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### The Road to Recovery — Key findings
- The Great East Japan earthquake and tsunami on March 11, 2011 "destroyed large parts of Japan’s northeastern coastal areas and damaged key infrastructure."
- Authorities responded swiftly to stabilize markets; activity has begun to recover, but outlook remains uncertain due to power-supply concerns, weak sentiment, and potential political uncertainty ahead of Lower House elections scheduled before 2013.
- Reconstruction spending and tax/social security blueprint decisions will have important implications for growth and fiscal outlook.

### Economic impact of the earthquake — initial effects and recovery signals
- Q1 2011 GDP contracted by 3.5 percent (q/q, s.a.a.r.), led by sharp declines in private consumption and stockbuilding.
- Damage and disruption factors:
  - private capital and public infrastructure damage estimated at 3–5 percent of GDP,
  - electricity shortages in the Kanto region including Tokyo, which accounts for 40 percent of GDP,
  - supply chain disruptions affecting automobiles and electronics (about 35 percent of exports),
  - sharp decline in sentiment weighing heavily on domestic demand.
- Supply-side recovery signals:
  - Industrial production declined by 15 percent in March and grew modestly in April.
  - Supply chains being restored faster than expected; confidence growing that summer demand for electricity will be met through energy conservation and added capacity.
- Demand-side conditions:
  - Retail sales and capital goods shipments have started to recover, but household and corporate sentiment remains weak.
- Prices and financial markets:
  - Core inflation excluding fresh food held steady in the first two months after the earthquake.
  - Equity markets fell by over 15 percent in the first weeks after the earthquake but recouped roughly one third of their losses by mid-June.
  - JGB 10-year rate moved in a narrow range between 1.1 and 1.2 percent after BoJ liquidity injections.
  - Spread between 3-month LIBOR and overnight indexed swaps (OIS) remained around 0.12 percent.
  - Yen / US$ traded in a band of 80–84 after coordinated G-7 intervention; in real effective terms the yen depreciated by 5 percent since the beginning of the year but remained about 15 percent stronger than during pre-Lehman lows.

### Outlook and staff projections
- Staff forecasts:
  - GDP growth: -0.7 percent in 2011; 2.9 percent in 2012.
  - Headline inflation: around zero percent in 2011 and 2012; underlying inflation—excluding food and energy—projected to remain negative.
- Output gap:
  - Projected to widen modestly by about ½ percentage point to 5.5 percent in 2011.
  - Estimated impact on underlying inflation about 0.1 percentage points in 2011.
- Risks and policy response:
  - Outlook unusually uncertain and biased downwards; key downside risks include delayed supply disruptions resolution and rebuilding electricity capacity (notably nuclear-related risks).
  - External downside risk from a slowdown in other advanced economies.
  - If downside risks materialize, policy response would need larger upfront fiscal spending and monetary easing combined with a more ambitious medium-term fiscal consolidation strategy.
  - Upside possibility: faster easing of supply constraints accelerating recovery in exports and investment.
- External position:
  - Trade balance turned negative in May due to supply disruptions; current account surplus projected above 2 percent of GDP in the medium term.
  - IMF methodologies indicate the yen appears broadly in line with medium-term fundamentals.

### Authorities’ views
- Officials expect a sharp recovery in the second half of the year consistent with staff projections; BoJ and Cabinet Office calendar-year forecasts roughly similar to staff’s after adjusting for Q1 outturn and revisions.
- Authorities view risks as mainly on the downside: pace of consumer sentiment rebound and addressing electricity shortages are key uncertainties, especially if more nuclear plants are shut down.
- Authorities emphasized exchange rates should be market-determined but expressed concern about yen volatility and viewed the G-7 coordinated intervention as successful.

### Box 1 — Implications of the Earthquake for Japan’s Electricity Supply (summary)
- TEPCO supply capacity to Kanto/greater Tokyo fell by nearly 30 percent to below 35 million KW in March; normal demand was around 35–40 million KW.
- TEPCO ended rolling blackouts by early April through restoration efforts.
- TEPCO projected supply capacity to rise to around 55 million KW by July, which "based on past usage, should be sufficient to meet peak demand this summer."
- Government called for a 15 percent reduction in electricity usage during summer peak hours.
- Longer-term uncertainty:
  - 35 out of 54 nuclear reactors had already been shut down for inspection; restarting depends on local government approval.
  - Shutting down all reactors could reduce electricity supply significantly.
- Cost and emissions implications:
  - Substituting nuclear with other sources may raise electricity costs by around 10 percent (or 0.3 percent of GDP).
  - The elasticity of GDP with respect to electricity supply is estimated to be around 1 over the past 10 years.
  - Transition toward thermal energy could conflict with Kyoto Protocol emission commitments.
- Policy need: a clear policy on securing a stable and affordable energy supply to mitigate risks.

### Policy discussions — Fiscal policy and reconstruction financing
- Fiscal trade-off: balance increased spending for recovery and longer-term reforms to reduce very high public debt.
- Fiscal cost estimates and near-term stance:
  - Fiscal costs of the earthquake could range between 2–4 percent of GDP spread over several years.
  - Reconstruction projected to increase the fiscal deficit in 2011 to 10½ percent of GDP and the net debt-to-GDP ratio to above 130 percent of GDP.
  - Government’s first supplementary budget in May was 0.8 percent of GDP, financed mainly from contingency reserves, reprioritized spending, and a temporary reduction in government contributions to the public pension fund. Additional supplementary budgets focused on regional revitalization were expected in summer.
- Financing constraints and options:
  - Near-term scope for further expenditure cuts limited; non-social security spending (excluding interest payment) is about 16 percent of GDP.
  - Tax space: overall tax revenue about 17 percent of GDP.
  - Consumption tax rate at 5 percent.
  - In absence of new taxes, JGB issuance could rise by 2 percent of GDP or more in 2011–12.
  - Risks to JGB market absorption capacity due to population aging and potential changes in institutional investor base.

### Box 2 — The Case for Raising the Consumption Tax in Japan
- VAT history and yield:
  - Introduced in 1989 at 3 percent; rose to 5 percent in 1997.
  - VAT revenue yield approximately 2½ percent of GDP.
  - C-efficiency ratio nearly 70 percent.
- Authorities’ proposal:
  - Plan proposing to gradually double the consumption tax to 10 percent by FY2015; plan also proposes to raise the pension retirement age and adjust nominal pension benefits for deflation.
- Staff near-term recommendation:
  - Moderate increase in the consumption tax, from 5 percent to 7–8 percent, in 2012 when a cyclical recovery is underway.
- Staff longer-term proposal:
  - Comprehensive tax reform with a gradual increase in the consumption tax to 15 percent over several years, yielding 5 percent of GDP.
- Fiscal adjustment needs and targets:
  - Stabilizing the net debt ratio by 2016 and reducing it to around 135 percent of GDP by 2020 would require a reduction of the primary fiscal deficit by 10 percent of GDP over a 10 year horizon.
  - Staff’s scenario assumes a 10 percent of GDP improvement (7.5 percent of GDP relative to no adjustment scenario) of the structural primary balance between 2010-20.
- Suggested composition (percent of GDP):
  - Consumption tax increase to 15 percent over several years: 5 percent of GDP.
  - Corporate income tax rate lowered from 40 percent to 35 percent (revenue losses offset by personal income tax base broadening).
  - Expenditure reforms and quantified savings:
    - Freeze central government contributions to the public pension system in nominal terms, including by raising the pension retirement age: 0.5
    - Freeze non social security spending in nominal terms (excluding interest payment): 2.5
    - Limit annual nominal growth in non pension social security spending at 1-1.5 percent: 1.0
  - Other items (over 10 years):
    - Withdrawal of fiscal stimulus: 1.0
    - Modest increase in personal income tax through broadening the base: 0.5
    - Corporate tax cut (by 5 percentage points): -0.5
  - Total savings (sum shown): 10.0 10.0 10.0
- Policy design considerations:
  - Timing: staff supports a moderate tax increase in 2012; authorities’ doubling to 10 percent by FY2015 welcomed but more is needed.
  - Complementary measures: limits on spending growth, targeted expenditure reforms, taxpayer identification system.
  - Fiscal framework: adopt an explicit fiscal rule targeting a primary surplus consistent with debt reduction plan.
  - Debt management: lengthening maturity; government has progressively lengthened average maturity to 5–6 years but annual financing requirements remain high at about 55 percent of GDP.

### 33. Broader communication of the special — Inflation, monetary options, and BoJ measures
- Inflation communication:
  - BoJ explained rise in inflation partly due to higher international commodity prices.
  - Recommendation: regularly report outlook for different inflation indices and give high weight to measures excluding food and energy.
- Monetary policy options to insure against deflation risks:
  - Further monetary easing.
  - Increase share of longer maturity JGBs (3 years and above) in BoJ portfolio.
  - Expand special loan facility to include reconstruction projects.
  - Accelerate and expand purchases of private assets: corporate bonds, commercial paper, ETFs, securitized SME loans.
- Event-study evidence on BoJ easing measures (Box 4) — key results:
  - 10-year JGB yield fell cumulatively by nearly 25 basis points; 2-year JGB yield by more than 10 basis points.
  - Corporate yields declined initially but reverted by end of following week.
  - Equity prices improved by more than 5–7 percent across events.
  - Monetary easing had almost no measurable effect on exchange rate and inflation expectations.
  - Easing most effective in financial and real estate sectors; insurance companies and large banks’ equity prices rose more than 10 percent across the events.
  - Asset purchase program (October 2010) appears to have lowered tail risks via reduced implied volatility.
- BoJ stance and concerns:
  - BoJ viewed its accommodative stance as sufficient to stabilize markets; concerns about costs and side effects of unconventional policies.
  - Special loan facility: committed ¥3 trillion; most used; authorities cautious about excess loan competition.
  - Purchases of private assets under evaluation; SME securitized loans promising but market small and illiquid.

