risks: stronger private consumption and investment.
- Medium term: staff raises potential growth estimate to 1¾–2 percent; potential growth could be higher with stepped-up reforms, increased labor-force participation, and a recovery in R&D.

### Authorities’ view
- Authorities broadly agreed with the outlook and judged risk of a deflationary spiral remote given stronger balance sheets and a closing output gap.
- BoJ and Cabinet Office estimate potential growth at 1½–2 percent; authorities consider reforms could boost longer-term real growth to about 2¼ percent despite population aging.

### The Bank of Japan’s post-deflation monetary framework
- Transition out of quantitative easing
  - Pre-announced conditions met in early 2006; BoJ announced exit on March 9, 2006, gradually draining liquidity while keeping overnight rates effectively at zero.
  - Excess reserves declined from over ¥30 trillion to around ¥10 trillion since March; short rates stable; money market activity reviving.
- Main features of the new framework
  - Anchor for inflation expectations: Policy Board’s “understanding of price stability” is headline CPI inflation of 0–2 percent over the medium and longer term; not a preset-horizon target; reviewed annually.
  - Forward-looking orientation: policy informed by (i) near-term (1–2 year) forecasts of activity and prices and (ii) longer-term risks, including low-probability/high-cost threats.
  - Communication parameters: Bank will outline its two-perspective analysis periodically, as a rule in the semi-annual Outlook for Economic Activity and Prices, disclosing Policy Board members’ forecasts.
  - Rationale for 0–2 percent range: CPI is timely and understood; range reflects statistical bias, downward wage flexibility, bi-annual bonuses around 20 percent of compensation, degree of wage rigidity, level of potential growth, robustness of financial system, availability of fiscal policy, and effectiveness of monetary transmission.
- Staff and BoJ views on implementation and stance
  - Near-term policy should remain accommodative to allow inflation expectations to drift up; Taylor-like rules suggest a near-zero rate appropriate for now; when tightening begins, proceed gradually.
  - Continued effective communication about implementation important to ensure markets understand BoJ intentions.
  - More explicit communication on risks associated with inflation at the lower end of the range and guidance on possible upward adjustment of the range over time would help market expectations.

### Monetary policy if fiscal headroom limited
- With limited fiscal maneuver, monetary policy would need to lead in offsetting adverse shocks.
- If abrupt foreign exchange or other shocks threaten price stability, BoJ could communicate that such developments would be considered together with other data in setting policy.

### Fiscal stance and consolidation
- Fiscal imbalances large and worrisome despite consolidation: deficits for 13 consecutive years have propelled gross and net general government debt to about 180 percent and 85 percent of GDP, respectively, and both continue to rise.
- Consolidation plan centers on primary account of general government excluding social security; aim to achieve balance through average yearly adjustment of ½ percent of GDP; indicative target date for balance moved to FY2011.
- Progress:
  - Outturn for FY2005 likely better than projected, with decline in primary deficit excluding social security of perhaps 1 percent of GDP.
  - FY2006 budget envisages a fall of some ¾ percent of GDP in general expenditure of the general account compared to FY2005 initial budget.
- Staff recommendation on pace:
  - Staff proposes adjustment of ¾ percent per year on average over six years (an additional ¼ percent per year relative to authorities’ projection), cumulatively about 4½ percent of GDP, to stabilize debt ratio and provide policy insurance.
  - Evidence from selected OECD consolidations suggests consolidation at such a pace need not have significant negative impact on output; strong case for front-loading the adjustment, with initial annual adjustments above ¾ percent of GDP.
- Composition and timing
  - Model simulations indicate package of expenditure and tax measures needed; expenditure cuts alone unlikely to suffice given social security outlays trajectory.
  - Empirical analysis indicates a consumption tax increase preferable among revenue measures with respect to output impact.
  - Early adoption of a package (lower spending, lower transfers, higher VAT) dominates a protracted adjustment.

### Key fiscal figures (percent of GDP, fiscal year basis) reproduced exactly
- General government — Revenue: 28.7, 29.1, 29.7, 30.4, 31.0, 31.7, 32.3, 32.9 (2004–2011)
- General government — Expenditure: 34.3, 34.5, 34.6, 35.2, 35.6, 36.0, 36.4, 37.0 (2004–2011)
- General government — Balance: -5.6, -5.3, -5.0, -4.8, -4.6, -4.3, -4.1, -4.2 (2004–2011)
- Primary Balance excluding social security: -3.9, -3.0, -2.3, -1.8, -1.2, -0.6, -0.2, 0.0 (2004–2011)

### Central Government: General Account FY2006 (percent of GDP) (as presented)
- Revenue: 10.1 (Revised), 9.5 (Initial), 10.5 (Revised 1/), 9.5 (Initial 2/)
- General expenditure: 10.5 (Revised), 9.7 (Initial), 10.1 (Revised 1/), 9.0 (Initial 2/)
- Other expenditures 3/: 7.0 (Revised), 6.5 (Initial), 7.0 (Revised 1/), 6.2 (Initial 2/)
- Bond issuance: 7.4 (Revised), 6.8 (Initial), 6.6 (Revised 1/), 5.7 (Initial 2/)
- General Government (Fund staff estimates): Balance: -5.6, -5.3, -5.0 (FY2004, FY2005, FY2006); Primary balance excluding social security: -3.9, -3.0, -2.3 (FY2004, FY2005, FY2006)

### Simulation and international evidence
- Lessons from selected OECD consolidations: historical improvements in primary balances between 5.1 percent of GDP (Australia) and 9.7 percent of GDP (Canada) over an average of 7 years; average pace 1.1 percent of GDP. Japan’s 1980s pace about ¾ percent of GDP per year.
- GFM simulation findings:
  - Reducing social security transfers has moderately smaller negative short-run impact than raising taxes or cutting other expenditure.
  - Among revenue measures, a VAT increase has the least negative effect on output.
  - Fiscal multipliers around unity or less in short run, smaller in long run.
  - A package of lower government spending, lower transfers, and higher VAT compares favorably (in output effects) to only increasing VAT or only reducing spending.
  - A modestly more ambitious consolidation (additional ¼ percent of GDP per year) would stabilize debt-to-GDP ratio and increase long-term output via capital accumulation; spillovers to global output modest but positive long run.

### Specific medium-term consolidation options considered
- (i) Reducing investment (public investment remains at 3½ percent of GDP).
- (ii) Economies through civil service reform.
- (iii) Broadening corporate and personal income tax bases (about 50 percent of personal income is taxable, compared to almost 80 percent in the United States and over 90 percent in the United Kingdom).
- (iv) Raising the consumption tax (now very low by international standards).
- (v) Reforming budget framework to consolidate earmarked Special Accounts.
- (vi) Further reforms of social security to address demographic pressures.

### Social Security expenditure (Box 4) — projections, reforms, risks
- Official projection: government expenditure on social security would rise to about 22 percent of GDP by 2025, up from about 18 percent of GDP in 2006 under a no-reform scenario.
- Pension reform (2004):
  - Employee Pension Insurance (EPI) contribution rate envisaged to increase from 13.6 percent to 18.3 percent of salary by 2017.
  - EPI replacement ratio reduced from 59 percent to 50 percent through “macro-indexation”.
  - National Pension flat contribution to increase by 27 percent in real terms by 2017; government contribution to National Pension to increase from ⅓ to ½ of total benefits by 2009.
- Medical care reform (law voted June 2006):
  - Short-run fee and drug tariff revisions downward by about 3 percent; raise out-of-pocket payments for well-to-do elderly to 30 percent (from 20 percent).
  - Medium-term: greater preventive medicine, shorter hospital stays; five-year reviews of expenditure trends.
  - New system for elderly to be introduced in FY2008; small insurers to be consolidated at prefectural level.
- Projected savings: reforms projected to save about ¥21 trillion (about 3 percent of GDP) by 2025; pension reform would yield largest economies.
- Remaining financing needs and risks: measures equivalent to about 1 percent of GDP still needed to finance increased government contribution to national pension scheme; risk that government projections overly optimistic (e.g., lower-than-expected birth rate may create revenue shortfall).

