## _cr08253

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---

### Executive Summary and Staff Appraisal — Outlook and risks
- Japan appears headed for a modest slowdown, supported by strong exports to non-U.S. destinations; subprime fallout limited.
- Staff projections:
  - GDP growth projected to moderate to around 1½ percent in 2008 and 2009.
  - Headline CPI inflation expected to rise to around 1 percent in 2008 and to moderate somewhat in 2009.
  - Current account surplus expected to narrow to 4 percent of GDP in 2008.
- Risk assessment and alternative scenarios:
  - Risks have become more balanced but considerable uncertainty remains, notably global commodity prices.
  - Global recession scenario (April 2008 WEO example): U.S. annual growth falls to -1¾ percent in 2009 (global growth declines to 2¼ percent); Japan could face a “shallow” recession; inflation could fall into negative territory; emerging Asia growth falls by 1¼ percentage points.
  - Global inflation scenario: a supply shock raising global inflation by about one percentage point in 2009 could raise Japanese inflation to as high as 2 percent by 2010 if monetary tightening lagged; simultaneous tightening would contain inflation but deepen an initial growth decline.

### Fiscal policy and public debt — recent performance, targets, and staff recommendations
- Recent performance:
  - Strong tax collections and cuts in public works trimmed the fiscal deficit; net public debt ratio estimated at about 90 percent of GDP in FY2007.
  - General government primary deficit (excluding social security) reduced to around ½ percent of GDP in FY2007, down from 3 percent of GDP in FY2005.
- Government targets:
  - Targeting a primary deficit (excluding social security) of ½ percent of GDP in FY2008 (year begins in April).
  - Aiming for primary balance by FY2011.
- Staff recommendation:
  - Maintain FY2008 deficit target even if tax revenue falls short, assuming only a slight cyclical downturn.
  - Beginning in FY2009, staff recommends deficit cuts of ¾ percent of GDP per year on average to place public debt on a firmly downward path.
  - Constraint: limited scope for further expenditure cuts implies fiscal consolidation will require comprehensive tax reform, including raising the consumption tax.
- Authorities’ medium-term plans and concerns:
  - Plan assumes expenditure cuts of ¥11.4-14.3 trillion (2¼–2¾ percent of GDP) but no major revenue measures.
  - Planned increase in government’s contribution to the National Pension from ⅓ to ½ in FY2009 at a cost of about ¥2½ trillion (0.5 percent of GDP) — equivalent to increasing the consumption tax rate by 1 percentage point to 6 percent.
  - Authorities reaffirm commitment to primary balance by FY2011 but note political and social security spending constraints.

### Tax reform
- Political context:
  - Tax reform debate progressing slowly.
  - Government’s FY2009 plan to end earmarking of gas taxes welcomed by staff.
  - Government intends to increase its contribution to the basic pension, requiring additional revenue.
- Staff view:
  - A consumption tax hike may be more palatable if linked to funding social security spending.
  - The opportunity to raise the consumption tax rate to finance social security should be seized.

### Monetary policy and the exchange rate
- Monetary stance and inflation:
  - Underlying inflation about zero; BoJ can hold interest rates steady until domestic and global concerns ease.
  - BoJ policy rate kept unchanged at 50 basis points since February 2007 (BoJ meeting update: policy rate kept unchanged at ½ percent as of July 14-15 meeting).
  - Core inflation (BoJ definition, excludes fresh food) projected to accelerate to around 1 percent; CPI headline reached 1.3 percent (y-o-y) in May.
  - Market-implied chance of a rate hike by end-2008 about 40 percent (since mid-April).
- Exchange rate:
  - Yen appreciated by about 10 percent in real effective terms since mid-2007 but staff estimates the yen remains undervalued relative to longer-term equilibrium.
  - Expected change in the real effective exchange rate implied by forward interest rates: 3¾ percent (current) vs 11 percent last year.
  - Bilateral expectation: yen around 100 against the U.S. dollar by 2013 (wide uncertainty).
  - Authorities have not intervened since March 2004; foreign reserves about $1 trillion.
- BoJ communication and liquidity management:
  - BoJ improving communication: two-perspective assessments, median Policy Board centering price-stability understanding around 1 percent, and risk-balance charts.
  - BoJ’s flexible liquidity management (including acceptance of ABCPs and longer maturities) helped stabilize money markets; 3-month LIBOR-OIS spread steady at about 40 basis points in July.

### Financial sector policies and vulnerabilities
- Exposure and losses:
  - Japan not a major subprime player; subprime-related losses for banks (including securities affiliates) risen to $8 billion.
  - Market estimate of total losses $14 billion when including other securities and insurance companies (official data for these not released).
  - Total holdings of U.S. agency bonds by Japan’s private and public entities amounted to $231 billion as of end-2007; three largest banks, major insurers and securities firms account for about $80 billion.
  - Individual bank exposures range from 5 to about 40 percent of Tier 1 capital (to U.S. agency bonds).
- Market developments:
  - 3-month LIBOR-OIS widened less than in U.S./Euro area; TOPIX fell sharply in early 2008 then recovered about half of its losses through early June.
  - CDS and FX swap risk premia narrowed since mid-March peaks; corporate bond spreads tightened mostly for low-rated companies.
- Bank performance and risks:
  - Major banks’ net profits declined by nearly a third in FY2007 due to subprime-related losses and higher loan-loss reserves; core earnings fell by 4 percent.
  - Falling share prices reduced unrealized equity gains on stockholdings by about 60 percent (representing two-thirds of Tier 1 capital).
  - Major banks’ exposures to structured products (excluding subprime) estimated at around $177 billion.
  - Overseas lending grew by 23 percent (y/y) in 2007; regional banks’ NPL ratios at 4 percent (more than twice major banks’), with regional banks more exposed to SME difficulties.
- Policy recommendations:
  - Remain vigilant to risks from global market disruptions and a slowing economy.
  - Bolster capital cushions and improve risk management; encourage improvement in quality of "core" capital as Tier 1 ratios remain below leading international banks.
  - Enhance transparency: greater disclosure of structured holdings and off-balance sheet vehicles; consider extending enhanced disclosure to nonbanks (insurers).
  - For regional banks consider gradually raising minimum capital requirement above current 4 percent; most regional banks’ capital ratios already above 8 percent.
  - Strengthen securitization markets via greater disclosure by originators and creation of market benchmarks.
  - Encourage further bank consolidation and manage Japan Post privatization to ensure level playing field; promote broader sharing of credit information.

### Structural policies to boost growth
- Need and priorities:
  - Reinvigorate structural reforms to lift medium-term growth and help resolve global imbalances.
  - Priority areas: increase labor market flexibility; promote competition via market opening and deregulation (agriculture, services); address regional and sectoral dualities and regular vs nonregular worker dualities.
- Labor-market specifics:
  - Recommendations: more flexible work arrangements (raise female labor participation), easier dismissal rules, greater portability of pensions, more balanced conditions between regular and temporary workers, more liberal immigration policy for skilled professionals.
  - Non-regular workers typically earn about 40 percent less than regular workers; share of non-regular workers grew from 20 percent in 1990 to 34 percent in 2007.
- Wages and productivity:
  - Real wages stagnated over past decade; wage-productivity gap about 20 percentage points (2002–07 expansion failure to raise wages).
  - Structural implication: strong manufacturing productivity gains vs low service-sector productivity contributed to rapid decline in labor income share.
- Reform upside:
  - Staff baseline: both total factor productivity and capital stock contribute around 1 percent to potential growth; labor input contributes -0.3 percentage points.
  - Reform progress (labor utilization, product market competition, agriculture liberalization, FDI facilitation) could raise productivity and wages.