### Safeguarding financial stability — immediate post-earthquake actions and exposures
- Liquidity provision:
  - BoJ provided an unprecedented ¥21.8 trillion of short-term liquidity on the first business day after the disaster.
- Banking sector:
  - Major banks account for 53 percent of total banking assets; small exposure to affected areas (½ percent of their loans).
  - Tier 1 capital ratio: 13 percent at end FY2010 (about one-third in preferred securities and tax deferred assets).
  - Regional banks: small systemic risk (2 percent of the banking system); Tier-1 capital ratio: 9.4 percent in FY 2010.
- Insurance sector:
  - Insured losses estimated at around ¥2.7 trillion; solvency margins above 760 percent of liabilities.
- TEPCO-related risks:
  - TEPCO’s share price fell by nearly 90 percent since the earthquake.
  - Company reported losses of around ¥1¼ trillion in FY2010.
  - Major banks have around ¥3 trillion in loans to TEPCO, of which around ¥2 trillion were extended as emergency financing after the disaster.

### Financial sector policy issues and staff recommendations
- Risks from sluggish recovery: delayed recovery could raise credit costs, especially for heavily indebted SMEs; emergency SME support measures should be withdrawn once recovery is underway.
- Market and interest risk:
  - Banks’ equity holdings account for nearly one half of Tier-1 capital; bank-held government bonds are over 15 percent of total assets.
  - Supervisors should encourage monitoring of market risks and reduction of equity holdings.
  - Any TEPCO rehabilitation plan should follow applicable laws on treatment of claims.
- Profitability and structural reforms:
  - Core profitability remains low; recommendations include promoting risk-based lending, consolidating or restructuring weak regional banks (including through public funds), and privatizing Japan Post.
- Regulatory developments:
  - Possible capital surcharges and Basel framework implications for G-SIFIs; authorities advocate balanced regulation.

### Authorities’ assessment and supervisory stance
- Authorities view the financial sector as having remained resilient since the disaster.
- Supervisors consider current bank capital levels sufficient to cover credit and market risks; pre-earthquake stress test showed banks’ capital would remain above regulatory minimums under a severe scenario.
- FSA focus: strengthen risk management, promote relationship-based banking, monitor banks’ Asian lending expansion, and consider capital injections for weakest banks under proposed Act amendments.

### 51. The authorities view their growth — strategy and measures
- Boosting labor participation:
  - Plan to increase childcare services, including merging kindergarten and childcare systems.
  - Emphasis on job training and matching for young and elderly.
- Trans Pacific Partnership (TPP):
  - Participation seen as boosting exports and investment in services; decision delayed post-earthquake to evaluate impact on farming and fishing in affected regions; agricultural compensation likely needed.
- SME restructuring:
  - Support for reforming credit guarantee system to promote start-ups; average length of a credit guarantee about 5½ years (shorter than maximum limits of 7 and 10 years).
  - Supportive of establishing asset management companies to facilitate bank-led restructuring of earthquake-related distressed loans pending evaluation of scale.
- Female labor participation data (2008, in percent):
  - 58.7
  - 67.3
  - 70.6
  - 71.5
  - 72.1
  - (Chart labels in source: KoreaJapanGermanyUKUS)

### Staff appraisal — priorities, risks, and recommendations
- Near-term recovery assessment:
  - Supply disruptions easing faster than expected; reconstruction spending will boost the second half of the year.
  - Recovery risks: delays in restoring electricity capacity and slow private demand pick-up.
- Fiscal policy priorities:
  - Immediate: repair damaged infrastructure and facilitate a swift recovery; timely passage of an additional supplementary budget well-targeted to revitalize affected regions.
  - Financing: support reconstruction with a moderate consumption tax increase in 2012 to limit bond issuance.
  - Medium-term: ambitious strategy to bring down public debt; reduce structural primary deficit by 10 percent of GDP over 10 years; rely on comprehensive tax reforms centered on gradual consumption tax increases.
  - Debt management: raise average maturity of public debt and adopt explicit fiscal rule based on a primary surplus and debt target with limited escape clauses.
- Monetary and financial recommendations:
  - Further monetary easing to guard against deflation risks; BoJ options include increasing share of longer maturity JGBs and private assets.
  - Supervisors should encourage weak banks to improve capital and act early on distressed borrowers; promote shift to risk-based lending; consolidate or restructure weak regional banks.
- Growth strategy implementation:
  - Priority actions: expand employment for women, youth, elderly; raise productivity via regional trade integration (TPP); reorient credit guarantee system and establish asset management companies to purchase distressed SME loans.
- International cooperation:
  - Despite the earthquake, Japan enacted law and budget to contribute to IDA replenishment and IMF quota increase.

### Key macroeconomic indicators (selected)
- Nominal GDP:  US$5,459 billion (2010)
- Population:  127.6 million (2010)
- GDP per capita:  US$42,783 (2010)
- Quota:  SDR 15,628.5 million

- Real GDP (percent change):
  - 2009: -6.3
  - 2010: 4.0
  - 2011: -0.7
  - 2012: 2.9

- Domestic demand (percent change):
  - 2010: 2.1
  - 2011: 0.0
  - 2012: 2.5
  - Private consumption (2010–2012): 1.8; -1.2; 1.3
  - Business investment (2010–2012): 2.1; 0.4; 5.8

- Inflation:
  - CPI (annual average): 2010: -0.7; 2011: 0.1; 2012: 0.0
  - GDP deflator: 2010: -2.1; 2011: -1.1; 2012: -0.3

- Unemployment rate (annual average): 2010: 5.1; 2011: 4.9; 2012: 4.7

### Government finance (general government, percent of GDP)
- Revenue: 2010: 30.6; 2011: 31.4; 2012: 32.1
- Expenditure: 2010: 40.2; 2011: 41.9; 2012: 41.1
- Balance (overall): 2010: -9.6; 2011: -10.5; 2012: -9.1
- Primary Balance: 2010: -8.5; 2011: -9.0; 2012: -7.6
- Public Debt, gross: 2010: 220.4; 2011: 233.1; 2012: 236.6

- Memorandum: Nominal GDP (FY, trillion yen) (2006–2012): 510.9; 515.8; 492.1; 474.0; 476.0; 474.2; 484.7

### External and financial indicators (selected)
- Current account balance (US$, in billions):
  - 2009: 141.8
  - 2010: 195.9
  - 2011 (latest): 144.7
  - Percent of GDP: 2009: 2.8; 2010: 3.6; 2011: 2.5

- Trade balance (US$, in billions):
  - 2009: 43.4
  - 2010: 91.0
  - 2011: 27.5
  - Percent of GDP: 2009: 0.8; 2010: 1.7; 2011: 0.5

- Exports of goods, f.o.b. (US$ billions): 2009: 545.3; 2010: 730.1; 2011: 800.1; 2012 proj.: 930.5
- Imports of goods, f.o.b. (US$ billions): 2009: 501.9; 2010: 639.1; 2011: 772.6; 2012 proj.: 874.1
- Oil imports (trade basis, US$ billions): 2009: 99.9; 2010: 134.3; 2011: 183.0; 2012 proj.: 195.5

- Total reserves minus gold (US$ billion): 2009: 1009.4; 2010: 1022.2; 2011 (latest): 1011.6; 2011 (table 3) latest: 1101.7

### Medium-term projections (2009–16) — selected series
- Real GDP (percent change): 2009: -6.3; 2010: 4.0; 2011: -0.7; 2012: 2.9; 2013: 2.2; 2014: 2.0; 2015: 1.4; 2016: 1.2
- Unemployment rate (percent): 2009: 5.1; 2010: 5.1; 2011: 4.9; 2012: 4.7; 2013: 4.6; 2014: 4.3; 2015: 4.3; 2016: 4.2
- CPI inflation (projections): 2010: -0.7; 2011: 0.1; 2012: 0.0; 2013: 0.4; 2014: 0.6; 2015: 0.7; 2016: 1.0
  - Note: Projections do not reflect the expected downward revision in the CPI due to the base-year change scheduled for August 2011.
- Output gap: 2009: -8.0; 2010: -4.7; 2011: -5.5; 2012: -3.3; 2013: -1.9; 2014: -0.7; 2015: -0.2; 2016: 0.0
- Overall fiscal balance (percent of GDP): 2009: -10.3; 2010: -9.6; 2011: -10.5; 2012: -9.1; 2013: -7.8; 2014: -7.4; 2015: -7.3; 2016: -7.4
- Gross debt (percent of GDP, projections): 2010: 220.3; 2011: 233.1; 2012: 236.6; 2013: 240.3; 2014: 242.8; 2015: 247.0; 2016: 250.3
- Net debt (percent of GDP, projections): 2010: 117.6; 2011: 130.9; 2012: 138.2; 2013: 145.0; 2014: 151.0; 2015: 158.2; 2016: 164.9
- Current Account Balance (percent of GDP, projections): 2010: 3.6; 2011: 2.5; 2012: 2.9; 2013: 2.8; 2014: 2.7; 2015: 2.5; 2016: 2.2