### Financial sector — profitability, oversight, and risks
- Major banks’ core profits remain low despite high net income; priorities: improve profitability and risk management.
- Banks expanding into fee-earning activities; effects of deregulation yet to be seen.
- Risks from rising interest rates considered manageable due to improved bank capital and reduced duration of exposures.
- Basel II introduction planned by end-March 2007; revisions to capital adequacy regulations and supervision guidelines made in March 2006.
- BoJ report: a 100-basis point rise in long-term yields → losses amount to about 5 percent of Tier 1 capital for major banks as of end-March 2005.
- Securities markets and GFIs: Financial Instruments and Exchange Law promotes market development; Tokyo Stock Exchange expanding capacity and will introduce a new system by 2009.

### International implications and exchange rate considerations
- Since 2002 Japan’s real GDP risen at 2¼ percent annual rate, adding on average about ¼ percent points to global growth each year.
- Since 2002 imports of goods and services increased by some $150 billion—nearly 35 percent in dollar terms.
- Net direct investment outflows rose by over 40 percent in dollar terms since 2002.
- Exchange rate risk and carry trades:
  - Derivatives imply only moderate near-term yen move risk; implied volatility on yen/dollar options below past peaks at short maturities.
  - Term structure of implied volatilities slopes upward; medium-term fundamentals imply yen should appreciate.
  - IMF Consultative Group on Exchange Rates estimates yen could appreciate in real effective terms over medium term.
- Policy view: market-determined exchange rate appropriate; intervention not needed under likely gradual adjustment where deflation pressures lifted and monetary transmission strengthened.
- Authorities emphasize multi-country strategy for smooth rebalancing of world demand and cautioned against undue emphasis on exchange rate adjustments; officials considered sustainable U.S. current account deficit possibly as high as 4½–5 percent of GDP.

### Structural reform agenda — priorities and estimated gains
- Rationale: high mark-ups and prices, low productivity in sectors (food and retail), limited competition, resource misallocation, impediments to factor mobility.
- Potential payoffs:
  - Static gains could be as large as 8 percent of GDP.
  - Dynamic gains range 0.3 to 2.4 percent of GDP.
- Labor market priorities:
  - Address shrinking working-age population, high share of part-time work, low female participation.
  - Measures: flexible labor hours, Childcare and Family Care Leave Act implementation, childcare support, avoid discrete social security contribution jumps when spouses return to work, job search support, clarify dismissal conditions, job training, improve portability of corporate pensions, broaden defined contribution plans, facilitate employment agencies.
  - Quantified payoff: a 1 percentage point rise in female participation would raise output by about ½ percentage point; female participation ratio is 9 percentage points higher in the United States and United Kingdom than in Japan.
- Deregulation and product markets:
  - Retail distribution: tackle trading practices that restrict competition; OECD (2004) estimates gains from comprehensive retail reforms exceeding 2 percent of GDP.
  - Network industries (post, telecoms, energy): recommendations include independent regulators, remove ownership restrictions, enhance competition in postal sector, bring electricity networks into separate firm; OECD (2004) estimates payoff from telecom and network reforms about ½ percent of GDP each; fully competitive energy markets gains would exceed ½ percent of GDP.
- Health services and inward FDI:
  - Health: open medical sector to JSCs, better disclosure, insurance functioning, drug price review; private sector efficiency margins 11–38 percent per Cabinet Office studies; potential macro benefits ¾–1½ percent of GDP if private participation raises efficiency by 10–20 percent.
  - Inward FDI: stock relative to GDP very low; allowing triangular mergers from May 2007 and easing constraints could boost productivity; Ito and Fukao (2003) estimate that moving inward FDI stock to OECD average could yield benefits around 1½ percent of GDP.

### Key projections and selected macro indicators (figures reproduced exactly)
- Near-term growth: GDP growth projected at nearly 3 percent in 2006 and slightly above 2 percent in 2007.
- Medium-term potential growth: 1.7 percent (staff raised estimate to 1¾–2 percent elsewhere).
- Selected data (excerpted):
  - Real GDP: 2003 1.8, 2004 2.3, 2005 2.6, 2006 Proj. 2.9
  - Private consumption: 2003 0.6, 2004 1.9, 2005 2.1, 2006 Proj. 2.1
  - Nonresidential investment: 2003 6.2, 2004 4.7, 2005 7.8, 2006 Proj. 7.3
  - Public investment: 2003 -10.8, 2004 -8.8, 2005 -5.9, 2006 Proj. -2.5
  - GDP deflator: 2003 -1.6, 2004 -1.2, 2005 -1.3, 2006 Proj. 0.0
  - CPI: 2003 -0.3, 2004 0.0, 2005 -0.3, 2006 Proj. 0.6
  - Unemployment rate (period average, percent): 2003 5.3, 2004 4.7, 2005 4.4, 2006 Proj. 4.1
  - Current account balance (billions of U.S. dollars): 2003 136.2, 2004 172.1, 2005 165.7, 2006 Proj. 169.6
  - Current account balance (percent of GDP): 2003 3.2, 2004 3.8, 2005 3.6, 2006 Proj. 3.7
  - General government balance including social security (percent of GDP, FY): 2003 -7.8, 2004 -5.6, 2005 -5.3, 2006 Proj. -5.0
  - General government balance excluding social security (percent of GDP, FY): 2003 -8.0, 2004 -6.0, 2005 -4.9, 2006 Proj. -4.7
  - Yen/dollar rate (period average): 2003 115.9, 2004 108.2, 2005 110.2, 2006 (as of July 26, 2006) 113.2 5/
  - Real effective exchange rate (2000 = 100): 2003 80.2, 2004 79.9, 2005 74.8, 2006 (as of May) 71.3 6/
  - 10-year government bond yield (period average): 2003 1.00, 2004 1.51, 2005 1.39, 2006 (as of July 26, 2006) 1.87 5/

### Staff appraisal and policy recommendations (concise)
- Monetary: keep near-term stance accommodative to allow inflation expectations to drift up; elaborate aspects of new framework to guide expectations (clarify risks of near-zero inflation and possibility of raising the floor over time); continue clear communications on implementation.
- Fiscal: consolidate decisively; staff recommends a somewhat more front-loaded and ambitious adjustment (¾ percent of GDP per year on average over six years) to stabilize debt and provide insurance against shocks; favor packages combining expenditure restraint, social security reforms, and revenue measures (VAT preferable among revenue options).
- Structural reform: accelerate deregulation, product and labor market liberalization, public sector downsizing, trade liberalization, and measures to raise female labor force participation and inward FDI to boost potential growth and ease fiscal consolidation.
- Financial sector: strengthen oversight and risk management; implement Basel II by end-March 2007; reduce government role in intermediation; streamline securities regulation; develop securities markets to reduce credit crunch risk.
- External: maintain market-determined exchange rate; emphasize domestic-demand-boosting reforms to help global rebalancing; multi-country cooperation needed for orderly adjustment.