### Public Sector Debt Sustainability Analysis (Appendix I) — baseline and scenarios
- Staff assessment:
  - Authorities likely to fall short of achieving a primary balance by FY2011.
  - Primary deficit (excluding social security) projected at 0.3 percent of GDP in FY2011 — "will not be enough to stabilize the debt-to-GDP ratio over the longer term."
- Baseline public sector net debt path (percent of GDP):
  - 2003: 76.5; 2004: 82.7; 2005: 84.6; 2006: 88.4; 2007: 90.7; 2008: 93.8; 2009 (Proj.): 95.1; 2010 (Proj.): 95.6; 2011 (Proj.): 95.3; 2012 (Proj.): 95.1; 2013 (Proj.): 94.9
- Change in public sector debt (percent of GDP):
  - 2003: 3.9; 2004: 6.2; 2005: 1.9; 2006: 3.8; 2007: 2.2; 2008: 3.1; 2009: 1.3; 2010: 0.5; 2011: -0.3; 2012: -0.2; 2013: -0.2
- Primary deficit (percent of GDP) series:
  - 2003: 6.7; 2004: 5.0; 2005: 4.2; 2006: 3.1; 2007: 2.1; 2008: 1.9; 2009: 1.7; 2010: 1.4; 2011: 1.0; 2012: 0.8; 2013: 0.5
- Revenue and expenditure (percent of GDP) highlights:
  - Revenue 2007: 31.3; 2008: 31.7; 2009: 32.0; 2010: 32.1; 2011: 32.4; 2012: 32.7; 2013: 33.2
  - Primary (noninterest) expenditure 2007: 33.4; 2008: 33.6; 2009: 33.7; 2010: 33.5; 2011: 33.4; 2012: 33.5; 2013: 33.7
- Gross financing need (percent of GDP):
  - 2003: 32.5; 2004: 31.9; 2005: 32.5; 2006: 31.9; 2007: 32.4; 2008: 33.4; 2009: 33.9; 2010: 34.0; 2011: 33.8; 2012: 33.7; 2013: 33.5
- Sensitivity analysis:
  - A permanent 100 basis points increase in real interest rates from 2011 with unchanged primary balance would push debt-to-GDP toward around 130 percent by 2025.
  - A permanent 1 percentage point decline in GDP growth from 2011 with unchanged primary balance would similarly push debt-to-GDP toward around 130 percent by 2025.
  - Under staff’s proposed scenario (faster consolidation), debt ratio would remain about the same level as in FY2009 (around 100 percent).

### Key statistics and projections (select figures preserved exactly)
- Nominal GDP: US$4,378 billion (2007)
- Population: 127.8 million (2007)
- GDP per capita: US$34,272 (2007)
- Quota: SDR 13,312.8 million
- Japan: Medium-Term Projections, 2007–13 (Real GDP, percentage change): 2007: 2.1; 2008: 1.5; 2009: 1.5; 2010: 1.7; 2011: 1.7; 2012: 1.7; 2013: 1.7
- Unemployment rate (percent) 2007–13: 2007: 3.9; 2008: 3.9; 2009: 4.0; 2010: 3.9; 2011: 3.8; 2012: 3.8; 2013: 3.8
- CPI inflation (2007–13): 2007: 0.0; 2008: 1.1; 2009: 0.8; 2010: 1.0; 2011: 1.5; 2012: 1.5; 2013: 1.5
- Current Account Balance (percent of GDP, selected years): 2007: 4.8; 2008 (proj): 3.9; 2009 (proj): 3.8; 2010 (proj): 3.7; 2011 (proj): 3.5; 2012 (proj): 3.2; 2013 (proj): 3.1
- Fiscal indicators (General government, percent of GDP, fiscal year basis, selected 2007–09 projections):
  - Revenue 2007: 31.6; 2008 (proj): 31.8; 2009 (proj): 31.7
  - Expenditure 2007: 34.5; 2008 (proj): 35.0; 2009 (proj): 34.9
  - Balance 2007: -2.9; 2008 (proj): -3.3; 2009 (proj): -3.2
  - Public Debt, gross (calendar year basis) 2007: 195.4; 2008 (proj): 197.9; 2009 (proj): 197.3
- Balance of payments (billions of US$):
  - Current account 2007: 211.0; 2008 (proj): 194.9; 2009 (proj): 195.3
  - Trade balance 2007: 105.1; 2008 (proj): 70.2; 2009 (proj): 74.8
- Medium-Term Scenario (Average, FY2008-11) — IMF Staff:
  - Nominal GDP Growth: 2.1; Real GDP Growth: 1.6; Long-term Interest Rate: 2.1; Primary Balance in FY2011 (excluding Social Security): -0.3
  - Note: A ¥14.3 trillion of expenditure cut is envisaged from FY2007-11.
- Authorities' scenario (average, FY2008-11):
  - Nominal GDP Growth: 2.7; Real GDP Growth: 2.4; Long-term Interest Rate: 2.3; Primary Balance in FY2011 (excluding Social Security): -0.1

### Institutional, political context and consultation cycle
- Political developments slowed reforms and hurt sentiment; opposition control of the Upper House weakened the ruling coalition and Prime Minister Fukuda’s approval rating slumped.
- Recommendation: next Article IV consultation on the standard 12-month cycle.

*Source: Executive Summary and Staff Appraisal, IMF staff report and related chapters in _cr08253._*

### Executive Summary and Staff Appraisal ..................................................................................

### Executive Summary and Staff Appraisal

### Outlook and risks
- Japan appears headed for a modest slowdown, although risks from the global economy remain.
- Subprime fallout has been limited and activity has been supported by strong exports to non-U.S. destinations.
- Staff projections:
  - GDP growth expected to moderate to slightly below potential in 2008–09.
  - Headline CPI inflation has edged up, reflecting higher commodity prices, but wages remain sluggish and inflation risks so far appear contained.
- Staff baseline (detailed in Section III):
  - GDP growth projected to moderate to around 1½ percent in 2008 and 2009.
  - Headline CPI inflation expected to rise to around 1 percent in 2008 and to moderate somewhat in 2009.
  - Current account surplus expected to narrow to 4 percent of GDP in 2008.
- Risk assessment:
  - Risks have become more balanced in recent months, but considerable uncertainty remains—particularly regarding global commodity prices and their effects on the economy.
  - Two significant alternative scenarios highlighted:
    - Global recession scenario (example from April 2008 WEO): U.S. annual growth falls to -1¾ percent in 2009 (global growth declines to 2¼ percent), likely putting Japan on the edge of a “shallow” recession; even with monetary easing, inflation could fall back into negative territory. Growth in emerging Asia would fall by 1¼ percentage points.
    - Global inflation scenario: a supply shock raising global inflation by about one percentage point in 2009 could, if Japan’s monetary tightening lagged, raise inflation in Japan to as high as 2 percent by 2010; simultaneous tightening would contain the pick-up in inflation but produce a larger initial growth decline followed by faster recovery.

### Fiscal policy and debt
- Recent performance:
  - Strong tax collections and cuts in public works have trimmed the fiscal deficit in recent years, but public debt remains high.
- Government targets:
  - Targeting a primary deficit (excluding social security) of ½ percent of GDP in FY2008 (year begins in April).
  - Aiming for primary balance by FY2011.
- Staff recommendation:
  - Assuming only a slight cyclical downturn, the FY2008 deficit target should be maintained even if tax revenue falls short.
  - Thereafter, to place public debt on a firmly downward path, beginning in FY2009 staff recommends deficit cuts of ¾ percent of GDP per year on average.
- Constraint:
  - Limited scope for further expenditure cuts implies fiscal consolidation will require comprehensive tax reform, including raising the consumption tax.