### APPENDIX I — JAPAN: PUBLIC SECTOR DEBT SUSTAINABILITY ANALYSIS (summary)
- Two scenarios:
  - No adjustment scenario: continued rise in net debt ratio.
  - Policy adjustment scenario: net debt-to-GDP ratio reduced to 115 percent by 2030.
- Macroeconomic assumptions:
  - Real GDP growth and inflation converge to 1 percent over the long term.
  - Nominal GDP growth around 2 percent per year over the next 10 years.
  - Nominal interest rate growth differential converges to 1¼ percent over the long run.
  - Average nominal interest rate assumed to rise to 3¼ percent over the long run.
- No adjustment scenario assumptions (next 10 years):
  - Expiration of enacted stimulus: 1 percent of GDP.
  - Modest expenditure adjustment: 1½ percent of GDP.
  - Unchanged tax policy.
  - These produce an improvement of 2½ percent of GDP in the structural primary balance over the next decade.
  - Projection: net public debt would rise and approach 250 percent of GDP by 2030.
- Policy adjustment scenario assumptions:
  - Improve structural primary balance by 10 percent of GDP over next decade (7.5 percent of GDP relative to no adjustment).
  - Components: withdrawal of stimulus 1 percent; additional policy measures 9 percent (5 percentage points from net tax increase including gradual consumption tax rise starting in 2012; 4 percentage points from expenditure reforms).
  - Specific assumed tax package: consumption tax increase by 10 percentage points cumulatively (2 percentage points each in 2012 and 2013, and 3 percentage points each in 2015 and 2017); corporate tax cut (0.5 percent of GDP) and personal income tax hike (0.5 percent of GDP) in 2013.
- Sensitivity:
  - Debt dynamics sensitive to interest-growth differential.
  - Even with higher differential of 2 percent (vs baseline 1¼ percent), net debt-to-GDP still declines under policy adjustment scenario.
  - Returning public debt ratio to pre-crisis level by 2030 would require adjustment between 12½–16 percent of GDP depending on interest-growth differential.

### Public sector debt dynamics and selected fiscal series (percent of GDP)
- Public sector net debt (2007–2016): 81.5; 96.5; 110.1; 117.6; 130.9; 138.2; 145.0; 151.0; 158.2; 164.9
- Change in public sector debt (2007–2016): -2.8; 15.0; 13.6; 7.5; 13.3; 7.3; 6.8; 6.0; 7.2; 6.8
- Primary deficit (2007–2016): 1.8; 3.3; 9.2; 8.5; 9.0; 7.6; 6.1; 5.5; 5.1; 4.8
- Revenue and grants (2007–2016): 31.0; 31.6; 29.8; 30.6; 31.4; 32.1; 32.5; 32.4; 32.5; 32.4
- Primary (noninterest) expenditure (2007–2016): 32.8; 34.9; 39.0; 39.1; 40.5; 39.7; 38.6; 37.9; 37.7; 37.3
- Automatic debt dynamics (2007–2016): -0.7; 2.7; 8.0; -0.8; 3.6; -1.8; -0.9; -1.4; -0.1; -0.5
- Contribution from real interest rate (2007–2016): 1.3; 1.7; 1.5; 3.5; 2.8; 1.9; 2.0; 1.5; 2.0; 1.4
- Contribution from real GDP growth (2007–2016): -1.9; 1.0; 6.5; -4.3; 0.8; -3.7; -2.9; -2.9; -2.1; -1.9
- Residual, including asset changes (2007–2016): -3.9; 9.0; -3.6; -0.1; 0.7; 1.5; 1.7; 1.9; 2.2; 2.4
- Public sector debt-to-revenue ratio (2007–2016): 262.8; 305.2; 369.5; 384.2; 416.5; 431.0; 445.9; 465.4; 486.5; 508.4

### Key macro and fiscal assumptions (selected)
- Real GDP growth (2007–2016): 2.3; -1.2; -6.3; 4.0; -0.7; 2.9; 2.2; 2.0; 1.4; 1.2
- Average nominal interest rate on public debt (2007–2016): 0.8; 1.1; 1.1; 1.1; 1.2; 1.1; 1.2; 1.3; 1.5; 1.6
- Inflation rate (GDP deflator, 2007–2016): -0.7; -1.0; -0.4; -2.1; -1.1; -0.3; -0.2; 0.3; 0.1; 0.7

### Second supplementary budget, tax and social security reforms
- Second Supplementary Budget (trillions of yen):
  - Contingency reserves for quake-related expenses: 0.8
  - Transfers to local governments: 0.5
  - Income support for households in affected areas: 0.3
  - Compensation over Fukushima nuclear accident: 0.1
  - Other: 0.2
  - Total: 2.0
- Financing:
  - Cabinet endorsed a second supplementary budget of ¥2 trillion (0.4 percent of GDP) funded by higher-than-expected FY2010 tax revenue and unused funds; it does not rely on bond issuances.
  - A larger third supplementary budget later in the year could exceed 2 percent of GDP and likely include large infrastructure projects.
- Tax and social security reform developments:
  - Joint panel decided to double the consumption tax rate to 10 percent "by the mid-2010s" to fund social security, with any tax increase conditional on economic recovery.
  - Proposal expected to be discussed and reflected in a tax and social security reform bill by end of FY2011 (end of March 2012).
- Staff views:
  - Modest second supplementary budget supports disaster relief and reconstruction.
  - Timely passage of a sizeable third supplementary budget focused on infrastructure is critical.
  - New tax measures needed to limit bond issuance and strengthen fiscal reform commitment.
  - Staff welcomes plan to double the consumption tax by the mid-2010s but notes further increases beyond FY2015 and caps on spending growth required to bring down public debt ratio.

### Executive Board Assessment — key points
- Yen to US$ traded in band of 80-84 until early July after G-7 intervention.
- Economy expected to expand later in the year as supply normalizes and reconstruction spending picks up.
- GDP growth expected: -0.7 percent in 2011; 2.9 percent in 2012.
- Headline inflation around zero percent in 2011 and 2012; underlying inflation likely to remain negative.
- Directors’ fiscal and monetary recommendations:
  - Repair damaged infrastructure, support sizeable well-targeted supplementary budget relying primarily on new tax measures, and pursue ambitious medium-term fiscal adjustment.
  - Support for broadening BoJ toolkit under comprehensive monetary easing; consideration of longer-maturity public securities and possibly private assets if deflationary pressures emerge.
  - Encourage banks to maintain adequate capital, shift to risk-based lending, and withdraw special SME loan measures as conditions permit.
- Key statistics highlighted:
  - Real GDP (annual growth): 2007: 2.4; 2008: -1.2; 2009: -6.3; 2010: 4.0; 2011 (Proj.): -0.7
  - Current account balance (US$ billions): 2007 211.0; 2008 157.1; 2009 141.8; 2010 195.9; 2011 (Proj.) 144.7
  - General government overall balance (percent of GDP): 2007 -2.4; 2008 -4.2; 2009 -10.3; 2010 -9.6; 2011 (Proj.) -10.5
  - Exchange and interest rates (period average): Yen/dollar rate 2011 (Proj.) 80.6 (June 24, 2011); 10-year government bond yield 2011 (Proj.) 1.1
  - Money and credit (May 2011): Base money 16.2; M2 (period average) 2.7; Bank lending -0.5

*Source: APPENDIX I. JAPAN: PUBLIC SECTOR DEBT SUSTAINABILITY ANALYSIS — 2011 Article IV Report (excerpts).*

### APPENDIX I. JAPAN: PUBLIC SECTOR DEBT SUSTAINABILITY ANALYSIS ___________________ 32

### APPENDIX I. JAPAN: PUBLIC SECTOR DEBT SUSTAINABILITY ANALYSIS ___________________ 32

### The Road to Recovery — Key findings
- The Great East Japan earthquake and tsunami on March 11, 2011 halted Japan’s nascent recovery and "destroyed large parts of Japan’s northeastern coastal areas and damaged key infrastructure."
- Authorities responded swiftly to stabilize markets; activity has begun to recover, but outlook remains uncertain due to power-supply concerns, weak sentiment, and potential political uncertainty ahead of Lower House elections scheduled before 2013.
- Reconstruction spending and tax/social security blueprint decisions will have important implications for growth and fiscal outlook.

### Economic impact of the earthquake — initial effects and recovery signals
- Q1 2011 GDP contracted by 3.5 percent (q/q, s.a.a.r.), led by sharp declines in private consumption and stockbuilding.
- Four factors explaining the severe initial impact:
  - extensive damage to private capital and public infrastructure (estimated at 3–5 percent of GDP),
  - electricity shortages in the Kanto region including Tokyo, which accounts for 40 percent of GDP,
  - widespread supply chain disruptions affecting production nationwide, especially in automobiles and electronics (about 35 percent of exports),
  - a sharp decline in sentiment following the earthquake, weighing heavily on domestic demand.
- Supply-side recovery:
  - Industrial production declined by 15 percent in March and grew modestly in April; leading indicators point to a solid rebound in coming months.
  - Supply chains being restored faster than expected; confidence growing that summer demand for electricity will be met due to energy conservation and added capacity.
- Demand-side weakness:
  - Retail sales and capital goods shipments have started to recover, but household and corporate sentiment remains weak.
- Prices and financial markets:
  - Core inflation excluding fresh food held steady in the first two months after the earthquake.
  - Equity markets fell by over 15 percent in the first weeks after the earthquake but recouped roughly one third of their losses by mid-June.
  - JGB 10-year rate moved in a narrow range between 1.1 and 1.2 percent after BoJ liquidity injections.
  - Spread between 3-month LIBOR and overnight indexed swaps (OIS) remained around 0.12 percent.
  - Yen / US$ traded in a band of 80–84 after coordinated G-7 intervention; in real effective terms the yen depreciated by 5 percent since the beginning of the year but remained about 15 percent stronger than during pre-Lehman lows.