*Source: _cr06275 - IMF staff report excerpts and boxes as provided in the supplied PDF content.*

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

### Executive Summary

### Main findings
- The post-bubble adjustment is essentially complete: economic activity is expanding robustly, driven by domestic demand; downside risks stem from external factors, with upside risks to private consumption and investment.  
- Financial and corporate sectors are strengthening: nonperforming loans continue to fall and bank lending is reviving, but core profits remain low; corporate restructuring is spurring productivity gains and yielding record profits.  
- Monetary policy is normalizing: with core CPI positive y/y for a few months and expected to remain so, in March the Bank of Japan shifted from targeting reserves to targeting the overnight policy interest rate (which remains at zero) and introduced a new framework for its post-deflation policy approach.  
- Fiscal consolidation is proceeding, but imbalances remain large: the authorities project achieving a primary balance excluding social security in 2011; the corresponding (estimated) deficit fell 1 percent of GDP in FY2005, but the net debt ratio is high by advanced-country standards and rising.  
- The external surplus is narrowing: the trade balance fell in 2005; the yen has recently strengthened but in effective terms remains relatively weak compared with the past.  
- Reforms underway (deregulation, product and labor market liberalization) will strengthen the supply side and aim to lift productivity and medium-term growth prospects.

### Key issues and policy discussions
- Monetary policy: the end of deflation and the smooth transition out of quantitative easing are milestones. Near-term policy should remain accommodative to allow inflation expectations to drift up. The new BoJ framework improves transparency; continued effective communication about implementation is important.  
- Fiscal policy: the commitment to fiscal consolidation is welcome. Given the strong expansion and the large task, a more front-loaded and ambitious adjustment would stabilize debt in the medium term, provide insurance against fiscal or economic shocks, and limit the risk of an undue rise in real interest rates.  
- Structural reform: accelerated reforms would boost underlying growth, facilitate fiscal consolidation, support living standards amid population aging, bolster world growth, and contribute to a more balanced pattern of global demand—helping to promote a smooth adjustment of global imbalances.

---

### Economic and financial backdrop

- Recent growth and inflation
  - 2005 GDP growth was over 2½ percent, driven mainly by private consumption and business investment.  
  - GDP grew at a (seasonally adjusted) annual rate of about 3 percent in Q1 2006.  
  - Core inflation (CPI excluding fresh food) has been positive since November 2005 (year-on-year core inflation was ½ percent in April 2006).  
  - The GDP deflator continues to decline, reflecting a rise in import prices; the implicit deflator for domestic demand is rising marginally.  
  - Land prices in major cities are rebounding after a fifteen-year slide.

- Labor market and corporate sector
  - Unemployment around an eight-year low at 4.1 percent; labor shortages emerging; wages and bonuses have risen though unit labor costs are still falling.  
  - Major banks’ NPL ratios fell to below 2 percent in March 2006; regional banks’ NPLs have fallen to 4½ percent of total loans.  
  - Corporate debt-to-sales ratios at lowest level since the bubble for all firms, and at the lowest level in 25 years for manufacturers. Bank lending (adjusted for provisions and write-offs) has been trending up since mid-2005 after about eight years of contraction.

- External sector and exchange rate
  - The trade balance fell in 2005 by ¾ percent of GDP despite a real effective yen depreciation.  
  - Current account declined more modestly as factor income surged.  
  - During 2005 the yen depreciated against the U.S. dollar by nearly 15 percent; since then the yen has appreciated modestly, but in nominal and real effective terms remains about 6¼ percent weaker than a year ago. The real effective yen is now about as weak as at the time of the 1985 Plaza Accord. No foreign exchange intervention since March 2004.

- Outlook and risks
  - Baseline: GDP growth projected at nearly 3 percent in 2006 (the output gap expected to turn positive for the first time since 1992) and just above 2 percent in 2007. The current account surplus would hover around 3½ percent of GDP.  
  - Downside risks are mostly external (volatile oil prices, rising long-term interest rates, or a global slowdown); low inflation raises the possibility of renewed deflation in adverse scenarios. Upside risks to private consumption and investment exist.  
  - Medium term: staff raises potential growth estimate to 1¾–2 percent, largely because of a rising capital contribution; potential growth could be higher with stepped-up reforms, increased labor-force participation, and a recovery in R&D. Faster productivity growth would also decrease the current account surplus over time by reducing private saving and boosting investment.

- Authorities’ views
  - Authorities broadly agreed with the outlook and judged the risk of a deflationary spiral remote given stronger balance sheets and a closing output gap.  
  - BoJ and Cabinet Office estimate potential growth at 1½–2 percent; authorities consider reforms could boost longer-term real growth to about 2¼ percent despite population aging.

---

### The Bank of Japan’s post-deflation monetary framework

- Transition out of quantitative easing
  - Pre-announced conditions for ending quantitative easing (in place since 2001) were met in early 2006; BoJ announced an exit on March 9, 2006, indicating it would gradually drain liquidity while keeping overnight interest rates effectively at zero.  
  - Since March, excess reserves declined from over ¥30 trillion to around ¥10 trillion, with short rates stable; money market activity is reviving.

- Main features of the new framework (BoJ “understanding of price stability” and conduct)
  - An anchor for inflation expectations: the BoJ’s Policy Board’s “understanding of price stability” is headline CPI inflation of 0–2 percent over the medium and longer term. This is not a preset-horizon target and will be reviewed annually.  
  - A forward-looking orientation: policy will reflect assessments from two perspectives—(i) near-term (1–2 year) forecasts of activity and prices; and (ii) longer-term risks, including low-probability/high-cost threats such as asset bubbles or overinvestment.  
  - Communication parameters: the BoJ will outline its analysis from the two perspectives periodically, as a rule in the Bank’s semi-annual Outlook for Economic Activity and Prices, expanding the practice of disclosing Policy Board members’ forecasts.  
  - Rationale for headline CPI and the 0–2 percent range: CPI is timely and understood by the public; the range reflects considerations of statistical bias, downward wage flexibility in Japan (bi-annual bonuses around 20 percent of compensation), and other factors (degree of wage rigidity; level of potential growth; robustness of the financial system; availability of fiscal policy; effectiveness of monetary transmission). The BoJ emphasizes that the framework preserves flexibility to act beyond the central forecast.

---

### Fiscal stance and structural reform priorities

- Fiscal consolidation
  - Authorities project achieving a primary balance excluding social security in 2011.  
  - The corresponding (estimated) deficit fell 1 percent of GDP in FY2005.  
  - Net debt ratio is high by advanced-country standards and rising; a more front-loaded and ambitious consolidation would help stabilize debt and guard against shocks.

- Structural reform agenda
  - Reforms include deregulation, product and labor market liberalization, and measures to boost productivity and medium-term growth.  
  - Accelerated structural reforms are emphasized as complementary to monetary and fiscal policies: they would raise potential growth, ease fiscal consolidation, support living standards amid aging, and contribute to a smoother global adjustment of imbalances.

---

*Source: _cr06275 - Executive Summary (IMF staff report).*

### 10.      The exit from quantitative easing has been orderly and monetary operations

### 10.      The exit from quantitative easing has been orderly and monetary operations have finally normalized

### Exit from quantitative easing and new monetary framework
- Limited volatility in money markets suggests skillful liquidity management and effective communication.
- Quantitative easing provided an unusually high degree of policy certainty through a commitment to maintain excess liquidity until core CPI showed durable increases.
- The new framework is more flexible and necessarily more complex, appropriate given that inflation risks have become two-sided.
- Staff recommendation: Authorities should continue to communicate how the new policy framework will be implemented to ensure markets clearly understand the BoJ’s policy intentions.
- Understanding of price stability:
  - The range reflects differences of view among Policy Board members about structural changes, statistical bias, conjunctural developments, and Japan’s historically low inflation.
  - From a medium-term perspective, a lower bound of zero seems too low to prevent unforeseen events from pushing the economy back into deflation.
  - Desirable for the range (or its floor) to rise over time as inflation becomes better entrenched.
  - More explicit communication on the risks associated with inflation at the lower end of the range would guide market expectations and provide insights on policy strategy.
- Policy stance:
  - With little danger of an inflation surge at present, policy should remain accommodative, allowing inflation expectations to drift up.
  - Taylor-like rules suggest that a near-zero rate is appropriate for the time being.
  - When tightening begins, it should proceed gradually.
  - Policy should take account of longer-term risks to sustained noninflationary growth, such as emergent asset price bubbles or other imbalances, especially against the backdrop of a combination of robust growth and limited inflation pressures.
  - Be attuned to incoming data and respond flexibly.