### Tax reform
- Political and policy context:
  - The tax reform debate has moved slowly.
  - The government’s FY2009 plan to end earmarking of gas taxes is welcomed by staff.
  - The government intends to increase its contribution to the basic pension, which will require additional revenue.
- Staff view:
  - Various tax reform options are on the table; a consumption tax hike may become more palatable if linked to funding social security spending.
  - The opportunity to raise the consumption tax rate to finance social security should be seized.

### Monetary policy and the exchange rate
- Inflation and policy stance:
  - Underlying inflation is still about zero; the BoJ can afford to hold interest rates steady until concerns over domestic activity and the global economy have eased.
  - Prices have begun to rise; to guide inflation expectations, the BoJ is rightly improving communication about the future conduct of monetary policy.
- Exchange rate:
  - The yen remains market-determined and has appreciated by about 10 percent in real effective terms since mid-2007.
  - Staff estimates suggest the yen remains undervalued relative to its longer-term equilibrium.
- Financial conditions and BoJ actions:
  - BoJ’s flexible liquidity management has kept money markets stable (see Section IV.C and Box II for detailed discussion of BoJ monetary policy framework developments).

### Financial sector policies and vulnerabilities
- Exposure and losses:
  - Japan was not a major subprime player; the financial system has escaped serious damage.
  - Subprime-related losses for banks (including securities affiliates) have risen to $8 billion, but remain well within operating profits and capital.
  - A market estimate indicates total losses of $14 billion when other securities and insurance companies are included (official data for these have not been released).
- Market developments:
  - Money markets: the spread between 3-month LIBOR and OIS widened less than in the United States and Euro area; BoJ liquidity operations, including same-day settlement, helped stabilize money markets.
  - Stock markets: TOPIX fell sharply in early 2008 but recovered about half of its losses through early June.
  - Spreads: CDS and FX swap market risk premia narrowed somewhat since their mid-March peaks; corporate bond yield spreads indicate lending conditions have tightened mostly for low-rated companies.
- Policy recommendations:
  - Authorities remain vigilant to risks from further global market disruptions and a slowing economy.
  - Banks’ end-year results already incorporate additional information on structured holdings as called for by the Financial Stability Forum (FSF).
  - Bolstering capital cushions and improving risk management would help further strengthen the financial system and enhance financial intermediation.

### Structural policies to boost growth
- Need for renewed reform:
  - It would be highly desirable to reinvigorate structural reforms to lift medium-term growth prospects and contribute to the resolution of global imbalances.
- Priority areas:
  - Increase labor market flexibility.
  - Promote competition through greater market opening and further deregulation in sectors such as agriculture and services.
  - Address dualities between regions and sectors, and between regular and nonregular workers.
- Wages and income:
  - Wages remain sluggish despite firms beginning to pass through some cost increases; unit labor costs continue to fall year-on-year.
  - Box III discusses the question “Why are Japanese Wages so Sluggish?” (see source).

### Institutional and political context
- Recent political developments have hurt sentiment:
  - Slowed reforms amid concerns over widening dualities.
  - Opposition control of the Upper House weakened the ruling LDP coalition; Prime Minister Fukuda’s approval rating slumped.
  - Feuding in the Diet in March left the BoJ without a Governor and led to a lapse of the gasoline surcharge; in April a new Governor was appointed and the gasoline surcharge was reinstated.

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

*Source: Executive Summary and Staff Appraisal (IMF).*

### 7.      The authorities had a similar assessment of the outlook and risks.

### _cr08253 - 7.      The authorities had a similar assessment of the outlook and risks.

### Authorities’ assessment: near-term outlook and risks
- Near-term outlook for growth and inflation:
  - BoJ April semi-annual Outlook: expected GDP growth to slow this fiscal year to around potential.
  - Core inflation (BoJ definition, excludes fresh food) projected to accelerate to around 1 percent, mainly driven by higher fuel and other commodity prices.
- Risks:
  - BoJ view: rising demand from emerging markets and commodity-producing countries so far more than offset adverse effects of deterioration in the terms of trade.
  - Identified risks to the near-term outlook: weaker global growth and financial markets, higher commodity prices, and deteriorating business confidence.
  - Overall risk balance: tilted slightly to the downside in 2008, more balanced in 2009.

### IV. Near-term policy imperatives in an uncertain global environment — overview
- Policy guidance:
  - Against forecast of a soft landing, fiscal policy should focus on medium-term challenges.
  - Given considerable uncertainty, current accommodative monetary policy setting appears appropriate.
  - Financial sector policies should guard against spillovers from global markets and risks from slowing domestic activity.

### A. Reducing the high debt burden — Background
- FY2007 outturn:
  - General government primary deficit (excluding social security) reduced to around ½  percent of GDP in FY2007, down from 3 percent of GDP in FY2005.
  - Net public debt ratio estimated to have risen to about 90 percent of GDP in FY2007.
- FY2008 budget:
  - Targets a broadly unchanged primary deficit with a slight increase in total expenditures due to higher social security costs and lower tax buoyancy.
  - Gasoline surcharge and other taxes that expired at end March were quickly reinstated with minimal effect on the FY2008 budget.
  - Revenue is still earmarked for road construction and maintenance; authorities intend to discontinue earmarking from FY2009.
- Authorities’ medium-term plans:
  - Revised fiscal plans continue to target a primary balance (excluding social security) by FY2011.
  - Plan assumes expenditure cuts of ¥11.4-14.3 trillion (2¼–2¾ percent of GDP), but no major revenue measures.
  - Under staff’s lower growth projections, authorities’ plans would be insufficient to prevent net public debt from continuing to trend up.
- Consumption tax and social security reform:
  - Planned increase in government’s contribution to the National Pension (NP) from ⅓ to ½ in FY2009 at a cost of about ¥2½ trillion (0.5 percent of GDP).
  - This is equivalent to increasing the consumption tax rate by 1 percentage point to 6 percent.

### A. Reducing the high debt burden — Policy issues and staff views
- Near-term fiscal stance:
  - FY2008 budget’s broadly neutral stance described as unambitious given high public debt and only a mild slowdown expected.
  - If revenues fall short, prudent to constrain spending to avoid undermining fiscal consolidation.
  - Recommendation: avoid an expansionary supplementary budget this year.
- Near-term fiscal stance under a global recession scenario:
  - Automatic stabilizers could be allowed to work, although their size is subject to uncertainty.
  - Scope for more active fiscal policy limited by high debt and unsuccessful experience with stimulus spending in the 1990s.
- Pace of consolidation over the medium term:
  - Staff recommends starting in FY2009 an adjustment of the primary balance (excluding social security) of about ¾ percent of GDP per year (about ½ percent of GDP more than in the authorities’ reference path).
  - If maintained on average through FY2013, this would lead to a primary surplus of 1¾ percent of GDP in FY2013 and put public net debt ratio firmly on a downward path.
  - Faster consolidation could help dispel uncertainties over the pension system that may be weighing on consumption.
- Broader policy points:
  - Comprehensive tax reform desirable to improve efficiency and secure fiscal sustainability.
  - Proposed ending of earmarking gasoline taxes to road construction in FY2009 is welcome and would support plan to continue reducing public works by 3 percent a year.
  - Proposals to link an increase in the consumption tax to social security funding have merit as potentially politically palatable and as a way to address inter-generational inequities in pension benefits.
  - Strengthening social security via parametric reforms remains important; next actuarial valuation of the pension system scheduled for 2009 provides an opportunity to assess further reforms (e.g., increasing retirement age).