### Outlook and staff projections
- Staff forecasts:
  - GDP growth to slow to -0.7 percent in 2011 before rising to 2.9 percent in 2012.
  - Headline inflation to be around zero percent in 2011 and 2012; underlying inflation—excluding food and energy—is projected to remain negative.
- Output gap note:
  - Output gap projected to widen modestly by about ½ percentage point to 5.5 percent in 2011.
  - Given the temporary nature of the shock and a very flat Phillips-curve, the estimated impact on underlying inflation is about 0.1 percentage points in 2011.
- Risks:
  - Outlook is unusually uncertain and biased downwards. Key downside risks include delayed supply disruptions resolution and rebuilding electricity capacity (notably nuclear-related risks).
  - External downside risk from a slowdown in other advanced economies.
  - If downside risks materialize, policy response would need larger upfront fiscal spending and monetary easing combined with a more ambitious medium-term fiscal consolidation strategy.
  - Upside possibility: faster easing of supply constraints accelerating recovery in exports and investment.
- Exchange rate and external position:
  - Trade balance turned negative in May due to supply disruptions; current account surplus projected above 2 percent of GDP in the medium term.
  - Based on IMF methodologies (macroeconomic balance, equilibrium real exchange rate, external sustainability), the yen appears broadly in line with medium-term fundamentals.

### Authorities’ views
- Officials expect a sharp recovery in the second half of the year consistent with staff projections; BoJ and Cabinet Office calendar-year forecasts roughly similar to staff’s after adjusting for Q1 outturn and revisions.
- Authorities view risks as mainly on the downside: pace of consumer sentiment rebound and addressing electricity shortages are key uncertainties, especially if more nuclear plants are shut down.
- Authorities emphasized that exchange rates should be market-determined but expressed concern about yen volatility and viewed the G-7 coordinated intervention as successful.

### Box 1 — Implications of the Earthquake for Japan’s Electricity Supply (summary)
- TEPCO supply capacity to Kanto/greater Tokyo fell by nearly 30 percent to below 35 million KW in March, forcing rolling blackouts when normal demand was around 35–40 million KW.
- TEPCO ended rolling blackouts by early April through restoration efforts.
- TEPCO projected supply capacity to rise to around 55 million KW by July, which "based on past usage, should be sufficient to meet peak demand this summer."
- Government called for a 15 percent reduction in electricity usage during summer peak hours.
- Longer-term uncertainty: 35 out of 54 nuclear reactors had already been shut down for inspection; restarting depends on local government approval amid rising public concerns. Shutting down all reactors could reduce electricity supply significantly.
- Substituting nuclear with other sources may raise electricity costs by around 10 percent (or 0.3 percent of GDP).
- The elasticity of GDP with respect to electricity supply is estimated to be around 1 over the past 10 years.
- Transition toward thermal energy could conflict with Kyoto Protocol emission commitments.
- A clear policy on securing a stable and affordable energy supply is needed to mitigate risks.

### Policy discussions — Fiscal policy and reconstruction financing
- Trade-off: fiscal policy must balance increased spending for a swift recovery and longer-term reforms to reduce very high public debt.
- Fiscal cost estimates and near-term fiscal stance:
  - Fiscal costs of the earthquake could range between 2–4 percent of GDP spread over several years.
  - Reconstruction is projected to increase the fiscal deficit in 2011 to 10½ percent of GDP and the net debt-to-GDP ratio to above 130 percent of GDP.
  - Government’s first supplementary budget in May was 0.8 percent of GDP, financed mainly from contingency reserves, reprioritized spending, and a temporary reduction in government contributions to the public pension fund. Additional supplementary budgets focused on regional revitalization were expected in summer.
- Financing constraints and options:
  - Near-term scope for further expenditure cuts is limited; non-social security spending (excluding interest payment) is about 16 percent of GDP and low among advanced economies.
  - Japan has ample room to raise additional tax revenue: overall tax revenue about 17 percent of GDP (one of the lowest among OECD economies).
  - Consumption tax rate at 5 percent is very low compared to other countries; personal income tax allows ample deductions and low marginal rates for middle-income households; corporate income tax rate of 40 percent is relatively high.
  - In the absence of new taxes, JGB issuance could rise by 2 percent of GDP or more in 2011–12.
  - While additional bond issuance size is manageable, bond market absorption capacity is projected to decline with population aging; JGB market faces risks from changes in institutional investor base, external developments, and reconstruction activity that could put upward pressure on interest rates.

*Source: APPENDIX I. JAPAN: PUBLIC SECTOR DEBT SUSTAINABILITY ANALYSIS — 2011 Article IV Report (excerpts).*

### Box 2. The Case for Raising the Consumption Tax in Japan

### Box 2. The Case for Raising the Consumption Tax in Japan

### Rationale for raising the consumption tax (VAT)
- VAT history and current rate:
  - Introduced in 1989 at the rate of 3 percent; rose to 5 percent in 1997.
  - Japan’s VAT is still the lowest among advanced economies that have a VAT.
- Revenue yield:
  - VAT revenue yield in Japan is approximately 2½ percent of GDP.
- Efficiency and administration:
  - The VAT is applied on a broad basis and has a uniform rate.
  - The C-efficiency ratio (VAT revenue divided by total consumption times the standard rate) is nearly 70 percent—one of the highest among OECD countries—indicating a broad base with relatively strong compliance.
- Stability of VAT in an aging society:
  - Aging implies dissaving by households, making the VAT tax base more robust than the base for labor income.
  - In Japan, labor income in nominal terms has grown by about ½ percentage points per year slower on average over the past 10 years than private consumption.
  - International evidence cited (Arnold, 2008) indicates VAT is less damaging for economic growth than personal or corporate income taxes; the less distortionary feature is particularly relevant given Japan’s relative shortage of labor.

### Authorities’ proposal and staff recommendation
- Authorities’ proposal:
  - In early June, the authorities outlined a social security reform plan proposing to gradually double the consumption tax to 10 percent by FY2015.
  - The plan also proposes to raise the pension retirement age and adjust nominal pension benefits for deflation, but does not specify steps beyond FY2015 for meeting the final target of reducing the debt ratio starting in FY2021 at the latest.
- Staff’s near-term recommendation:
  - Staff recommends a moderate increase in the consumption tax, from 5 percent to 7–8 percent, in 2012 when a cyclical recovery is underway.
- Longer-term staff proposal:
  - Comprehensive tax reform with a gradual increase in the consumption tax to 15 percent over several years, yielding 5 percent of GDP.

### Fiscal adjustment needs, targets, and macro implications
- Fiscal goals and required adjustment:
  - Stabilizing the net debt ratio by 2016 and reducing it to around 135 percent of GDP by 2020 would require a reduction of the primary fiscal deficit by 10 percent of GDP over a 10 year horizon.
  - Staff’s policy adjustment scenario assumes a 10 percent of GDP improvement (7.5 percent of GDP relative to no adjustment scenario) of the structural primary balance between 2010-20.
- Growth effects:
  - Staff estimates that in the short run, fiscal adjustment could reduce growth by 0.3–0.5 percentage points per year, but that over the longer term it could raise growth due to improved confidence in public finances.

### Suggested composition of fiscal adjustment (key elements and amounts)
- Main elements and quantified contributions (in percent of GDP):
  - Consumption tax increase to 15 percent over several years, yielding 5 percent of GDP.
  - Corporate income tax rate lowered from 40 percent to 35 percent (revenue losses to be offset by personal income tax base broadening).
- Expenditure reforms and quantified savings:
  - Freeze central government contributions to the public pension system in nominal terms, including by raising the pension retirement age: 0.5
  - Freeze non social security spending in nominal terms (excluding interest payment): 2.5
  - Limit annual nominal growth in non pension social security spending at 1-1.5 percent: 1.0
- Other revenue and adjustment items (from the possible options table and assumed impacts over 10 years):
  - Withdrawal of fiscal stimulus: 1.0
  - Modest increase in personal income tax through broadening the base: 0.5
  - Corporate tax cut (by 5 percentage points): -0.5
  - Total savings (sum shown): 10.0 10.0 10.0

### Policy design and implementation considerations
- Timing and sequencing:
  - Staff supports implementing a moderate tax increase in 2012 when cyclical recovery is underway; the authorities’ proposed doubling to 10 percent by FY2015 is welcomed but staff notes more is needed to place net debt-to-GDP on a downward path earlier.
- Complementary measures:
  - Comprehensive tax reform should be combined with limits on spending growth and targeted expenditure reforms.
  - Introduction of a taxpayer identification system is supported to allow more effective targeting of social transfers.
- Fiscal framework:
  - Adopting an explicit fiscal rule targeting a primary surplus consistent with the debt reduction plan could help sustain consolidation; the framework should be based on prudent economic assumptions and permit temporary deviations only under narrowly defined conditions.
- Debt management:
  - Lengthening the maturity of public debt could help limit rollover risks and keep funding costs low; the government has progressively lengthened average maturity to 5–6 years but annual financing requirements remain high at about 55 percent of GDP.