### Role of monetary policy if fiscal headroom is limited
- With no room for fiscal maneuver, monetary policy would need to take the lead in offsetting adverse shocks.
- If abrupt movements in foreign exchange markets or other shocks threaten price stability, the BoJ could communicate that such developments would be taken into account—together with other data—in setting monetary policy.

### The Authorities’ views and intentions on monetary policy
- BoJ officials welcomed normalization of monetary operations.
  - End to pre-commitment: Ending the explicit pre-commitment of quantitative easing has increased flexibility, but also raised policy uncertainty for market participants.
  - Reinvigoration of money markets: The shift encourages a better allocation of funds and improvements in risk management as financial institutions reestablish credit lines and reassess counterparty risks.
- On specifics of the new framework:
  - Understanding of price stability: The BoJ stresses that the range is not an inflation target or a commitment to achieve a certain inflation rate over any timeframe; Board members consider 0–2 percent CPI inflation as consistent with price stability at present. While the range can adjust over time, too-frequent changes should be avoided.
  - Lower bound of the “understanding” range: Officials note inflation has historically been at least 1 percent lower in Japan than in other advanced economies, which has affected public perception of price stability. The BoJ is not aiming to achieve zero percent inflation.
  - Policy stance:
    - Monetary policy should remain accommodative for now and aim to engineer a soft landing.
    - Monetary settings will be data-dependent and the BoJ will examine incoming data closely to assess if a soft landing is likely.
    - In the unlikely event that deflation reappears, the BoJ will respond appropriately; one option could be announcing a policy pre-commitment, if necessary.
  - Evaluation of longer-term risks: The “second perspective” is unique and important—monetary policy must respond to low probability—but high cost—risks, such as large investment swings. Further elaboration of the “second perspective” will be helpful.
  - Implementation: Markets will need to learn to adjust to greater policy uncertainty. The BoJ will continue to explain decisions and views in the context of the “two perspectives.”

### B. Tackling Fiscal Imbalances — Background: key facts and recent developments
- Fiscal imbalances remain large and worrisome despite ongoing consolidation.
  - Deficits for 13 consecutive years have propelled gross and net general government debt to about 180 percent and 85 percent of GDP, and both continue to rise.
  - Population aging will heighten spending pressures.
- Consolidation plan:
  - The plan revolves around a reference path for the primary account of the general government excluding social security, aiming first at achieving balance and later at reducing the debt ratio.
  - Balance is to be achieved through an average yearly adjustment of ½ percent of GDP.
  - Underlying measures have not been spelled out; a balance would not be sufficient to stabilize the debt ratio.
  - In January 2006, the indicative target date for a balance was brought forward to FY2011.
  - A prudent approach that envisages a positive interest rate/growth rate differential over the medium term seems to have carried the day.
- Consolidation progress:
  - Outturn for FY2005 (ended in March) was likely better than projected a year ago, with a decline in the primary deficit excluding social security of perhaps 1 percent of GDP.
  - The FY2006 budget envisages a fall of some ¾ percent of GDP in the general expenditure of the general account of the central government, compared to the FY2005 initial budget.
  - The general government primary balance (excluding social security) would fall by a similar amount.
- Upcoming policy releases: Detailed options to be announced in the June-July releases of a “Roadmap for Income-Expenditure Reform” and the Basic Policies for FY2006.

### Key fiscal figures (percent of GDP, fiscal year basis)
- General government — Revenue: 28.7, 29.1, 29.7, 30.4, 31.0, 31.7, 32.3, 32.9 (2004–2011)
- General government — Expenditure: 34.3, 34.5, 34.6, 35.2, 35.6, 36.0, 36.4, 37.0 (2004–2011)
- General government — Balance: -5.6, -5.3, -5.0, -4.8, -4.6, -4.3, -4.1, -4.2 (2004–2011)
- Primary Balance excluding social security: -3.9, -3.0, -2.3, -1.8, -1.2, -0.6, -0.2, 0.0 (2004–2011)

### Central Government: General Account FY2006 (percent of GDP)
- Revenue: 10.1 (Revised), 9.5 (Initial), 10.5 (Revised 1/), 9.5 (Initial 2/) — as presented in the table.
- General expenditure: 10.5 (Revised), 9.7 (Initial), 10.1 (Revised 1/), 9.0 (Initial 2/).
- Other expenditures 3/: 7.0 (Revised), 6.5 (Initial), 7.0 (Revised 1/), 6.2 (Initial 2/).
- Bond issuance: 7.4 (Revised), 6.8 (Initial), 6.6 (Revised 1/), 5.7 (Initial 2/).
- General Government (Fund staff estimates):
  - Balance: -5.6, -5.3, -5.0 (FY2004, FY2005, FY2006)
  - Primary balance excluding social security: -3.9, -3.0, -2.3 (FY2004, FY2005, FY2006)

### Policy issues and staff views — pace, composition, and timing of consolidation
- Key fiscal challenge: put public finances on a more sustainable footing.
- On the pace:
  - FY2006 budget is passed, but savings should be sought and an expansionary supplementary budget should be avoided.
  - Staff view: there remains a case for a more ambitious medium-term adjustment than in the authorities’ plan.
  - Staff recommendation: An adjustment of ¾ percent per year on average over six years (an additional ¼ percent per year compared with the authorities’ projection) would buy “policy insurance” and boost credibility. Such an adjustment—cumulatively about 4½ percent of GDP—would achieve the primary surplus excluding social security needed to stabilize the debt ratio.
  - Evidence from selected OECD consolidations suggests consolidation at such a pace need not have a significant negative impact on output.
  - Barring a deterioration of the conjuncture, there is a strong case for front-loading the adjustment, with initial annual adjustments above ¾ percent of GDP.
- On composition and timing:
  - Model-based simulations suggest a package of expenditure and tax measures will be needed to regain sustainable debt dynamics.
  - Given the prospective evolution of social security outlays and sizeable reduction in spending so far, expenditure cuts alone do not seem a realistic strategy to balance the primary account, much less achieve a surplus.
  - Empirical analysis indicates that, on the revenue side, an increase in the consumption tax is preferable to other tax revenue-enhancing measures with respect to impact on output.
  - An early adoption of a package (lower spending, lower transfers, higher VAT) dominates a protracted adjustment.
- Primary Balance Needed to Stabilize Debt (General Government, Social Security, General Government excl. Social Security):
  - FY2006: -3.4, -1.1, -2.3
  - FY2012: 0.9, -1.1, 2.0
  - Change: 4.3, 0.0, 4.3

### Boxed evidence and simulation results (selected findings)
- Box 2 (Lessons from Selected OECD Countries):
  - Historical consolidations improved primary balances between 5.1 percent of GDP (Australia) and 9.7 percent of GDP (Canada), taking on average 7 years; average pace 1.1 percent of GDP.
  - Japan’s 1980s pace was about ¾ percent of GDP per year, the same pace staff recommend now.
  - Composition varied: spending cuts often represented more than half of the adjustment; revenue increases emphasized direct taxes in some cases.
  - Large adjustments did not tend to be accompanied by economic downturns; growth was at or near potential in these episodes.
- Box 3 (GFM simulations — strategies for fiscal consolidation in Japan):
  - Reducing social security transfers has a moderately smaller negative short-run impact compared with raising taxes or cutting other government expenditure.
  - Among revenue measures, a VAT increase has the least negative effect on output.
  - Fiscal multipliers in the model are around unity or less in the short run, smaller in the long run.
  - A package of lower government spending, lower transfers, and a higher VAT compares favorably to only increasing the VAT or only reducing government spending in terms of output effects.
  - A modestly more ambitious consolidation (additional ¼ percent of GDP per year recommended by staff), if sustained, would stabilize the debt-to-GDP ratio and increase long-term output by promoting capital accumulation.
  - Spillovers to global output are modest but positive in the long run.