### A. Reducing the high debt burden — Authorities’ responses and policy intentions
- Near-term fiscal stance:
  - Authorities recognized budget outlook uncertainty and expressed uncertainty about the extent to which they could reduce expenditure if revenue falls short.
  - Authorities questioned applicability of Fund advice to allow full play to automatic stabilizers; staff noted Japan’s fiscal problems seemed particularly pressing.
- Pace of consolidation over the medium term:
  - Authorities reaffirmed commitment to achieving primary balance (excluding social security) by FY2011.
  - Noted difficulty of accelerating consolidation given need for additional social security outlays and political opinion favoring growth over consolidation.
- Reform options:
  - Terminating earmarking of gasoline tax revenue could facilitate consolidation by allowing road-related spending financing to be moved to social security.
  - Plan to raise government’s funding share for basic national pension in FY2009 added immediacy to tax reform debate; authorities hopeful a comprehensive reform involving a hike in the consumption tax would soon be initiated.

### B. Monetary policy and the exchange rate — Background and assessment
- Monetary policy stance:
  - BoJ kept policy rate unchanged at 50 basis points since February 2007, implying a drop in real interest rates given uptick in inflation.
- Inflation and market expectations:
  - Core inflation (excluding fresh food) is now close to the center of the BoJ “understanding” of price stability (between zero and 2 percent).
  - Since mid-April, market prices show about a 40 percent chance of a rate hike by end-2008, compared to earlier expectation of a rate cut.
- Asset prices and liquidity:
  - Land prices rose by 1.7 percent in 2007, mainly in large metropolitan areas and commercial sites; land prices have lagged nominal GDP cumulatively since 1970.
  - Entrenched expectations of a continued rise in land prices are absent according to BoJ opinion surveys.
  - BoJ has flexible monetary management, accepts wide range of collateral including ABCPs, and extends liquidity at fairly long maturities; banks more willing to use discount window after quantitative easing experience.
- Overall assessment:
  - Monetary policy described as accommodative and inflation risks seem contained.
  - Broader measures of financial conditions do not point to significant tightening.
  - Model-based assessments point to future interest rate increases; markets began to price these in as concerns about severity of global slowdown moderated, pushing long-term JGB yields higher amid an unwinding of earlier flight to quality.

### Box II highlights: Developments regarding the BoJ’s monetary policy framework
- Two perspectives used by Policy Board:
  - (i) Most likely outlook for economic activity and prices 1-2 years ahead (currently through FY2009).
  - (ii) Broad variety of risks to the outlook, including low-probability high-cost events, over a longer horizon.
- “Understanding of medium- to long-term price stability” defined as CPI inflation between 0 and 2 percent; not an inflation target.
- Communication changes to guide expectations:
  - Median of Board Members’ understanding of price stability now more clearly centered around 1 percent.
  - Discussion of risks in the Outlook report expanded to include detailed risk-balance charts (averages of probability distributions from individual Policy Board members).
- Operational performance:
  - Monetary policy framework and tools performed well during recent global market disruptions; BoJ able to provide liquidity and assess asset price imbalances.

*Source: _cr08253 - 7.      The authorities had a similar assessment of the outlook and risks.*

### 13.      The yen remains undervalued relative to longer-term fundamentals.

### 13.      The yen remains undervalued relative to longer-term fundamentals.

### Exchange rate dynamics and market assessment
- Continued wide interest rate differentials and a fading home bias have led to large capital outflows over the last few years that have depressed the value of the yen.
- Paring back of yen-financed risk positions after the subprime crisis caused some outflows to abate, but the yen remains below its 2002 level in real effective terms.
- Staff projections: at current levels, the yen would lead over the longer term to a current account surplus above that consistent with economic fundamentals.
- Market-implied expectations:
  - Expected change in the real effective exchange rate implied by forward interest rates is now 3¾ percent, compared with 11 percent last year.
  - On a bilateral basis, the yen is expected to be around 100 against the U.S. dollar by 2013 (wide uncertainty around this assessment).
- Intervention and reserves:
  - Authorities have not intervened in the foreign exchange market since March 2004.
  - Foreign reserves have increased to about $1 trillion on strong valuation gains and interest earnings.
  - Political pressure exists for setting up a Sovereign Wealth Fund (SWF) to manage a portion of reserves; authorities oppose this given the reserve build-up was financed by issue of short-term yen borrowing, implying that reserves do not constitute net sovereign wealth.

### Policy issues and staff views on monetary policy
- BoJ stance:
  - Given uncertainties, the BoJ’s “wait and see” approach is judged appropriate; Policy Board is keeping monetary policy on hold until outlook concerns ease.
  - Inflation expectations appear contained; increased pass-through of cost increases to consumers makes guiding inflation expectations more challenging.
- Risks and alternative scenarios:
  - If growth slows sharply, the BoJ could ease policy, although with the policy rate already low at 50 basis points, firepower would be limited.
  - Under a global inflation scenario, BoJ might need to consider normalizing interest rates faster than domestic factors alone warrant, especially if rising interest differentials were to lead to a weaker yen.
- Communication and liquidity management:
  - Recent enhancements to communication (greater discussion of risks and Policy Board views; emphasis on the 1 percent median of the "understanding of price stability") are welcome and may help anchor expectations.
  - BoJ’s more frequent and larger liquidity provisions have helped keep money markets stable.
  - Scope to strengthen monitoring of the overall financial system by expanding information sharing between the BoJ and the Financial Services Agency (FSA), particularly on liquidity positions of securities firms and off-balance sheet exposures of nonbanks.
- Exchange rate policy guidance:
  - Exchange rate should continue to be market determined.
  - Longer-term expectation: yen to appreciate in real effective terms and Japan’s current account surplus to narrow, facilitated by far-reaching structural reforms that boost productivity, return to capital, reinvigorate domestic demand and reduce structural outflows.
  - In the event of excess volatility and disorderly movements, intervention could be considered—more likely to be effective if coordinated with other major countries.

### Authorities’ responses and intentions regarding exchange rate and BoJ policy
- BoJ officials:
  - Agreed inflation expectations were contained and saw it unlikely inflation would rise beyond the understanding of price stability, while watching for a possible steepening of the Phillips curve.
  - Favored gradual normalization of interest rates once downside risks to activity recede, given long-term risks.
  - Would be flexible in a severe downturn; a global inflation-driven widening of interest differentials that weakens the yen would not alone justify a monetary response unless domestic outlook changed.
  - Continue to strive for better communication; considered the risk balance chart in the April outlook report useful.
- On equilibrium exchange rate methodologies:
  - Authorities skeptical about current account-based estimates (e.g., CGER), arguing they do not fully account for capital flows—an important omission for Japan given structural outflows—and that such methodologies overplay the exchange rate’s role in current account adjustment.
  - See no case for intervention as long as conditions remain orderly, consistent with recent G7 communiqué.

### Financial sector vulnerabilities and implications for policy
- Major banks and market risk:
  - In FY2007, major banks’ net profits are estimated to have declined by nearly a third due to subprime-related losses and higher loan-loss reserves.
  - Core earnings fell by 4 percent amid compressed margins and declines in fee income.
  - Falling share prices reduced by about 60 percent the unrealized equity gains on stockholdings (representing two-thirds of Tier 1 capital).
  - Major banks have significant exposures to structured products excluding subprime (estimated at around $177 billion).
- Overseas lending and regional banks:
  - Overseas lending grew by 23 percent (y/y) in 2007 as banks turned abroad with domestic interest rates expected to remain low.
  - NPL ratios for regional banks have stopped declining and, at 4 percent, are more than twice as high as for major banks.
  - Regional banks are more exposed to SME sector difficulties where bankruptcy rates are rising.
- Japan Post and market structure:
  - Japan Post transformed into a joint-stock company wholly owned by the government in October 2007; its potential entry into retail banking has prompted regional banks to form partnerships or merge.