*Source: 2011 Article IV Report — Box 2. The Case for Raising the Consumption Tax in Japan.*

### 33. Broader communication of the special

### 33. Broader communication of the special

### Inflation communication and measurement
- The BoJ has explained that the rise in inflation has been partly due to higher international commodity prices.
- Recommendation: regularly report the outlook for different inflation indices and explain their influence on monetary policy setting.
- In the current environment, where underlying inflation pressures are very subdued, the BoJ should give high weight to measures of inflation that exclude food and energy.

### Policy options to insure against deflation risks
- The BoJ could consider:
  - Further monetary easing.
  - Increase the share of longer maturity JGBs (3 years and above) in its portfolio to further reduce term premia on yields.
  - Expand its special loan facility to "support the foundations of growth" to include reconstruction projects in the affected regions.
  - Accelerate and expand purchases of private assets: corporate bonds, commercial paper, ETFs, and securitized SME loans to ease financial conditions and foster a new market for lending to smaller firms.

### Event-study evidence on BoJ easing measures (Box 4)
- Method: compare changes in high-frequency financial indicators around BoJ announcement/implementation events since December 2009 with changes on a typical trading day.
- Key findings:
  - Sovereign yields: the 10-year JGB yield fell cumulatively by nearly 25 basis points, and the 2-year JGB yield by more than 10 basis points; these declines were statistically significant and larger than the 0.1 basis point change in a typical two-day trading window. The term premium also fell, helping to flatten the yield curve.
  - Corporate yields: yields on corporate bonds across various investment grades declined initially, but reverted by the end of the following week.
  - Stock prices: equity prices improved by more than 5–7 percent, with the increase being statistically significant compared with changes during typical trading days.
  - Exchange rate and inflation expectations: monetary easing had almost no measurable effect.
  - Across industries, easing was most effective in the financial and real estate sectors: equity prices of insurance companies and large banks rose strongly relative to the market index (more than 10 percent in total across the events identified); other sectors did not show significant excess return after beta adjustment.
  - Asset purchase program (October 2010) appears to have lowered tail risks: implied volatility declined significantly, reducing risk premia and the perceived risk of a double-dip recession.
- Interpretation: results suggest asset purchases reduced term and risk premia and could be expanded further to support activity, though the size of the impact has been modest.

### Exchange rate considerations
- Monetary easing has had little effect on the yen exchange rate recently.
- Since the global crisis, interest differentials between major currencies have narrowed, reducing incentives for yen-funded carry trade.
- If Japan maintains accommodation longer than other advanced economies, the yen could weaken and affect other economies via trade and financial channels, although a return of large-scale carry trades appears unlikely.

### The Authorities’ (BoJ) views on easing measures
- The BoJ considered its exceptionally accommodative stance sufficient to stabilize financial markets and meet credit demand; their outlook did not warrant further easing immediately.
- Concerns about policy insurance costs and potential side effects of unorthodox policies:
  - Extending maturities of JGB purchases: buying longer maturities could absorb duration risk and catalyze portfolio rebalancing, but with very low 10-year JGB yield expected gains appear limited; without a credible fiscal strategy it could signal unconstrained debt issuance and push up long-term yields.
  - Special loan facility: most of the committed ¥3 trillion in funds has been used; the facility was upgraded but authorities wished to avoid contributing to excess loan competition; uncertain suitability for immediate reconstruction needs.
  - Purchases of private assets: ongoing and under evaluation; expansion must weigh market-distortion risks and BoJ balance-sheet soundness; SME securitized loans are promising but market is too small and illiquid.

### Safeguarding financial stability — immediate post-earthquake actions and exposures
- BoJ provided an unprecedented ¥21.8 trillion of short-term liquidity on the first business day after the disaster, nearly three times larger than injected after the Lehman crisis.
- Major banks:
  - Account for 53 percent of total banking assets.
  - Have small exposure to affected areas (½ percent of their loans) with estimated losses well within capital buffers.
  - Tier 1 capital ratio: 13 percent at end FY2010, though about one-third of this capital is in preferred securities and tax deferred assets.
- Regional and shinkin banks:
  - Some have sizeable exposures to affected regions but pose little systemic risk given small size (2 percent of the banking system) and limited connectedness.
  - Regional banks’ Tier-1 capital ratio: 9.4 percent in FY 2010.
- Insurance sector:
  - Insured losses from life and non-life insurers are estimated at around ¥2.7 trillion, well within solvency margins, which stood at above 760 percent of liabilities.
- TEPCO-related risks:
  - TEPCO’s share price fell by nearly 90 percent since the earthquake.
  - Company reported losses of around ¥1¼ trillion in FY2010.
  - Major banks have around ¥3 trillion in loans to TEPCO, of which around ¥2 trillion were extended as emergency financing after the disaster.
  - Financial market reactions have been negative due to uncertainty about TEPCO’s financial situation and implications for creditors and shareholders.

### Policy issues and staff views on financial sector resilience
- Banks face risks from a sluggish recovery: delayed recovery could raise credit costs, especially for heavily indebted SMEs; emergency SME support measures should be withdrawn once recovery is underway to limit moral hazard and strengthen risk management.
- Market and interest risk:
  - Banks’ equity holdings account for nearly one half of Tier-1 capital; bank-held government bonds are over 15 percent of total assets.
  - Supervisors should encourage monitoring of market risks and reduction of equity holdings.
  - Any TEPCO rehabilitation plan should follow applicable laws on the treatment of claims.
- Profitability and structural reforms:
  - Core profitability remains low: FY2010 results show compressed net interest margins and overall lending declined despite improving credit costs.
  - Recommendations: promote more risk-based lending, consolidate or restructure weak regional banks (including through public funds), and privatize Japan Post to ensure a level playing field and broaden financial intermediation.
- Regulatory developments:
  - Possible capital surcharges and other Basel framework regulations for G-SIFIs could have implications; if Japanese institutions are classified as G-SIFIs they would need to meet surcharges and additional regulations within the agreed timeline.
  - Authorities advocate that the G-SIFIs framework should avoid excessive regulations, ensure institutions are regulated according to respective risk levels, and adopt a comprehensive, well-balanced policy package.

### Authorities’ assessment and supervisory stance
- Authorities view the financial sector as having remained resilient since the disaster, crediting responses by financial institutions, the BoJ, and government actions (including amendments to the Act on Special Measures for Strengthening Financial Functions).
- Supervisors consider current bank capital levels sufficient to cover credit and market risks:
  - Notes that credit risk increases would be manageable due to reinforced capital through retained earnings.
  - On market risk, officials noted the impact of yield curve changes is unclear and will continue to encourage reduction in equity holdings.
  - A stress test (pre-earthquake) showed banks’ capital would remain above regulatory minimums under a severe scenario: a 1 percentage point slowdown in growth combined with a decline in equity prices to the lowest level since 2008.
- FSA focus: strengthen risk management to boost bank profitability, promote relationship-based banking, monitor banks’ expanding lending in Asia, and consider capital injections for the weakest banks under proposed Act amendments.

*Source: _cr11181 - 33. Broader communication of the special*

### 51. The authorities view their growth

### 51. The authorities view their growth

### Authorities' growth strategy: measures and views
- Boosting labor participation
  - Plan to increase childcare services, including by merging kindergarten and childcare systems, in response to the high drop-out rate of women from the labor force following childbirth.
  - Emphasis on job training and matching efforts to raise employment of the young and elderly.
- Trans Pacific Partnership (TPP)
  - Authorities agreed that participation in the TPP would provide a boost to exports and encourage new investment in the service sectors.
  - After the earthquake, the need to evaluate the impact of a TPP on farming and fishing in the affected regions delayed a decision to join negotiations.
  - Authorities underscored that a plan on agricultural compensation will likely be needed to garner broader support for the TPP.
- SME restructuring
  - Authorities generally supportive of reforming the credit guarantee system to promote start-ups, keeping guarantee maturities reasonably short and limiting rollovers.
  - Altering the system immediately would be difficult given its widespread use and need to promote reconstruction.
  - Supportive of establishing asset management companies to facilitate bank-led restructuring of earthquake-related distressed loans, but would first need to evaluate the scale of the distressed loan problem before laying out concrete proposals.
  - Credit guarantee system numeric details preserved:
    - The average length of a credit guarantee is about 5½ years, shorter than the maximum limit of 7 and 10 years under the regular and special guarantee systems.
- Female labor participation data (2008, in percent)
  - 58.7
  - 67.3
  - 70.6
  - 71.5
  - 72.1
  - (Chart labels in source: KoreaJapanGermanyUKUS)

### Staff appraisal — near-term outlook and risks
- Near-term recovery
  - Japan’s economy is set to recover later this year.
  - Supply disruptions are easing faster than expected, and reconstruction spending will provide a boost in the second half of the year.
  - Recovery faces risks from delays in restoring electricity capacity and a slow pick-up in private demand.
- Electricity and production risks
  - Significant downside risk from uncertainty over longer-term electricity supply if nuclear power plants remain offline following routine inspections.
  - Uncertainty over the power situation and higher energy costs could undermine confidence and accelerate a shift of production abroad.