### Specific medium-term consolidation options considered by staff
- (i) Reducing investment (public investment remains at 3½ percent of GDP).
- (ii) Seeking economies through civil service reform (civil service small by industrial country standards).
- (iii) Broadening corporate and personal income tax bases (about 50 percent of personal income is taxable, compared to almost 80 percent in the United States and over 90 percent in the United Kingdom).
- (iv) Raising the consumption tax (now very low by international standards).
- (v) Reforming the budget framework to consolidate earmarked Special Accounts, which limit expenditure control and hinder transparency.
- (vi) Further reforms of the social security system to address demographic pressures.

### The Authorities’ views and intentions on fiscal policy
- The authorities give fiscal consolidation top priority and noted progress: the primary balance (excluding social security) declined by nearly 2¾ percent of GDP over the last 2 fiscal years.
- On the pace:
  - Consolidation should be paced flexibly, with due account of economic conditions.
  - Numerical consolidation targets carry risks of excessive rigidity and pro-cyclicality; nonetheless, consolidation will proceed as fast as possible and overperformance relative to initial budget targets is likely.

*Source: IMF staff report chapter on monetary normalization and fiscal consolidation as presented in the provided content.*

### Box 4. Social Security Expenditure in Japan

### Box 4. Social Security Expenditure in Japan

### Official projection and baseline scenario
- Government expenditure on social security would rise to about 22 percent of GDP by 2025, up from about 18 percent of GDP in 2006, under a no-reform scenario.
- Recent and planned reforms may keep this trend in check.

### Pension reform (2004 public pension reform)
- Employee Pension Insurance (EPI) scheme:
  - Contribution rate envisaged to increase from 13.6 percent to 18.3 percent of salary by 2017 for the EPI scheme (covers all private employees).
  - EPI replacement ratio will gradually be reduced from 59 percent to 50 percent through “macro-indexation” (an index will be defined every year reflecting any decline in pension contributions and any increase in life expectancy; indexation of benefits would then be to CPI inflation minus this index).
- National Pension scheme:
  - The flat contribution to the universal National Pension scheme will increase by 27 percent in real terms by 2017.
  - Government contribution to the National Pension will increase from ⅓ to ½ of total benefits by 2009.

### Medical care reform (law voted June 2006)
- Key elements:
  - Cost containment:
    - Short-run measures: revise medical fees and drug tariffs downward by about 3 percent; raise out-of-pocket payments for the well-to-do elderly to 30 percent (from 20 percent).
    - Medium-term measures: increase role of preventive medicine and reduce length of hospital stays.
    - Five-year reviews of expenditure trends to identify further possible areas for cost containment.
  - Medical insurance scheme:
    - A new system for the elderly will be introduced in FY2008, to which the elderly are expected to contribute directly.
  - Reorganization of insurers:
    - Small insurers are to be consolidated at the prefectural level to improve risk sharing.

### Projected savings and composition
- These reforms are officially projected to produce savings of about ¥21 trillion (about 3 percent of GDP) by 2025.
- The savings would be broad based, but pension reform would yield the largest economies.

### Risks and remaining financing needs
- Risks that government projections are overly optimistic:
  - A lower-than-expected birth rate may create a revenue shortfall for the pension system.
- Additional measures still needed:
  - Measures equivalent to about 1 percent of GDP still need to be identified to finance the increased share of the government’s contribution to the national pension scheme.

*Source: _cr06275 - Box 4. Social Security Expenditure in Japan*

### 26.      The authorities agreed that the priority is to continue revitalizing the financial

### 26. The authorities agreed that the priority is to continue revitalizing the financial system.

### Banking sector—profitability, risks, and oversight
- Major banks’ core profits remain low despite high net income; priorities are improving banks’ profitability and risk management.
- Banks are expanding into fee-earning activities in search of new business models; the effects of recent deregulation are yet to be seen.
- Risks from rising interest rates are considered manageable because of improved bank capital and reduced duration of banks’ exposures.
- Authorities are preparing to strengthen oversight of risk management and risk management systems at banks in the context of Basel II (Japan is represented in the Basel Committee).
  - The Basel II framework is to be introduced by end-March 2007; corresponding revisions to capital adequacy regulations and supervision guidelines were made in March 2006, with other revisions to be finalized soon.
- Regarding credit derivatives, the domestic market is relatively small and risks are limited.
- A BoJ report shows that losses that would result from a yield curve steepening with a 100-basis point rise in long-term yields amount to only about 5 percent of Tier 1 capital for major banks as of end-March 2005.

### Securities markets and GFIs
- Authorities are promoting development of securities markets, particularly through the Financial Instruments and Exchange Law; effective enforcement will enhance investor protection.
- The Tokyo Stock Exchange is expanding its trading capacity this year, and will introduce a new system by 2009.
- The new law allows the stock exchange to set up an independent self-regulatory body.
- As for the GFIs, implementation details for the reform plans will be fleshed out later this year; in principle, the reform opens up business opportunities for private institutions.

### International implications of Japan’s recovery and policies — background effects
- Since 2002, Japan’s real GDP has risen at a 2¼ percent annual rate, adding on average about ¼ percent points to global growth each year.
- Since 2002, Japan’s imports of goods and services have increased by some $150 billion—an increase of nearly 35 percent in dollar terms.
- After rising in 2004, the current account imbalance shrank modestly in 2005, notwithstanding a jump in income flows from Japan’s large creditor position as overseas FDI matured.
- Since 2002, net direct investment outflows rose by over 40 percent in dollar terms.
- Limited adverse regional spillovers from yen weakening: Asian countries (except Korea) compete with Japan in third markets to only a limited extent; a weaker yen cheapens capital imports for other Asian countries.

### Exchange rate risk and carry trades
- Derivatives prices imply only moderate risk of large near-term yen moves.
  - Implied volatility on yen/dollar option contracts remains below past peaks at short maturities, suggesting limited concerns that unwinding of carry trades could prompt appreciation.
  - The term structure of implied volatilities slopes upward, suggesting slightly greater uncertainty about exchange-rate moves over longer horizons.
  - The risk of a rapid unwinding of carry trades as monetary policy normalizes seems moderate. Forward yen interest rates remain low compared, for example, to U.S. dollar forward rates, and market participants see limited leverage in carry trades.
- Over the medium term, underlying macroeconomic fundamentals imply that the yen should appreciate.
  - IMF Consultative Group on Exchange Rates estimates suggest the yen could appreciate in real effective terms over the medium term, likely in the context of multilateral adjustment in partner-country currencies.
  - Fiscal consolidation and further reductions in home-bias by Japanese investors may slow the medium-term appreciation.