### Financial stability policy priorities and staff recommendations
- Enhance transparency:
  - Greater disclosure of structured holdings (including underlying assets and hedging coverage) and of off-balance sheet vehicles; consider extending enhanced disclosure to nonbanks (insurers) while accounting for differing accounting and regulatory treatments.
- Adequacy of capital cushions:
  - Encourage major banks to improve the quality of their "core" capital as their Tier 1 capital ratios remain below those of other leading international banks.
  - For regional banks, consider gradually raising the minimum capital requirement for domestic banks above the current 4 percent level; most regional banks’ capital ratios are already above 8 percent, and a higher minimum would give supervisors more flexibility to address weaker banks earlier.
- Strengthen securitization markets:
  - Greater disclosure by originators on underlying assets (e.g., SME-ABSs) and creation of reliable market benchmarks (e.g., for commercial real estate) to improve price discovery and liquidity in the secondary market.
- Strengthen risk management and reduce market risk:
  - Supervisors should ensure banks, particularly regional banks, have appropriately classified and provisioned against problem loans and robust credit risk assessment systems for overseas portfolios.
  - Banks should continue efforts to gradually reduce large stockholdings as part of improving risk-return profiles; increase in capital charge for existing equity holdings to the same level as for new equity purchases is set for 2014 under Basel II.
- Longer-term reforms:
  - Encourage further bank consolidation to boost core profitability; manage Japan Post privatization to ensure a level playing field; promote broader sharing of credit information to strengthen risk pricing and financial stability.
  - Further development of capital markets to enhance Tokyo's appeal as an international financial center.

### Authorities’ actions in response to financial sector concerns
- Disclosure and transparency:
  - Authorities have encouraged banks under Pillar III of the Basel framework and non-life insurers to disclose more detailed information on structured holdings in end-year reports; Accounting Standards Board of Japan reviewing enhanced disclosure for off-balance sheet items.
- Capital adequacy debate:
  - Authorities argued raising the minimum capital requirement for domestic banks above 4 percent is not called for under the Basel framework (which established a minimum of 8 percent for internationally active banks) and could harm weak local economies reliant on relationship-based lending.
  - Staff noted Basel does not preclude regulators from tightening minimum capital requirements for domestic banks if conditions warrant, and that tighter standards could encourage weak regional banks to rebuild capital or merge.
- Securitization and risk management:
  - Steps under Basel II require rating agencies to disclose more detailed information on underlying assets of securitized products; a 2004 working group laid out measures for infrastructure and disclosure improvements, but authorities recognize more should be done.
  - FSA observed regional banks have strengthened financial conditions (improved capital and NPL ratios) and remain vigilant; authorities did not view SME weakening as a systemic risk compared to U.S. slowdown or renewed global turmoil.
- Reducing market risk:
  - Authorities noted banks have reduced equity holdings but pace has slowed; schedule for raising capital charge for existing equity holdings is set three years earlier than for European and U.S. banks.

*Source: IMF country consultation chapter — "13.      The yen remains undervalued relative to longer-term fundamentals."*

### 27.      Some progress has been made in implementing structural reforms commitments

### 27.      Some progress has been made in implementing structural reforms commitments

### Progress on structural reform commitments
- Liberalizing product markets:
  - The government signed economic partnership agreements (EPAs) with Brunei, Chile, Indonesia, and Thailand in 2007 and with ASEAN in 2008.
  - Some progress expanding successful reforms outside “special zones,” but little progress in opening up protected sectors, such as in nursing and education.
- Promoting inward FDI:
  - The government allowed capital gains to be deferred in “triangular” mergers where a foreign company acquires a Japanese target via a local unit; this facilitated Japan’s first major triangular merger.
  - Foreigners still view investing in Japan as difficult as firms have taken steps to limit minority shareholder rights (e.g., through “poison pills” and cross-shareholdings).
- Labor reforms:
  - Privately-run job placement centers have been set up on a trial basis.
  - The bill to extend pension coverage to temporary workers was not passed by the Diet.
  - The government plans to revise the labor standard law to raise the minimum overtime pay and reduce overtime hours worked.
- Financial market development:
  - The Diet amended the Financial Instruments and Exchange Act in June inter alia to enable new exchange markets exclusively for professional investors and to expand exchange-traded funds to include commodity futures.
- Momentum on these reforms has slowed despite some advances under the Multilateral Consultation.

### Policy issues and staff views
- Priority: reinvigorate the structural reforms outlined in previous Article IV Consultations.
- Labor and product market reforms:
  - Reforms to enhance labor market flexibility and participation, and further deregulation in product markets, would raise productivity and wages (particularly in the service sector), encourage firms to hire more regular workers, and contribute to narrowing of dualities.
- Specific labor-market recommendations:
  - More flexible work arrangements (including those aimed at raising female labor participation).
  - Easier rules for dismissal.
  - Greater portability of pensions.
  - More balanced employment conditions for regular and temporary workers.
  - A more liberal and bolder approach to immigration policy to address special labor needs and shortages; a government panel is considering recommendations for accepting more skilled professionals into Japan.
- Product-market recommendations:
  - Further deregulation and market opening in agriculture, retail, and services to boost productivity and attract foreign investment.
  - In services, priorities include deregulation of transportation, network industries, the electricity sector, and gas utilities.
  - Apply successful reforms in Special Zones nationwide and open further "government-driven" markets to the private sector.

### Box III — Why Are Japanese Wages So Sluggish?
- Key finding:
  - Real wages have stagnated in Japan over the past decade; wage growth failed to pick up during the 2002-07 expansion, widening the accumulated gap between hourly wages and productivity to about 20 percentage points.
- Explanations put forward:
  - Impact of foreign competition:
    - Real productivity growth in Japanese manufacturing has been rapid, but international competition has pushed down relative prices of manufactured goods, reducing nominal gains; manufacturing wages have grown at an even lower pace than nominal productivity.
  - Deregulation measures:
    - Legal changes in the late 1990s expanded the list of industries that can hire non-regular workers.
    - Large differences in employment protection and benefits between regular and non-regular workers have stimulated firms (often in services) to offer mostly lower-paid temporary positions.
    - Non-regular workers (part-time workers, dispatched workers, etc.) typically earn about 40 percent less than regular workers, are much easier to dismiss, and have limited social insurance.
    - The share of non-regular workers has grown from 20 percent of the labor force in 1990 to 34 percent in 2007.
  - Population aging:
    - Retirement of highly-paid baby-boomers and their re-employment at lower part-time wage rates has possibly tended to depress aggregate wage growth.
- Structural implications:
  - The unbalanced nature of Japan’s growth—strong manufacturing productivity gains and low productivity gains in nonfinancial services (two-thirds of total employment)—has contributed to a more rapid decline in the labor income share than in other advanced countries.
  - Cross-country evidence suggests that countries with sizeable differentials between manufacturing and services productivity growth have experienced the largest declines in labor income share.
- Policy implication:
  - Reforms aimed at increasing productivity in services and reducing gaps in employment protection and benefits between regular and non-regular workers could help put wages in Japan on an upward trajectory.

### Medium-term growth and external stability (staff baseline and reform upside)
- Staff baseline scenario:
  - Growth converges to potential over the medium term.
  - Assumes continued efficiency gains from past corporate restructuring and R&D spending offset negative effects of a shrinking labor force.
  - Both total factor productivity and the capital stock contribute around 1 percent to potential growth, while labor input contributes -0.3 percentage points.
- Reform upside:
  - Productivity growth could be higher with further progress in structural reforms, particularly improving labor utilization, enhancing product market competition, liberalizing agriculture, and facilitating foreign direct investment.