### Fiscal policy priorities and recommendations
- Immediate priorities
  - Repair damaged infrastructure and facilitate a swift recovery.
  - Timely passage of an additional supplementary budget that is well-targeted to revitalize the affected regions would help address downside risks and catalyze private spending.
  - While other tax measures could be considered, financing should be supported by a moderate increase in the consumption tax in 2012 to take advantage of a cyclical recovery and limit bond issuance.
- Medium-term fiscal strategy
  - Japan needs a more ambitious medium-term strategy for bringing down public debt.
  - To reduce the public debt ratio by the middle of the decade will require a reduction in the structural primary deficit by 10 percent of GDP over a 10 year period.
  - Given limited scope for cutting expenditures, fiscal adjustment should rely on comprehensive tax reforms centered on a gradual increase in the consumption tax.
  - Raising the average maturity of public debt and adopting an explicit fiscal rule based on a primary surplus and debt target with limited escape clauses would strengthen credibility and reduce fiscal risks.

### Monetary and financial sector recommendations
- Monetary policy
  - Further monetary easing could guard against deflation risks and support the recovery.
  - The sharp fall in demand and heightened uncertainty could add to deflationary pressures.
  - BoJ options include increasing the share of longer maturity JGBs and private assets in its portfolio.
  - The BoJ could also strengthen its communication strategy by explaining the outlook for inflation measures that exclude both food and energy.
- Financial sector resilience
  - Supervisors should encourage weak banks to improve their capital bases and take early action vis-à-vis distressed borrowers.
  - To raise banks’ core profitability, a shift to more risk-based (as opposed to collateral-based) lending would help increase lending margins.
  - Consolidation or restructuring of weak regional banks would strengthen the banking sector.

### Growth strategy implementation and external spillovers
- Timely implementation of the government's growth strategy would help sustain fiscal adjustment and support the recovery.
  - Priority actions: expanding employment opportunities for women, youth, and the elderly; raising productivity by promoting further regional trade integration, such as through the proposed TPP.
  - Reorienting the public credit guarantee system to support startups and establishing asset management companies to purchase distressed SME loans would promote bank-led restructuring of the SME sector.
- Regional and global spillovers
  - Japan accounts for nearly 9 percent of global GDP and about half of its international trade is conducted with the region.
  - Fiscal consolidation would have long-term benefits for partners by reducing tail risks from a disruption in Japan’s large sovereign debt market and freeing up domestic savings to help lower global interest rates.

### International cooperation
- Despite the earthquake, Japan enacted law and budget to contribute to:
  - The replenishment of capital of the International Development Association (IDA) of the World Bank and other multinational development banks.
  - The quota increase of the IMF.

*2011 ARTICLE IV REPORT JAPAN, INTERNATIONAL MONETARY FUND*

### 62. It is recommended that the next Article

### _cr11181 - 62. It is recommended that the next Article

### Key macroeconomic indicators (selected)
- Nominal GDP:  US$5,459 billion (2010)
- Population:  127.6 million (2010)
- GDP per capita:  US$42,783 (2010)
- Quota:  SDR 15,628.5 million

- Real GDP (percent change)
  - 2009: -6.3
  - 2010: 4.0
  - 2011: -0.7
  - 2012: 2.9

- Domestic demand (percent change)
  - 2010: 2.1
  - 2011: 0.0
  - 2012: 2.5
  - Private consumption (2010–2012): 1.8; -1.2; 1.3
  - Business investment (2010–2012): 2.1; 0.4; 5.8

- Inflation
  - CPI (annual average): 2010: -0.7; 2011: 0.1; 2012: 0.0
  - GDP deflator: 2010: -2.1; 2011: -1.1; 2012: -0.3

- Unemployment rate (annual average): 2010: 5.1; 2011: 4.9; 2012: 4.7

### Government finance (general government, percent of GDP)
- Revenue: 2010: 30.6; 2011: 31.4; 2012: 32.1
- Expenditure: 2010: 40.2; 2011: 41.9; 2012: 41.1
- Balance (overall): 2010: -9.6; 2011: -10.5; 2012: -9.1
- Primary Balance: 2010: -8.5; 2011: -9.0; 2012: -7.6
- Public Debt, gross: 2010: 220.4; 2011: 233.1; 2012: 236.6

- Table 2 highlights (2006–12, percent of GDP)
  - Total revenue (2006–2012): 30.7; 31.0; 31.6; 29.8; 30.6; 31.4; 32.1
  - Total expenditure (2006–2012): 34.7; 33.4; 35.8; 40.1; 40.2; 41.9; 41.1
  - Net lending/borrowing (overall balance) (2006–2012): -4.0; -2.4; -4.2; -10.3; -9.6; -10.5; -9.1
  - Primary balance (2006–2012): -3.4; -1.8; -3.3; -9.2; -8.5; -9.0; -7.6
  - Gross debt (2006–2012): 191.3; 187.7; 195.0; 216.3; 220.3; 233.1; 236.6

- Memorandum: Nominal GDP (FY, trillion yen) (2006–2012): 510.9; 515.8; 492.1; 474.0; 476.0; 474.2; 484.7

### External and financial indicators
- Current account balance (US$, in billions)
  - 2009: 141.8
  - 2010: 195.9
  - 2011 (latest): 144.7
  - Percent of GDP: 2009: 2.8; 2010: 3.6; 2011: 2.5

- Trade balance (US$, in billions)
  - 2009: 43.4
  - 2010: 91.0
  - 2011: 27.5
  - Percent of GDP: 2009: 0.8; 2010: 1.7; 2011: 0.5

- Exports of goods, f.o.b. (US$ billions): 2009: 545.3; 2010: 730.1; 2011: 800.1; 2012 proj.: 930.5
- Imports of goods, f.o.b. (US$ billions): 2009: 501.9; 2010: 639.1; 2011: 772.6; 2012 proj.: 874.1
- Oil imports (trade basis, US$ billions): 2009: 99.9; 2010: 134.3; 2011: 183.0; 2012 proj.: 195.5

- Total reserves minus gold (US$ billion): 2009: 1009.4; 2010: 1022.2; 2011 (latest): 1011.6; 2011 (table 3) latest: 1101.7

- Net international investment position (US$ billion): 2009: 2849.4; 2010: 2865.1

### Balance of payments (2005–10, US$ billions and percent of GDP)
- Current account (US$ billions)
  - 2005: 165.7
  - 2006: 170.4
  - 2007: 211.0
  - 2008: 157.1
  - 2009: 141.8
  - 2010: 195.9
- Current account (percent of GDP)
  - 2005: 3.6
  - 2006: 3.9
  - 2007: 4.8
  - 2008: 3.2
  - 2009: 2.8
  - 2010: 3.6

- Capital account (US$ billions): 2005: -4.9; 2006: -4.7; 2007: -4.1; 2008: -5.6; 2009: -5.0; 2010: -5.0
- Financial account (US$ billions): 2005: -144.8; 2006: -134.7; 2007: -224.3; 2008: -204.6; 2009: -158.2; 2010: -174.7
- Reserve assets (US$ billions): 2005: -22.3; 2006: -32.0; 2007: -36.5; 2008: -30.8; 2009: -27.3; 2010: -44.3

### Medium-term projections (2009–16)
- Real GDP (percent change)
  - 2009: -6.3
  - 2010: 4.0
  - 2011: -0.7
  - 2012: 2.9
  - 2013: 2.2
  - 2014: 2.0
  - 2015: 1.4
  - 2016: 1.2

- Unemployment rate (percent): 2009: 5.1; 2010: 5.1; 2011: 4.9; 2012: 4.7; 2013: 4.6; 2014: 4.3; 2015: 4.3; 2016: 4.2

- CPI inflation (projections): 2010: -0.7; 2011: 0.1; 2012: 0.0; 2013: 0.4; 2014: 0.6; 2015: 0.7; 2016: 1.0
  - Note: Projections do not reflect the expected downward revision in the CPI due to the base-year change scheduled for August 2011.

- Output gap: 2009: -8.0; 2010: -4.7; 2011: -5.5; 2012: -3.3; 2013: -1.9; 2014: -0.7; 2015: -0.2; 2016: 0.0

- Overall fiscal balance (percent of GDP): 2009: -10.3; 2010: -9.6; 2011: -10.5; 2012: -9.1; 2013: -7.8; 2014: -7.4; 2015: -7.3; 2016: -7.4

- Gross debt (percent of GDP, projections): 2010: 220.3; 2011: 233.1; 2012: 236.6; 2013: 240.3; 2014: 242.8; 2015: 247.0; 2016: 250.3
- Net debt (percent of GDP, projections): 2010: 117.6; 2011: 130.9; 2012: 138.2; 2013: 145.0; 2014: 151.0; 2015: 158.2; 2016: 164.9

- Current Account Balance (percent of GDP, projections): 2010: 3.6; 2011: 2.5; 2012: 2.9; 2013: 2.8; 2014: 2.7; 2015: 2.5; 2016: 2.2

### Economic outlook, risks, and shocks
- Production began to recover from immediate impact of the earthquake, while business and residential investments remain weak.
- Household spending has not yet recovered; uncertainty around the outlook is large and perceived tail risks have risen.
- Commodity prices have pushed up headline inflation, but underlying inflation remains negative.