### Policy issues and staff views on global imbalances and reforms
- Japan has a key role in contributing to a smooth resolution of global imbalances; accelerated structural reforms to boost domestic demand are a key ingredient.
- Simulation scenario: a combination of an additional ¼ percent per year in productivity growth, along with a moderate rise in female labor force participation, could raise potential GDP growth by ½ percent per year.
  - Under this scenario, the current account would fall over the near term by some ⅓ percent of GDP relative to the baseline.
- The baseline and “structural reform” scenarios assume the authorities’ program of ½ percent of GDP consolidation per year. The “structural and fiscal reforms” scenario assumes the staff’s recommendation of ¾ percent of GDP consolidation per year.
- Under a scenario that incorporates both stronger productivity growth and the staff’s recommended path of fiscal consolidation (an additional ¼ percent of GDP per year), higher growth partly offsets the effects of fiscal consolidation on the external surplus.
- A return to a more neutral monetary stance is likely to have had some effect on global liquidity conditions; unwinding of yen carry trades has had an impact on selected markets outside Japan, although factors specific to those markets were at play.
- The policy of a market-determined exchange rate remains appropriate; under a likely scenario of gradual adjustment in the exchange rate, intervention would not be needed where deflation pressures have lifted, the monetary policy transmission mechanism has strengthened, and corporations are in robust shape.
- Authorities agreed that a multi-country strategy is needed to promote smooth rebalancing of world demand; near-term risks of disorderly adjustment seem limited.
- Authorities cautioned against undue emphasis on exchange rate adjustments and instead emphasized fiscal consolidation in the United States complemented by structural reforms to boost domestic demand in Europe and Japan.
- Authorities considered the sustainable current account deficit for the U.S. may have risen to perhaps as high as 4½–5 percent of GDP; thus, the needed adjustment might be moderate.
- Authorities saw limited risks in a disorderly unwinding of yen carry trades; speculative positions by hedge funds proxied by IMM contracts have been built up and wound down smoothly.

### Staff appraisal — macro and policy assessment
- Japan’s post-bubble legacies have essentially been resolved and deflation has ended; fragilities in the corporate and financial sector have been dealt with, supporting a rebound in investment.
- Consumer prices now seem likely to continue rising and the risk of a deflationary relapse has receded.
- New challenges: monetary policymakers face two-way inflation risks; fiscal policy must rein in budgetary imbalances and make room for population aging; structural reforms must boost productivity amid a shrinking labor force.
- The end of deflation and the smooth transition out of quantitative easing are milestones; the sizeable reduction in excess reserves without undue volatility reflects deft BoJ operations and communications.
- Near-term policy stance should remain accommodative to allow inflation expectations to drift up.
- The new monetary framework improves transparency and allows flexibility; steps to elaborate aspects of the framework could help guide expectations and bolster credibility.
  - Specifically, clearer explanation of risks associated with near-zero inflation and the possibility of adjusting the range (or its floor) upwards over time could signal the desirability of a buffer against deflationary shocks.
- Considerable progress has been made in fiscal consolidation without holding back the expansion; discretionary measures—curbing public works, reforming social security, and rolling back past tax cuts—have played an important role.
- Given the strength of the expansion, a somewhat more front-loaded and ambitious adjustment than envisioned by authorities would be appropriate to stabilize the debt and buy insurance against unanticipated shocks.
- Progress in structural reforms should continue: downsizing government, rationalizing labor and product market regulation, and liberalizing trade to lift productivity.
- Accelerating structural reform would facilitate fiscal consolidation, support living standards amid population aging, bolster world growth, and help promote an orderly resolution of global imbalances.
- Further financial sector reforms—reducing the government’s role in intermediation, streamlining securities regulation, and bolstering financial risk management—will safeguard stability, improve efficiency, and promote development of securities markets to reduce the risk of a credit crunch.

### Key quantitative figures reproduced exactly from the text and table
- 2¼ percent (annual rate of real GDP rise since 2002)
- ¼ percent points (average addition to global growth each year)
- $150 billion (increase in imports of goods and services since 2002)
- nearly 35 percent (increase in imports in dollar terms)
- over 40 percent (rise in net direct investment outflows since 2002, in dollar terms)
- end-March 2007 (Basel II framework introduction date)
- March 2006 (revisions to capital adequacy regulations and supervision guidelines made)
- 100-basis point rise → about 5 percent of Tier 1 capital (losses from yield curve steepening as of end-March 2005)
- Implied scenario numeric assumptions:
  - additional ¼ percent per year in productivity growth
  - raise potential GDP growth by ½ percent per year
  - current account would fall by some ⅓ percent of GDP relative to baseline under the scenario
- Fiscal consolidation scenarios:
  - authorities’ program: ½ percent of GDP consolidation per year (baseline and structural reform scenarios)
  - staff recommendation: ¾ percent of GDP consolidation per year (structural and fiscal reforms scenario)
- Authorities’ view on sustainable U.S. current account deficit: 4½–5 percent of GDP

*Source: _cr06275 - 26.      The authorities agreed that the priority is to continue revitalizing the financial system.*

### 48.      It is recommended that the next Article IV consultation take place on the standard 12-

### _cr06275 - 48.      It is recommended that the next Article IV consultation take place on the standard 12-

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

### Key macroeconomic indicators and trends (figures and tables summarized)
- Nominal GDP: US$4,571 billion (2005).
- Main exports (percent of total, 2005): electrical machinery (22), manufacturing (11).
- Unemployment rate (2005): 4.4 percent.
- FDI (2005): $3.3 billion.
- Public debt, gross (2005): 175.4 percent of GDP.
- Foreign public debt (2005): 4.9 percent of total public debt.
- Population: 127.7 million (2005).
- GDP per capita: US$35,795 (2005).
- Quota: SDR 13,312.8 million.
- Current account balance (2005): 169.6 (in billions of US$); Percent of GDP: 3.7 (2005).
- Exports of goods and services (2005): 601.5 (in billions of US$).
- Imports of goods and services (2005): 519.9 (in billions of US$).
- Public finances (fiscal year basis, selected years):
  - General government revenue (2005): 29.7 percent of GDP.
  - General government expenditure (2005): 34.5 percent of GDP.
  - General government balance (2005): -5.3 percent of GDP.
  - Primary Balance (2005): -4.1 percent of GDP.
- Government debt (calendar year, selected): Gross debt 181.6 percent of GDP (2005); Net debt 86.7 percent of GDP (2005).
- Total reserves minus gold (US$ billion, latest series): e.g., 461.2; 663.3; 833.8; 834.3; 849.8 (series in Table 3).
- Banking sector indicators (selected):
  - Share of nonperforming loans in total loans (major banks, end-fiscal year): 6.1, 5.4, 5.3, 8.4, 7.2, 5.2, 2.9 (series).
  - Risk-weighted capital ratio (major banks, end-fiscal year): 11.6, 11.8, 11.7, 10.8, 9.4, 11.2, 11.6 (series).

### Annex I — Structural reform agenda: overview and estimated gains
- Steady progress made in structural reforms, but further reforms warranted due to:
  - High mark-ups and prices (OECD, 2004).
  - Low productivity in sectors such as food and retail; labor productivity in these sectors about 40 percent lower in Japan than in the United States (Ministry of the Economy, Trade and Industry (2006)).
  - Evidence of limited competition, resource misallocation, and impediments to factor mobility.
- Potential payoffs:
  - Static gains could be as large as 8 percent of GDP.
  - Dynamic gains could be in a range of 0.3 to 2.4 percent.
- Comparative estimates of gains from structural reform (excerpted):
  - Bradford / Economic Planning Agency / OECD (years published vary): Static gain examples — 2.2, 8.0, 5.2 (In percent).
  - TFP Growth Reversion / Japan Center for Economic Research / MITI/Sanwa: Dynamic gain examples — 2.2, 0.3, 2.4 (In percent).
  - Overall gain (5-year horizon) examples: 12.4, 1.6, 12.6 (In percent).