### Authorities’ responses and policy intentions
- Authorities recognized the need to speed up reforms and indicated new measures to boost medium-term growth and reduce dualities to be outlined in the 2008 Basic Policies.
- Raising productivity:
  - Authorities noted they are in the process of easing visa requirements for high-skilled workers.
  - Measures to liberalize the aviation industry and agriculture were under consideration, including reducing regulations on land usage.
  - Japan will continue increasing the number of EPAs.
- Labor market reform:
  - June 2008 Basic Policies was likely to include measures such as greater childcare facilities and more flexible working hours aimed at raising participation by women and the elderly.
- Enhancing Tokyo’s appeal as an international financial center:
  - Developing the financial system would provide households with alternative instruments for savings, help raise income, and reduce dualities.
  - Strengthening corporate governance is important.

### Key statistics and projections (select figures preserved exactly as reported)
- Nominal GDP:  US$4,378 billion (2007)
- Population:  127.8 million (2007)
- GDP per capita:  US$34,272 (2007)
- Quota:  SDR 13,312.8 million
- Japan: Medium-Term Projections, 2007–13 (Real GDP, percentage change):
  - 2007: 2.1
  - 2008: 1.5
  - 2009: 1.5
  - 2010: 1.7
  - 2011: 1.7
  - 2012: 1.7
  - 2013: 1.7
- Unemployment rate (percent) 2007–13:
  - 2007: 3.9
  - 2008: 3.9
  - 2009: 4.0
  - 2010: 3.9
  - 2011: 3.8
  - 2012: 3.8
  - 2013: 3.8
- CPI inflation (2007–13):
  - 2007: 0.0
  - 2008: 1.1
  - 2009: 0.8
  - 2010: 1.0
  - 2011: 1.5
  - 2012: 1.5
  - 2013: 1.5
- Current Account Balance (percent of GDP, selected years):
  - 2007: 4.8
  - 2008 (proj): 3.9
  - 2009 (proj): 3.8
  - 2010 (proj): 3.7
  - 2011 (proj): 3.5
  - 2012 (proj): 3.2
  - 2013 (proj): 3.1
- Fiscal indicators (General government, percent of GDP, fiscal year basis, selected 2007–09 projections):
  - Revenue 2007: 31.6; 2008 (proj): 31.8; 2009 (proj): 31.7
  - Expenditure 2007: 34.5; 2008 (proj): 35.0; 2009 (proj): 34.9
  - Balance 2007: -2.9; 2008 (proj): -3.3; 2009 (proj): -3.2
  - Public Debt, gross (calendar year basis) 2007: 195.4; 2008 (proj): 197.9; 2009 (proj): 197.3
- Balance of payments (in billions of US$):
  - Current account 2007: 211.0
  - Current account 2008 (proj): 194.9
  - Current account 2009 (proj): 195.3
  - Trade balance 2007: 105.1
  - Trade balance 2008 (proj): 70.2
  - Trade balance 2009 (proj): 74.8
- Medium-Term Scenario: Main Assumptions (Average, FY2008-11) — IMF Staff:
  - Nominal GDP Growth: 2.1 (In percentage)
  - Real GDP Growth: 1.6 (In percentage)
  - Long-term Interest Rate: 2.1 (In percentage)
  - Primary Balance in FY2011 (excluding Social Security): -0.3 (In percentage)
  - Note: A ¥14.3 trillion of expenditure cut is envisaged from FY2007-11.
- Authorities' scenario (average, FY2008-11):
  - Nominal GDP Growth: 2.7
  - Real GDP Growth: 2.4
  - Long-term Interest Rate: 2.3
  - Primary Balance in FY2011 (excluding Social Security): -0.1

*Source: _cr08253 - 27.      Some progress has been made in implementing structural reforms commitments*

### APPENDIX I. JAPAN: PUBLIC SECTOR DEBT SUSTAINABILITY ANALYSIS (DSA)

### APPENDIX I. JAPAN: PUBLIC SECTOR DEBT SUSTAINABILITY ANALYSIS (DSA)

### Overview
- Analysis updated using authorities’ medium-term expenditure plans and tax policy changes announced in the FY2008 budget, based on staff macroeconomic assumptions.
- Baseline scenario focuses on the net debt of the general government including social security.

### Baseline DSA findings and projections
- Staff assessment: authorities likely to fall short of achieving a primary balance by FY2011.
- Primary deficit (excluding social security) projected at 0.3 percent of GDP in FY2011.
- That primary deficit "will not be enough to stabilize the debt-to-GDP ratio over the longer term."
- Baseline public sector debt (net) path (in percent of GDP):
  - 2003: 76.5
  - 2004: 82.7
  - 2005: 84.6
  - 2006: 88.4
  - 2007: 90.7
  - 2008: 93.8
  - 2009 (Proj.): 95.1
  - 2010 (Proj.): 95.6
  - 2011 (Proj.): 95.3
  - 2012 (Proj.): 95.1
  - 2013 (Proj.): 94.9
- Change in public sector debt (percent of GDP):
  - 2003: 3.9
  - 2004: 6.2
  - 2005: 1.9
  - 2006: 3.8
  - 2007: 2.2
  - 2008: 3.1
  - 2009: 1.3
  - 2010: 0.5
  - 2011: -0.3
  - 2012: -0.2
  - 2013: -0.2
- Identified debt-creating flows (4+7+12) (percent of GDP):
  - 2003: 8.1
  - 2004: 4.9
  - 2005: 4.5
  - 2006: 2.6
  - 2007: 2.1
  - 2008: 2.8
  - 2009: 1.3
  - 2010: 0.7
  - 2011: 0.1
  - 2012: 0.2
  - 2013: 0.0
- Primary deficit (percent of GDP):
  - 2003: 6.7
  - 2004: 5.0
  - 2005: 4.2
  - 2006: 3.1
  - 2007: 2.1
  - 2008: 1.9
  - 2009: 1.7
  - 2010: 1.4
  - 2011: 1.0
  - 2012: 0.8
  - 2013: 0.5
- Revenue and grants (percent of GDP):
  - 2003: 28.7
  - 2004: 28.1
  - 2005: 29.4
  - 2006: 30.6
  - 2007: 31.3
  - 2008: 31.7
  - 2009: 32.0
  - 2010: 32.1
  - 2011: 32.4
  - 2012: 32.7
  - 2013: 33.2
- Primary (noninterest) expenditure (percent of GDP):
  - 2003: 35.4
  - 2004: 33.0
  - 2005: 33.6
  - 2006: 33.7
  - 2007: 33.4
  - 2008: 33.6
  - 2009: 33.7
  - 2010: 33.5
  - 2011: 33.4
  - 2012: 33.5
  - 2013: 33.7
- Public sector debt-to-revenue ratio (percent):
  - 2003: 266.1
  - 2004: 294.7
  - 2005: 288.1
  - 2006: 289.2
  - 2007: 289.7
  - 2008: 295.5
  - 2009: 297.5
  - 2010: 297.4
  - 2011: 294.2
  - 2012: 290.5
  - 2013: 286.3
- Gross financing need (percent of GDP):
  - 2003: 32.5
  - 2004: 31.9
  - 2005: 32.5
  - 2006: 31.9
  - 2007: 32.4
  - 2008: 33.4
  - 2009: 33.9
  - 2010: 34.0
  - 2011: 33.8
  - 2012: 33.7
  - 2013: 33.5
- Gross financing need in billions of U.S. dollars (years shown):
  - 2003: 1376.9
  - 2004: 1472.7
  - 2005: 1480.5
  - 2006: 1397.9
  - 2007: 1420.6
  - 2008: 1620.9
  - 2009: 1686.8
  - 2010: 1740.4
  - 2011: 1792.6
  - 2012: 1844.0
  - 2013: 1890.3

### Sensitivity analysis and scenarios
- DSA underscores sensitivity of debt dynamics to macro assumptions and benefits of faster consolidation.
- Shock examples:
  - With a 100 basis points increase in interest rates from 2011 onwards (permanent 100 basis point shock to real interest rate) and unchanged primary balance, the debt-to-GDP ratio would reach around 130 percent by 2025 under the authorities' and IMF adjustment comparisons.
  - With a 1 percentage point decline in GDP growth from 2011 onwards (permanent 1 percentage point shock to growth rate) and unchanged primary balance, the debt-to-GDP ratio would reach around 130 percent by 2025.
  - Under the staff’s proposed scenario, the debt ratio would remain at about the same level as in FY2009 (at around 100 percent).
- Scenario outcomes presented:
  - Scenario with key variables at their historical averages (2008–2013 path shown): debt moves from 93.8 to 127.8 (years implied by chart).
  - Scenario with no policy change (constant primary balance) in 2008-2013: debt evolution listed as 93.8, 95.2, 96.3, 96.9, 97.9, 99.1 with change of -0.6 noted.