### Fiscal policy implications and reconstruction costs
- Estimates of the fiscal cost of the earthquake range between 2-4 percent of GDP.
- Reconstruction spending is projected to push net debt above 130 percent of GDP by end-2011.
- Japan has room to raise taxes to help finance reconstruction, but limited space to cut further non-social security discretionary spending.
- Gross public financing needs are high, while the average maturity of debt remains low compared to the OECD average.

### Financial sector developments
- Equity markets fell sharply after the earthquake and have remained about 15 percent below the pre-quake level.
- The yen has remained broadly stable against the USD but has depreciated against other key currencies; NEER movements are noted.
- JGB yields have been broadly stable.
- Spreads on lower-rated corporate bonds have modestly picked up after the earthquake.
- Credit demand remains sluggish but is expected to pick up with reconstruction; financing conditions improved but remain tight for SMEs.
- Interest rate indicators (end-year)
  - 3-month General collateral repo rate (end-year): 2010: 0.12; 2011 latest: 0.11

### Labor market and inequality
- Since the mid 1990s, the share of non-regular workers has gradually increased.
- Overall income inequality has been on the rise (Gini comparisons with OECD countries reported).
- After the earthquake, business bankruptcies are set to rise as observed after Kobe; older and low-skilled workers likely to face greater difficulty finding employment.
- Female labor participation is low compared to other advanced countries, with low public support for child care (pre-primary and childcare spending comparisons reported).

*JAPAN  2011 ARTICLE IV REPORT, INTERNATIONAL MONETARY FUND*

### APPENDIX I. JAPAN: PUBLIC SECTOR DEBT

### APPENDIX I. JAPAN: PUBLIC SECTOR DEBT

### Sustainability Analysis — overview
- Two scenarios are presented:
  - No adjustment scenario: continued rise in the net debt ratio.
  - Policy adjustment scenario: net debt-to-GDP ratio reduced to 115 percent by 2030.
- Macroeconomic assumptions:
  - Real GDP growth and the inflation rate converge to 1 percent over the long term.
  - Nominal GDP growth is around 2 percent per year over the next 10 years.
  - Nominal interest rate growth differential converges to 1¼ percent (pre-crisis average since 2000) over the long run.
  - Consequently, average nominal interest rate assumed to rise to 3¼ percent (compared to 1.1 percent currently) over the long run.
- Analyses focus on net debt of the general government including the social security fund.

### No adjustment scenario — assumptions and projections
- Assumptions over next 10 years:
  - Expiration of enacted stimulus: 1 percent of GDP.
  - Modest expenditure adjustment: 1½ percent of GDP.
  - Unchanged tax policy (no increase in the consumption tax).
  - These measures produce an improvement of 2½ percent of GDP in the structural primary balance over the next decade.
- Projection:
  - Without adjustment, net public debt would rise and approach 250 percent of GDP by 2030.

### Policy adjustment scenario — assumptions and impact
- Objective: stabilize and put debt-to-GDP ratio on a downward path; reduce net debt-to-GDP to 115 percent by 2030.
- Assumed improvement of the structural primary balance over the next decade: 10 percent of GDP (7.5 percent of GDP relative to the no adjustment scenario).
  - Components:
    - Withdrawal of stimulus: 1 percent of GDP.
    - Additional policy measures: 9 percent of GDP, of which:
      - 5 percentage points from a net tax increase, including a gradual rise in the consumption tax starting in 2012.
      - 4 percentage points from expenditure reforms (e.g., freezing non social security spending in nominal terms, limiting growth in social security spending).
- More specific assumed tax package (as described in footnote):
  - Consumption tax increase by 10 percentage points cumulatively (2 percentage points each in 2012 and 2013, and 3 percentage points each in 2015 and 2017).
  - Corporate tax cut (0.5 percent of GDP) and a personal income tax hike (0.5 percent of GDP) in 2013.

### Sensitivity analysis — interest-growth differential and required adjustment
- Debt dynamics are sensitive to the interest rate growth differential.
- Even with a higher differential of 2 percent (vs baseline 1¼ percent), the net debt-to-GDP ratio still declines over the longer term under the policy adjustment scenario.
- Returning the public debt ratio to its pre-crisis level by 2030 would require an adjustment between 12½–16 percent of GDP, depending on the interest rate growth differential.

### Selected scenario outcomes (from staff table)
- No adjustment scenario — Net Debt Ratio (in percent of GDP) for selected differentials and years:
  - Baseline nominal interest rate growth differential 1.25:
    - 2011: 2.5
    - 2015: 13
    - 2020: 15
    - 2030: 18
    - (table shows progression to 24 and 7? — preserve tabular source structure in text: "1.25 (baseline)2.5131158183247")
  - Differential 2.0:
    - (table entry) "2.02.5131158185265"
  - Differential 4.0:
    - (table entry) "4.02.5131161209354"
- Policy adjustment scenario — Net Debt Ratio (in percent of GDP) for selected differentials and years:
  - Baseline nominal interest rate growth differential 1.25:
    - (table entry) "1.25 (baseline)10.0131147136116"
  - Differential 2.0:
    - (table entry) "2.010.0131147138127"
  - Differential 4.0:
    - (table entry) "4.010.0131149155186"
- Target pre-crisis (2007) level in 2030 — required structural primary balance improvement:
  - Differential 1.25 (baseline): "12.612914613082"
  - Differential 2.0: "2.013.312914413082"
  - Differential 4.0: "4.015.912914313282"
- Note: table labels and numeric entries are preserved exactly as presented in the source.

### Public sector debt dynamics: 2007–2016 (selected series)
- Public sector net debt (general government basis, net of social security fund) — percent of GDP:
  - 2007: 81.5
  - 2008: 96.5
  - 2009: 110.1
  - 2010: 117.6
  - 2011: 130.9
  - 2012: 138.2
  - 2013: 145.0
  - 2014: 151.0
  - 2015: 158.2
  - 2016: 164.9
- Change in public sector debt (percent of GDP):
  - 2007: -2.8
  - 2008: 15.0
  - 2009: 13.6
  - 2010: 7.5
  - 2011: 13.3
  - 2012: 7.3
  - 2013: 6.8
  - 2014: 6.0
  - 2015: 7.2
  - 2016: 6.8
- Identified debt-creating flows (4+7+12) (percent of GDP):
  - 2007: 1.1
  - 2008: 6.0
  - 2009: 17.2
  - 2010: 7.7
  - 2011: 12.6
  - 2012: 5.8
  - 2013: 5.2
  - 2014: 4.1
  - 2015: 5.0
  - 2016: 4.3
- Primary deficit (percent of GDP):
  - 2007: 1.8
  - 2008: 3.3
  - 2009: 9.2
  - 2010: 8.5
  - 2011: 9.0
  - 2012: 7.6
  - 2013: 6.1
  - 2014: 5.5
  - 2015: 5.1
  - 2016: 4.8
- Revenue and grants (percent of GDP):
  - 2007: 31.0
  - 2008: 31.6
  - 2009: 29.8
  - 2010: 30.6
  - 2011: 31.4
  - 2012: 32.1
  - 2013: 32.5
  - 2014: 32.4
  - 2015: 32.5
  - 2016: 32.4
- Primary (noninterest) expenditure (percent of GDP):
  - 2007: 32.8
  - 2008: 34.9
  - 2009: 39.0
  - 2010: 39.1
  - 2011: 40.5
  - 2012: 39.7
  - 2013: 38.6
  - 2014: 37.9
  - 2015: 37.7
  - 2016: 37.3
- Automatic debt dynamics (percent of GDP):
  - 2007: -0.7
  - 2008: 2.7
  - 2009: 8.0
  - 2010: -0.8
  - 2011: 3.6
  - 2012: -1.8
  - 2013: -0.9
  - 2014: -1.4
  - 2015: -0.1
  - 2016: -0.5
- Contribution from interest rate/growth differential (percent of GDP):
  - Same series as automatic debt dynamics (see above).
- Of which contribution from real interest rate (percent of GDP):
  - 2007: 1.3
  - 2008: 1.7
  - 2009: 1.5
  - 2010: 3.5
  - 2011: 2.8
  - 2012: 1.9
  - 2013: 2.0
  - 2014: 1.5
  - 2015: 2.0
  - 2016: 1.4
- Of which contribution from real GDP growth (percent of GDP):
  - 2007: -1.9
  - 2008: 1.0
  - 2009: 6.5
  - 2010: -4.3
  - 2011: 0.8
  - 2012: -3.7
  - 2013: -2.9
  - 2014: -2.9
  - 2015: -2.1
  - 2016: -1.9
- Residual, including asset changes (2-3) (percent of GDP):
  - 2007: -3.9
  - 2008: 9.0
  - 2009: -3.6
  - 2010: -0.1
  - 2011: 0.7
  - 2012: 1.5
  - 2013: 1.7
  - 2014: 1.9
  - 2015: 2.2
  - 2016: 2.4
- Public sector debt-to-revenue ratio (in percent):
  - 2007: 262.8
  - 2008: 305.2
  - 2009: 369.5
  - 2010: 384.2
  - 2011: 416.5
  - 2012: 431.0
  - 2013: 445.9
  - 2014: 465.4
  - 2015: 486.5
  - 2016: 508.4