### A. Labor market — findings and policy priorities
- Challenges:
  - Shrinking working-age population.
  - Historically-high share of part-time workers limiting human capital accumulation because of short job tenure.
  - Increase in structural unemployment since the early 1990s suggesting skill mismatches.
  - Relatively low and declining participation rates for women among younger generations due to lack of family-friendly policies, unequal job opportunities, and wage discrimination.
- Policy priorities and recommendations:
  - Establish more flexible labor hours (including by implementing the Childcare and Family Care Leave Act).
  - Provide focused financial support for parents in need of childcare and encourage the supply of high-quality childcare.
  - Avoid discrete jumps in social security contributions for families when spouses return to work.
  - Provide job search support through government and private agencies.
  - Clarify conditions for dismissing workers (including whether compensated lay-offs are legal).
  - Provide appropriate job training and career development planning for young people.
  - Review personal deduction rules for adult children living with parents and social security contributions to strengthen incentives to participate in labor markets.
  - Improve portability of corporate pensions (enhance labor mobility); broaden participation in defined contribution plans and raise upper limits on contributions.
  - Facilitate further development of employment agencies.
- Quantified payoff:
  - A 1 percentage point rise in the female participation rate would raise output by about ½ percentage point.
  - The female participation ratio is 9 percentage points higher in the United States and United Kingdom than in Japan.

### B. Deregulation and product markets — findings and policy priorities
- Challenges:
  - High mark-ups and prices reflect weak competition, barriers to entry, inefficiencies in retail distribution and network industries (especially energy).
  - Inward FDI is low owing to regulatory factors and limited market contestability.
- Recent developments:
  - New Antimonopoly Act enhances powers and resources for the Fair Trade Commission, with stiffer surcharges and penalties for anticompetitive behavior.
- Retail distribution:
  - Certain trading practices (e.g., standard prices and rebates) may restrict competition.
  - Recommendation: regular assessments of the effectiveness of competition policy by the Fair Trade Commission using ex-post indicators such as margins.
  - OECD (2004) estimates potential gains from comprehensive retail reforms as exceeding 2 percent of GDP.
- Network industries:
  - Post and Telecommunications:
    - Past deregulation reduced internet access and cellular interconnection costs.
    - Key recommended steps:
      - Establish an independent telecoms regulator to separate shareholder and regulator roles.
      - Remove ownership restrictions in telecoms to level the playing field.
      - Enhance competition in the postal sector (for example, abolish strict service obligations for general correspondence delivery business operators).
    - OECD (2004) estimates payoff from reforms in these sectors at about ½ percent of GDP.
  - Energy:
    - Retail choice of electricity expanded to 63 percent of the market as of 2005.
    - Following the amended Gas Industry Law in 2005, retail choice in natural gas expected to grow over time to 59 percent of the market.
    - Prices remain high (OECD (2004, 2005)).
    - Priorities:
      - Set up effective, independent sectoral regulators.
      - Enhance incentives for infrastructure investment, including by bringing together networks in electricity into a separate firm.
    - OECD (2004) estimates economic gains from fully competitive energy markets would exceed ½ percent of GDP.

_Source: IMF Country Report content as provided in the supplied PDF excerpts._

### 7.      Health Services: Priorities in this sector include opening up the medical sector to

### _cr06275 - 7.      Health Services: Priorities in this sector include opening up the medical sector to

### Health services: priorities, efficiency findings, and potential gains
- Priorities:
  - Opening up the medical sector to commercial providers by allowing a broader scope for the operation of medical joint stock companies (JSCs), and rolling out medical JSCs nation-wide.
  - Better information disclosure.
  - Improving the functioning of the insurance system.
  - Reviewing drug prices.
- Efficiency evidence:
  - Cabinet Office studies estimate that private enterprises in the fields of medical care, home nursing, and daycare centers are more efficient than their public sector counterparts by margins of 11–38 percent.
- Potential macroeconomic benefits:
  - If private participation in healthcare could increase overall efficiency in the sector by 10–20 percent, and with that sector accounting for about 8 percent of expenditure (and that share set to rise), potential benefits could be ¾–1½ percent of GDP or higher.

### Inward FDI: constraints and policy priorities
- Current situation and constraints:
  - FDI into Japan has picked up since the late 1990s but remains low, with the stock relative to GDP less than one-tenth the average in other G-7 countries.
  - Limitations on inward (“out-in”) M&A have constrained inward FDI; foreign firms have been unable to use their stock in “triangular” mergers to acquire Japanese companies.
  - Under the new Corporate Code, triangular mergers will be allowed from May 2007. However, the new Code also increases the range of possible takeover defenses for Japanese firms, while leaving unclear key issues surrounding the use of foreign shares in M&A.
- Priorities to raise inward FDI:
  - Giving out-in M&A the same tax deferrals as in-in M&A.
  - Ensuring that foreign shares are effectively usable in M&A (noting that if normal foreign listed shares are at some point included under the definition of shares with “limited transferability”, this would effectively preclude their use of triangular mergers).
  - Allowing greater foreign participation in sheltered sectors (such as health care).
- Empirical and estimated gains:
  - Murakami and Fukao (2006) find that target firms of out-in M&A tend to become more productive; a pickup in overall out-in M&A might be expected to boost overall productivity.
  - Ito and Fukao (2003) estimate that if Japan’s inward FDI stock (relative to GDP) moved towards the average OECD level, then overall benefits could be around 1½ percent of GDP.
- Inward FDI stock (Liabilities) — selected values (In percent of GDP):
  - Japan: 1998: 0.7; 2004: 2.1
  - United States: 1998: 24.9; 2004: 22.9
  - United Kingdom: 1998: 24.9; 2004: 34.8
  - Germany: 1998: 11.6; 2004: 24.7
  - France: 1998: 37.3; 2004: 45.8
  - Italy: 1998: 8.7; 2004: 13.2
  - Canada: 1998: 23.2; 2004: 30.6

### Agriculture and trade: reform priorities and estimated gains
- Problems and reform direction:
  - High protection in agriculture boosts domestic food prices while stifling sectoral productivity.
  - The recent move from price toward direct support in agriculture has begun to address this problem, but would achieve maximum benefits if taken further—particularly with the liberalization of trade in agricultural products and reductions in the high level of overall support to farmers.
- Specific policy measures:
  - Allow nation-wide entry of JSCs in agriculture; support this with reforms of agricultural cooperatives by promoting more efficient and transparent management, and enhanced disclosure on cost-revenue structure and subsidies.
  - Promote economies of scale in land use.
  - On trade, pursue ambition in the Doha Round and in the commitment to offering duty and quota free access on at least 97 percent of tariff lines for products from LDCs under the WTO Hong Kong Ministerial in December 2005.
  - Design preferential trade agreements (“Economic Partnership Agreements”) to emphasize complementary liberalization on a most favored nation (MFN) basis, and implement them with transparent, consistent, and liberal rules of origin to mitigate trade diversion.
- Estimated gains from reforms:
  - Bradford (2003) estimates the gains from the elimination of tariffs and non-tariff barriers to be 2.2 percent of GDP.
  - Tokarick (2005) estimates that a full multilateral agricultural policy reform would yield a welfare gain for Japan of ½ percent of GDP.
  - Francois and others (2005) suggest that agricultural policy reform that results in a flow of the factors of production out of agriculture and into sectors such as manufacturing could more than double the estimated welfare benefits of agricultural reforms.