### Key macroeconomic and fiscal assumptions underlying the baseline
- Real GDP growth (in percent):
  - 2003: 1.5
  - 2004: 2.7
  - 2005: 1.9
  - 2006: 2.4
  - 2007: 2.1
  - 2008: 1.5
  - 2009: 1.5
  - 2010: 1.7
  - 2011: 1.7
  - 2012: 1.7
  - 2013: 1.7
- Average nominal interest rate on public debt (in percent) 8/:
  - 2003: 1.8
  - 2004: 1.5
  - 2005: 1.0
  - 2006: 0.8
  - 2007: 1.2
  - 2008: 1.4
  - 2009: 1.5
  - 2010: 1.7
  - 2011: 2.0
  - 2012: 2.2
  - 2013: 2.3
- Average real interest rate (nominal rate minus change in GDP deflator, in percent):
  - 2003: 3.5
  - 2004: 2.6
  - 2005: 2.2
  - 2006: 1.7
  - 2007: 2.0
  - 2008: 2.5
  - 2009: 1.1
  - 2010: 1.0
  - 2011: 0.7
  - 2012: 1.0
  - 2013: 1.1
- Nominal appreciation (increase in US dollar value of local currency, in percent):
  - 2003: 12.0
  - 2004: 2.9
  - 2005: -11.7
  - 2006: -0.8
  - 2007: 4.3
  - 2008 onward: data elided in source excerpt
- Inflation rate (GDP deflator, in percent):
  - 2003: -1.6
  - 2004: -1.1
  - 2005: -1.2
  - 2006: -1.0
  - 2007: -0.8
  - 2008: -1.1
  - 2009: 0.4
  - 2010: 0.7
  - 2011: 1.2
  - 2012: 1.2
  - 2013: 1.2
- Growth of real primary spending (deflated by GDP deflator, in percent):
  - 2003: 0.6
  - 2004: -4.2
  - 2005: 3.5
  - 2006: 2.8
  - 2007: 1.2
  - 2008: 2.3
  - 2009: 1.6
  - 2010: 1.2
  - 2011: 1.5
  - 2012: 1.9
  - 2013: 2.2

### Indicators on automatic debt dynamics and contributions
- Automatic debt dynamics (percent of GDP):
  - 2003: 1.5
  - 2004: 0.0
  - 2005: 0.3
  - 2006: -0.5
  - 2007: 0.0
  - 2008: 0.9
  - 2009: -0.4
  - 2010: -0.6
  - 2011: -0.9
  - 2012: -0.6
  - 2013: -0.6
- Contribution from interest rate/growth differential (percent of GDP) matches automatic debt dynamics series above.
- Of which contribution from real interest rate (percent of GDP):
  - 2003: 2.5
  - 2004: 2.0
  - 2005: 1.8
  - 2006: 1.5
  - 2007: 1.8
  - 2008: 2.3
  - 2009: 1.0
  - 2010: 1.0
  - 2011: 0.6
  - 2012: 0.9
  - 2013: 1.0
- Of which contribution from real GDP growth (percent of GDP):
  - 2003: -1.1
  - 2004: -2.0
  - 2005: -1.6
  - 2006: -2.0
  - 2007: -1.8
  - 2008: -1.4
  - 2009: -1.4
  - 2010: -1.6
  - 2011: -1.6
  - 2012: -1.5
  - 2013: -1.5
- Contribution from exchange rate depreciation (percent of GDP): 0.0 for years shown in excerpt.
- Other identified debt-creating flows and privatization receipts (negative) shown as 0.0 for years presented.

### Staff statement: market developments and near-term outlook (July 21, 2008)
- Recent developments do not alter staff’s broad assessment in the staff report but shift balance of risks:
  - Renewed global market volatility increases downside risks to growth outlook.
  - Continued strength of commodity prices underscores upside risks to inflation.
- Financial market conditions in Japan in July:
  - CDS spreads for Japanese financials have risen broadly; nonbank lenders particularly affected.
  - Money markets remained stable with the 3-month LIBOR-OIS spread steady at about 40 basis points.
  - JGB yields declined slightly despite uptick in inflation; yen fluctuated with global risk appetite.
  - Total holdings of U.S. agency bonds by Japan’s private and public entities (including official reserves) amounted to $231 billion as of end-2007.
    - Of this $231 billion, the three largest banks, major insurers and securities firms reportedly account for about $80 billion.
    - For individual banks, exposures range from 5 to about 40 percent of Tier 1 capital.
- Real activity and inflation outlook:
  - Indicators point to a slowdown after a strong Q1 outturn; staff projects a "soft landing" to 1½ percent growth in calendar years 2008 and 2009.
  - Headline inflation reached 1.3 percent (y-o-y) in May; staff forecast for 2008 inflation was 1.1 percent (subject to upside risk).
  - Higher commodity prices could reduce Japan’s current account surplus and narrow estimated yen undervaluation.
- Bank of Japan (BoJ) policy as of July 14-15 meeting:
  - Policy rate kept unchanged at ½ percent.
  - Median Policy Board growth forecast downgraded: FY2008 from 1.5 percent to 1.2 percent; FY2009 from 1.7 percent to 1.5 percent.
  - Median Board inflation forecast for FY2008 raised from 1.1 percent to 1.8 percent.
  - BoJ decisions to enhance communication: release assessments from "two perspectives" after each meeting and publish Risk Balance Charts more frequently.

*International Monetary Fund — JAPAN: Staff Report for the 2008 Article IV Consultation (Appendix I: Public Sector Debt Sustainability Analysis, and related staff statement, June 27, 2008 / July 21, 2008).*

### 5.      The government released its FY2008 Basic Policies on June 27. The policy program

### _cr08253 - 5.      The government released its FY2008 Basic Policies on June 27. The policy program

### Policy program and structural reform intentions
- Reaffirms commitment to achieving primary balance (excluding social security) by FY2011.
- Commits to comprehensive tax reform including raising the consumption tax and abolishing road tax earmarking.
- Calls for measures to:
  - further open the Japanese economy (increasing trade with EPA partners, liberalizing aviation, revising FDI rules);
  - improve labor market participation;
  - enhance productivity in services and SMEs;
  - reduce regional disparities;
  - cut CO2 emissions.
- An expert panel at the Council on Economic and Fiscal Policy recommends medium-term structural reforms with main priorities:
  - greater labor market flexibility;
  - increased competition in the corporate sector;
  - reform of the social security system;
  - better integration of Japanese regions into global markets.
- Staff view: structural reforms in areas highlighted by Basic Policies and the expert report would be very desirable; challenge is translating broad intentions into specific actions.