### Key macroeconomic and fiscal assumptions (selected)
- Real GDP growth (in percent):
  - 2007: 2.3
  - 2008: -1.2
  - 2009: -6.3
  - 2010: 4.0
  - 2011: -0.7
  - 2012: 2.9
  - 2013: 2.2
  - 2014: 2.0
  - 2015: 1.4
  - 2016: 1.2
- Average nominal interest rate on public debt (in percent):
  - 2007: 0.8
  - 2008: 1.1
  - 2009: 1.1
  - 2010: 1.1
  - 2011: 1.2
  - 2012: 1.1
  - 2013: 1.2
  - 2014: 1.3
  - 2015: 1.5
  - 2016: 1.6
- Inflation rate (GDP deflator, in percent):
  - 2007: -0.7
  - 2008: -1.0
  - 2009: -0.4
  - 2010: -2.1
  - 2011: -1.1
  - 2012: -0.3
  - 2013: -0.2
  - 2014: 0.3
  - 2015: 0.1
  - 2016: 0.7

### Second supplementary budget, tax and social security reforms, and staff views
- Second Supplementary Budget (trillions of yen):
  - Contingency reserves for quake-related expenses: 0.8
  - Transfers to local governments: 0.5
  - Income support for households in affected areas: 0.3
  - Compensation over Fukushima nuclear accident: 0.1
  - Other: 0.2
  - Total: 2.0
- Financing and context:
  - The cabinet endorsed a second supplementary budget of ¥2 trillion (0.4 percent of GDP) to fund additional earthquake reconstruction.
  - The second budget will be funded by higher-than-expected FY2010 tax revenue and unused funds; it does not rely on bond issuances.
  - The government is expected to compile a larger, third supplementary budget later in the year, which could exceed 2 percent of GDP and likely include large infrastructure projects to rebuild affected regions.
- Tax and social security reform developments:
  - Joint government and ruling party panel on social security reform decided to double the consumption tax rate to 10 percent “by the mid-2010s” to fund social security, with any tax increase conditional on an economic recovery.
  - The plan expands health and pension spending combined with measures to raise the efficiency of social security spending.
  - Proposal expected to be discussed with opposition parties and reflected in a tax and social security reform bill by the end of FY2011 (end of March 2012).
- Staff views and recommendations:
  - The modest second supplementary budget will provide support for disaster relief and reconstruction.
  - Timely passage of a sizeable (third) supplementary budget focused on large infrastructure to rebuild affected regions is critical to address downside risks and support the recovery.
  - New tax measures are needed to limit bond issuance and strengthen commitment to fiscal reforms.
  - Staff welcomes the plan to double the consumption tax by the mid-2010s, but notes that further increases in the consumption tax beyond FY2015 and caps on spending growth will be required to bring down the public debt ratio over the medium term.

*Source: APPENDIX I. JAPAN: PUBLIC SECTOR DEBT (Japan: 2011 Article IV Report informational annex).*

### 1.2 percent. After concerted intervention in coordination with the G-7 in mid-March, the

### Japan: 2011 Article IV Consultation — Executive Board Assessment

### Economic outlook
- Japanese Yen to the US dollar rate traded in a band of 80-84 until early July after concerted intervention in coordination with the G-7 in mid-March.
- The Japanese economy is set to expand later this year as supply conditions normalize and reconstruction spending picks up.
- GDP growth:
  - Expected to slow to -0.7 percent in 2011.
  - Expected to rise to 2.9 percent in 2012.
- Inflation:
  - Headline inflation projected to be around zero percent in 2011 and 2012.
  - Underlying inflation—excluding food and energy—will likely remain negative due to a wide output gap.
- Key downside risks: delays in restoring electricity capacity and a slow pick-up in private demand.
- Uncertainty surrounding the outlook is large with risks mainly on the downside.

### Fiscal policy and reconstruction costs
- Fiscal cost of the earthquake could range between 2–4 percent of GDP spread over several years.
- Reconstruction projections:
  - Increase the fiscal deficit in 2011 to 10½ percent of GDP.
  - Raise the net debt-to-GDP ratio to above 130 percent of GDP.
- Supplementary budgets:
  - First supplementary budget passed in May: 0.8 percent of GDP (to repair damaged infrastructure).
  - Second supplementary budget endorsed in early July: 0.4 percent of GDP (to continue reconstruction).
  - An additional supplementary budget focused on regional revitalization expected later this year.
- Directors’ fiscal recommendations:
  - Immediate priority: repair damaged infrastructure and facilitate a speedy recovery.
  - Support for a sizeable, well-targeted supplementary budget that relies primarily on new tax measures.
  - Need for a more ambitious medium-term strategy with significant adjustment of the structural primary balance to accelerate public debt reduction.
  - Suggested measures: expenditure freezes, comprehensive tax reform, further gradual increase in consumption tax, and adopting a fiscal rule with some flexibility.

### Monetary and financial policies
- Bank of Japan (BoJ) actions to support reconstruction and contain deflation risks:
  - Expanded asset purchase program to ¥10 trillion.
  - New ¥1 trillion loan program to support lending activity of financial institutions in affected regions.
  - Expanded lending facility to “strengthen the foundations of economic growth” by ¥½ trillion to encourage asset-based lending.
- Directors’ monetary recommendations:
  - Support for broadening the BoJ’s toolkit under comprehensive monetary easing to combat deflation.
  - Authorities welcomed to take additional easing measures as warranted.
  - If deflationary pressures emerge, consideration could be given to increasing purchases of longer-maturity public securities, and possibly private assets, under the BoJ’s asset purchase program—while considering implications for financial market stability and the BoJ’s balance sheet.
  - Some scope exists for further improving monetary policy communication to the public.
- Financial sector:
  - Financial sector policies helped maintain financial stability and ensured smooth functioning of financial transactions in affected regions.
  - Directors urged banks to maintain adequate capital and shift to more risk-based lending.
  - Encouraged gradual withdrawal of special measures facilitating loans to SMEs as conditions permit.

### Executive Directors’ assessment and spillovers
- Directors commended swift policy response to stabilize markets after the earthquake and tsunami.
- Observations:
  - Economic activity has recovered faster than expected.
  - Impact on global supply chains expected to be short-lived.
  - Unusually large uncertainty with risks from power supply disruptions and protracted weak demand and market sentiment.
- Exchange rate stance:
  - Directors agreed exchange rates should be market-determined, reflecting underlying fundamentals.
  - Noted the need to avoid excessive volatility and disorderly movements.
- Spillovers and global implications:
  - Policy spillovers from Japan on the global economy have been relatively limited in recent years, but Japan remains an important contributor to regional growth and stability.
  - Fiscal consolidation would free up domestic savings and help reduce risk of a rise in government bond yields that could lead to higher interest rates elsewhere.
  - Timely implementation of the new growth strategy (boosting employment, raising productivity through regional integration, promoting startups and restructuring of SMEs) would help contain negative short-term effects of fiscal consolidation.
  - Directors commended Japan’s strong commitment to international cooperation and development aid.
- Directors welcomed spillover analysis initiative and noted the need for further development.

### Key statistics (selected figures from staff projections and data)
- Real GDP (annual growth):
  - 2007: 2.4
  - 2008: -1.2
  - 2009: -6.3
  - 2010: 4.0
  - 2011 (Proj.): -0.7
- Private consumption (annual growth):
  - 2007: 1.6
  - 2008: -0.7
  - 2009: -1.9
  - 2010: 1.8
  - 2011 (Proj.): -1.2
- Exports of goods and services (annual growth):
  - 2007: 8.4
  - 2008: 1.6
  - 2009: -23.9
  - 2010: 23.9
  - 2011 (Proj.): 0.9
- Inflation (period average):
  - GDP deflator: 2009 -0.4; 2010 -2.1; 2011 (Proj.) -1.1
  - CPI (SA) 1/: 2009 -1.3; 2010 -0.7; 2011 (Proj.) 0.1
  - CPI (NSA) 1/: 2009 -1.4; 2010 -0.7; 2011 (Proj.) 0.1
- Unemployment rate (period average, percent):
  - 2007: 3.9
  - 2008: 4.0
  - 2009: 5.1
  - 2010: 5.1
  - 2011 (Proj.): 4.9
- Current account balance:
  - Billions of U.S. dollars: 2007 211.0; 2008 157.1; 2009 141.8; 2010 195.9; 2011 (Proj.) 144.7
  - Percent of GDP: 2007 4.8; 2008 3.2; 2009 2.8; 2010 3.6; 2011 (Proj.) 2.5
- General government balances (percent of GDP):
  - Overall balance: 2007 -2.4; 2008 -4.2; 2009 -10.3; 2010 -9.6; 2011 (Proj.) -10.5
  - Primary balance: 2007 -1.8; 2008 -3.3; 2009 -9.2; 2010 -8.5; 2011 (Proj.) -9.0
  - Structural balance 2/: 2007 -2.6; 2008 -3.7; 2009 -7.0; 2010 -7.7; 2011 (Proj.) -8.1
- Money and credit (12-month growth rate; end period, May 2011):
  - Base money: 2011 16.2
  - M2 (period average): 2011 2.7
  - Bank lending 3/: 2011 -0.5
- Exchange and interest rates (period average):
  - Yen/dollar rate: 2007 117.8; 2008 103.4; 2009 93.6; 2010 87.8; 2011 (Proj.) 80.6 (June 24, 2011)
  - Yen/euro rate: 2011 (Proj.) 114.5
  - Real effective exchange rate 4/: 2011 (Proj.) 86.7
  - 3-month CD rate: 2011 (Proj.) 0.3
  - 10-year government bond yield: 2011 (Proj.) 1.1

*Source: IMF staff report excerpt for the 2011 Article IV Consultation with Japan.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11181.pdf_