*Source: IMF staff report supplement and associated chapters as provided in the content unit.*

### 4.      On July 7, the Cabinet issued its Basic Policies 2006, which contains—in broad

### _cr06275 - 4.      On July 7, the Cabinet issued its Basic Policies 2006, which contains—in broad

### Basic Policies 2006: fiscal plan and roadmap
- Authorities reiterate intention to achieve a primary balance excluding social security in 2011 and goal of starting to reduce the debt ratio by the mid-2010s.
- "Roadmap for Income and Expenditure Reform" aims to balance the primary account excluding social security with total savings of ¥16.5 trillion (about 2¾ percent of GDP).
- Suggested composition of adjustment:
  - Expenditure measures to bear the bulk of the adjustment (up to ¥14.3 trillion).
  - Expenditure savings to come from reducing the government payroll, social welfare outlays, and public works spending.
  - Additional revenue needs of up to ¥5 trillion, but no specific measures identified pending a re-evaluation of Japan’s tax system.
- IMF staff view: the envisaged fiscal adjustment should be achievable, particularly given the favorable conjuncture, but it could be more ambitious (as discussed in the staff report).

### Medium-term reform program and implementation
- Basic Policies 2006 outlines a comprehensive description of initiatives underway and areas for further action.
- No explicit prioritization in the strategy; staff view that clearer focus on reforms promising the largest payoffs (along lines of the staff report) would help speed implementation.

### Recent market and geopolitical developments
- Financial markets reflected geopolitical events in the last three weeks:
  - North Korea’s July 4 missile tests sparked a short-lived sell-off of equities.
  - Oil price spikes related to conflict in the Middle East weighed on the stock market.
- On balance, turbulence limited; asset prices (including the exchange rate) are only modestly below end-June levels.

### Macroeconomic outlook and recent performance
- 2005 GDP growth was around 2¾ percent, led mainly by private consumption and investment.
- First quarter 2006 pace about 3 percent (seasonally adjusted at an annual rate).
- Core inflation (CPI excluding fresh food) has been clearly positive since November 2005; year-on-year core inflation was 0.6 percent in May.
- GDP deflator continues to decline; deflator for domestic demand is rising marginally.
- Land prices in urban areas have halted a fifteen year slide and are beginning to rebound.
- Yen movements:
  - Real effective terms: about 6¾ percent weaker than a year ago.
  - Depreciated nearly 15 percent in 2005 against the U.S. dollar; appreciated modestly this year (mainly against the dollar).
  - No intervention since March 2004.

### External sector and financial flows
- Trade balance fell in 2005 by ¾ percent of GDP despite yen depreciation.
- Current account declined more modestly as factor income surged.
- Heavy purchases of foreign bonds and repatriation of funds by foreign banks strengthened the financial account, notwithstanding record foreign purchases of domestic equities.

### Financial and corporate sector conditions
- Major banks’ nonperforming loans fell to below 2 percent of loans in March 2006 under tougher regulation; progress at regional banks more uneven.
- Intense corporate restructuring has buoyed profits to record highs and unlocked productivity gains.
- Bank lending (adjusted for provisions and write-offs) has been trending up since mid-2005 after eight years of contraction.

### Monetary policy assessment
- Bank of Japan shifted on March 9 from targeting banks’ excess reserves (quantitative easing) to targeting the overnight interest rate.
- Exit from quantitative easing was smooth; limited volatility in short-term rates and private money market activity picking up.
- Directors recommended near-term policy stance remain accommodative to allow inflation expectations to firm and drift up.
- Directors suggested elaborating aspects of the new monetary framework to guide expectations and bolster credibility, including clarification of risks associated with near-zero inflation and considering a higher floor over time for the "understanding of price stability."

### Fiscal stance and recommendations
- Net general government debt about 90 percent of GDP.
- FY2005 general government primary deficit excluding social security estimated to have narrowed by 1 percent of GDP to around 3 percent of GDP.
- FY2006 budget envisages a further fall of some ½ percent of GDP.
- Directors welcomed fiscal consolidation progress but saw challenges to gain a sounder footing.
- Most Directors favored a somewhat more front-loaded and ambitious adjustment than authorities envisioned to stabilize the debt ratio and bolster credibility; some Directors cautioned implementing consolidation as planned to avoid weakening the expansion.

### Structural reform priorities
- Directors welcomed progress in structural reforms and noted further gains from downsizing the public sector, increasing labor and product market flexibility, and trade liberalization.
- Emphasis that accelerated structural reform would:
  - Raise potential growth,
  - Facilitate fiscal consolidation,
  - Help support living standards amid rapid population aging,
  - Support a more balanced pattern of global growth and orderly resolution of global current account imbalances.

### Key projections and selected indicators (as presented)
- Near-term growth:
  - GDP growth projected at nearly 3 percent in 2006 and slightly above 2 percent in 2007.
- Medium-term potential growth: 1.7 percent.
- Risks:
  - Downside: volatile oil prices, rising long-term interest rates, sharp global slowdown; low inflation raises possibility of renewed deflation.
  - Upside: stronger private consumption and investment.
- Selected data (excerpted):
  - Real GDP: 2003 1.8, 2004 2.3, 2005 2.6, 2006 Proj. 2.9
  - Private consumption: 2003 0.6, 2004 1.9, 2005 2.1, 2006 Proj. 2.1
  - Nonresidential investment: 2003 6.2, 2004 4.7, 2005 7.8, 2006 Proj. 7.3
  - Public investment: 2003 -10.8, 2004 -8.8, 2005 -5.9, 2006 Proj. -2.5
  - GDP deflator: 2003 -1.6, 2004 -1.2, 2005 -1.3, 2006 Proj. 0.0
  - CPI: 2003 -0.3, 2004 0.0, 2005 -0.3, 2006 Proj. 0.6
  - Unemployment rate (period average, percent): 2003 5.3, 2004 4.7, 2005 4.4, 2006 Proj. 4.1
  - Current account balance (billions of U.S. dollars): 2003 136.2, 2004 172.1, 2005 165.7, 2006 Proj. 169.6
  - Current account balance (percent of GDP): 2003 3.2, 2004 3.8, 2005 3.6, 2006 Proj. 3.7
  - General government balance including social security (percent of GDP, FY): 2003 -7.8, 2004 -5.6, 2005 -5.3, 2006 Proj. -5.0
  - General government balance excluding social security (percent of GDP, FY): 2003 -8.0, 2004 -6.0, 2005 -4.9, 2006 Proj. -4.7
  - Structural balance 2/ (percent of GDP, FY): 2003 -6.9, 2004 -4.7, 2005 -5.0, 2006 Proj. -5.0
  - Base money (12-month growth rate; end period): 2003 13.2, 2004 4.2, 2005 1.0, 2006 Jun. -16.2 3/
  - M2 + CDs (period average) 4/: 2003 1.7, 2004 1.9, 2005 1.9, 2006 Jun. 1.2 3/
  - Bank lending 4/ (12-month growth rate; end period): 2003 -5.2, 2004 -3.2, 2005 -0.3, 2006 Jun. 1.8 3/
  - Yen/dollar rate (period average): 2003 115.9, 2004 108.2, 2005 110.2, 2006 (as of July 26, 2006) 113.2 5/
  - Real effective exchange rate 6/ (2000 = 100): 2003 80.2, 2004 79.9, 2005 74.8, 2006 (as of May) 71.3 6/
  - 3-month CD rate (period average): 2003 0.09, 2004 0.06, 2005 0.06, 2006 (as of July 26, 2006) 0.28 5/
  - 10-year government bond yield (period average): 2003 1.00, 2004 1.51, 2005 1.39, 2006 (as of July 26, 2006) 1.87 5/

*Public Information Notice (PIN) No. 06/81 — IMF Executive Board Concludes 2006 Article IV Consultation with Japan (July 28, 2006).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06275.pdf_