### Macro outlook and Executive Board assessment
- Recent performance:
  - GDP grew by 2.1 percent in 2007, down from 2.4 percent in 2006.
  - CPI inflation was 1.3 percent (y-o-y) in May 2008; core inflation (excluding fuel and food) fell by 0.1 percent (y-o-y).
  - Wage pressures limited; unit labor costs continue to fall on a year-on-year basis.
- External position:
  - Current account surplus rose to 4.8 percent of GDP in 2007.
  - Yen appreciated against major currencies through March 2008; authorities have not intervened since March 2004.
- Near-term outlook:
  - GDP growth expected to moderate to 1½ percent in 2008-09 (slightly below potential).
  - Headline CPI inflation expected to rise; inflation risks appear contained.
  - Considerable uncertainty; risks more balanced recently but downside risks remain.
- Medium-term outlook:
  - Growth expected to converge to potential (about 1.7 percent).
  - Current account surplus expected to narrow.
  - Scenario assumes continued efficiency gains in corporate and financial sectors and a shrinking labor force.
- Executive Directors’ views:
  - Commended resilience to U.S. slowdown and global market turmoil.
  - Agreed monetary policy should remain accommodative while fiscal policy remain focused on medium-term challenges.
  - Urged reinvigoration of structural reforms to boost productivity and medium-term growth.

### Fiscal policy and public debt
- FY2008 budget targets a broadly unchanged primary deficit (excluding social security).
- Net public debt ratio estimated to rise to 94 percent of GDP, up from about 85 percent of GDP three years ago.
- Authorities’ revised fiscal plans continue to target a primary balance by FY2011.
- Staff assessment: under staff’s lower growth projections, authorities’ plans would be insufficient to prevent net public debt from continuing to trend up.
- Directors’ comments and recommendations:
  - Recognized progress with fiscal consolidation and welcomed commitment to primary balance excluding social security by FY2011.
  - Encouraged authorities to meet budget deficit target even if revenues fall short; some noted automatic stabilizers could be allowed to work if growth slowed sharply.
  - Most Directors considered that beginning in FY2009 larger fiscal adjustments than currently envisaged will be required to stabilize high public debt and make room for population aging fiscal costs.
  - Noted limited scope for further expenditure cuts; future consolidation likely to require revenue-side measures.
  - Saw merits in comprehensive tax reform; most Directors supported consideration of an increase in the consumption tax.
  - Noted the government’s intention to increase its contribution to the basic pension during FY2009 as an opportunity to raise the consumption tax rate.
  - Welcomed plans to end earmarking of gasoline tax revenue for road-related spending from next year.

### Monetary policy and exchange rate
- Bank of Japan policy:
  - Policy rate unchanged at 50 basis points since February 2007.
  - Monetary policy judged accommodative; real interest rates have fallen given uptick in inflation.
  - Directors endorsed BoJ “wait and see” approach and readiness to respond flexibly to downside risks or worsening inflation expectations.
  - Directors welcomed BoJ’s enhanced communication strategy.
- Exchange rate policy:
  - Directors supported authorities’ market determined exchange rate policy and limiting intervention to counter excessive fluctuations and disorderly movements.
  - Staff assessment noted the yen remains undervalued relative to its longer-term value in real effective terms, while capital outflows related to Japanese investors’ international diversification may contribute to near-term yen weakness.
  - Over the longer term, the yen could be expected to appreciate on the back of policy reforms yielding productivity gains.

### Financial sector and market stability
- Impact of global market turmoil:
  - Fallout on financial system limited to date.
  - Money markets relatively stable due to lower banking system exposure to subprime/securitized products and increased BoJ liquidity operations.
  - Subprime-related losses for banks have risen to $8 billion.
  - Financial conditions tightened for nonbank lenders relying on wholesale financing and for low-rated corporates; bankruptcies edged up led by SMEs.
- Directors’ recommendations:
  - Continue efforts to strengthen the financial sector; bolster capital cushions and improve risk management.
  - Welcome increased transparency and disclosure of subprime exposures; encouraged continued vigilance to risks from further global market disruptions.
  - Welcomed steps toward privatizing the Japan Post Bank and emphasis on a level playing field.
  - Welcomed Financial Services Agency steps to enhance transparency in line with Financial Stability Forum recommendations and BoJ flexible liquidity management.

### Selected economic indicators (selected rows and exact figures as reported)
- Real GDP: 2004 2.7; 2005 1.9; 2006 2.4; 2007 2.1; 2008 (Proj.) 1.5
- Private consumption: 2004 1.6; 2005 1.3; 2006 2.0; 2007 1.5; 2008 (Proj.) 1.1
- Nonresidential investment: 2004 5.6; 2005 9.2; 2006 4.3; 2007 2.2; 2008 (Proj.) 0.9
- Residential investment: 2004 1.9; 2005 -1.5; 2006 0.9; 2007 -9.5; 2008 (Proj.) -4.4
- Public investment: 2004 -9.0; 2005 -10.1; 2006 -8.1; 2007 -2.5; 2008 (Proj.) -3.2
- Exports of goods and services: 2004 13.9; 2005 7.0; 2006 9.7; 2007 8.6; 2008 (Proj.) 8.5
- Imports of goods and services: 2004 8.1; 2005 5.8; 2006 4.2; 2007 1.8; 2008 (Proj.) 3.4
- GDP deflator: 2004 -1.1; 2005 -1.2; 2006 -1.0; 2007 -0.8; 2008 (Proj.) -1.1
- CPI (SA) 1/: 2004 0.0; 2005 -0.6; 2006 0.2; 2007 0.1; 2008 (Proj.) 1.1
- Unemployment rate (period average, percent): 2004 4.7; 2005 4.4; 2006 4.1; 2007 3.9; 2008 (Proj.) 3.9
- Current account balance (Billions of U.S. dollars): 2004 172.1; 2005 165.7; 2006 170.4; 2007 211.0; 2008 (Proj.) 190.6
- Current account balance (Percent of GDP): 2004 3.7; 2005 3.6; 2006 3.9; 2007 4.8; 2008 (Proj.) 3.9
- General government balances (percent of GDP, FY):
  - Balance including social security: 2004 -5.5; 2005 -4.5; 2006 -3.3; 2007 -2.9; 2008 (Proj.) -3.2
  - Balance excluding social security: 2004 -6.0; 2005 -4.8; 2006 -3.2; 2007 -2.3; 2008 (Proj.) -2.6
  - Structural balance 2/: 2004 -4.9; 2005 -4.3; 2006 -3.4; 2007 -2.9; 2008 (Proj.) -3.2
- Money and credit (12-month growth rate; end period):
  - Base money: 2004 4.2; 2005 1.0; 2006 -20.0; 2007 0.4; 2008 (June) 0.4
  - M2 (period average): 2004 2.0; 2005 1.9; 2006 0.7; 2007 2.1; 2008 (June) 2.3
  - Bank lending 4/: 2004 -1.2; 2005 1.1; 2006 2.8; 2007 0.8; 2008 (June) 2.4
- Exchange and interest rates (period average / as of dates reported):
  - Yen/dollar rate: 2004 108.2; 2005 110.2; 2006 116.3; 2007 117.8; 2008 (July 21, 2008) 106.7
  - Yen/euro rate: 2004 134.5; 2005 137.3; 2006 146.0; 2007 161.4; 2008 (July 21, 2008) 169.5
  - Real effective exchange rate 6/ (2000 = 100): 2004 76.3; 2005 71.7; 2006 65.1; 2007 60.0; 2008 (May) 63.8
  - 3-month CD rate: 2004 0.06; 2005 0.06; 2006 0.22; 2007 0.51; 2008 (July 21, 2008) 0.53
  - 10-year government bond yield: 2004 1.51; 2005 1.39; 2006 1.74; 2007 1.68; 2008 (July 21, 2008) 1.58

*Public Information Notice (PIN) No. 08/92 — IMF Executive Board Concludes 2008 Article IV Consultation with Japan (July 21, 2008).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08253.pdf_