## _cr14236

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---

### Background and context and recent developments
- Japan adopted the “three arrows of Abenomics” about one and half years earlier: aggressive monetary easing, flexible fiscal policy, and structural reforms.
- Progress to date:
  - Arrow I — QQE executed as planned; BoJ balance sheet grew to 52 percent of GDP by end-May 2014; BoJ forecast of reaching 2 percent inflation in or around fiscal year 2015 maintained.
  - Arrow II — Consumption tax raised to 8 percent with planned increase to 10 percent in October 2015 (decision expected by end of the year); government reviewing options to reduce the CIT rate.
  - Arrow III — Gradual, limited reforms (electricity sector reform; farmland consolidation bill; GPIF governance and investment reforms; corporate Stewardship Code; SEZs; limited labor reforms).
- Q1 2014 macro outcomes:
  - GDP growth: 6.7 percent (q/q, saar).
  - Private consumption: 9.2 percent (q/q, saar) pre-tax hike, then declined in April.
  - Private nonresidential investment: 34.2 percent (q/q, saar) in Q1 2014.
  - Real exports of goods: -1.0 percent (q/q, sa) in Q1 2014.
  - Imports: 4.6 percent (q/q, sa) in Q1 2014; imports declined sharply in April (9.9 percent, m/m, sa).
  - Unemployment: 3.5 percent in May 2014.
  - 10-year JGB yields: near historic lows of 60–65 basis points.
  - BoJ balance sheet: 52 percent of GDP by end-May 2014.

### Outlook and key projections
- GDP projections:
  - 2014: 1.6 percent.
  - 2015: 1.1 percent.
  - Q2 2014: expected -3.7 percent (q/q, saar) payback after Q1 advance.
- Contributions to growth in 2014:
  - Business investment: >1 percent of GDP growth contribution.
  - Private consumption: 0.4 percent of GDP growth contribution.
- Inflation and wages:
  - Headline inflation: 2.8 percent (2014 average, assuming full pass-through of consumption tax).
  - Underlying inflation: 1.1 percent (2014).
  - Inflation projected to reach 2 percent by 2017.
  - Nominal labor income growth: 2.5 percent composed of 1 percent overtime/bonuses; 0.5 percent first rise in base wages; 0.5 percent employment growth; 0.4 percent reversal of a 10 percent public sector wage cut after the earthquake.
- Potential growth:
  - Current estimate: about ½ percent.
  - With investment recovery and some reforms: rise to 1 percent over the medium term.
  - Breakdown of projected 0.5 percent increase: capital stock rise 0.6 percent; productivity improvements 0.1 percent; declining labor contribution 0.2 percent.
- Output gap: about -1 percent in 2014.
- Long-term interest rates: expected to rise gradually; near-term flat due to QQE.

### Structural impediments to private-sector led growth (findings and channels)
- Staff projection: potential growth not to increase above the pre-earthquake level of 1 percent by 2017 given declines in the working-age population and structural headwinds.
- Main impediments:
  - Labor market and wage growth:
    - Rising share of non-regular and part-time workers; low horizontal mobility of regular workers.
  - Investment impediments:
    - Weak SME sector: nearly 70 percent of total employment and over half of manufacturing value-added.
    - Population aging dampening future demand.
  - Export displacement and competitiveness:
    - Sales of Japanese subsidiaries abroad now exceed exports from Japan; offshoring exceeds 20 percent of overall manufacturing output.
    - Greater import penetration in sectors such as electrical machinery.
  - Energy cost shock:
    - Higher energy costs since 2011 (high natural gas imports) weakening the trade balance and spurring offshoring risk.
- Quantitative indicators:
  - BoJ balance sheet: 52 percent of GDP by end-May 2014.
  - April inflation readings (y/y, excluding consumption tax effects): headline ~1.7 percent and core excluding food and energy ~0.7 percent; headline CPI rose to 3.4 percent (y/y) in April (consistent with full pass-through).
  - Capital stock age in manufacturing: >16 years on average.

### Risks and policy implications (near-term and medium-term)
- Near-term risks (balanced):
  - Upside: positive investment-inventory cycle; public investment could rise if absorption capacity and access to foreign labor improve.
  - Downside: sharper slowdown in China or ASEAN; geopolitical risks could raise energy prices.
- Medium-term risks (tilted to sustainability concerns):
  - Risk that higher growth and inflation cannot be sustained without sustained fiscal consolidation and high-impact structural reforms.
  - Sudden spike in bond yields is the main tail risk; failure to implement reforms could erode confidence and raise JGB risk premia.
- Policy guidance if downside outcomes materialize:
  - Continue fiscal reforms to restore confidence; limited scope for additional fiscal stimulus without a concrete medium-term fiscal strategy beyond 2015.
  - Monetary and structural policies should respond to restore growth, inflation, and confidence; BoJ may expand purchases of private assets and government bonds and lengthen maturities.

### Structural reform priorities and recommended measures
- Raise employment of women, older workers, and foreign labor:
  - Fully implement plans to increase availability of child care.
  - Gradually raise the retirement age.
  - Relax immigration restrictions in areas with labor shortages.
  - Address labor market duality; encourage modified contracts (limited regular).
- Enhance risk capital provision (Box 2):
  - Improve access to credit registries.
  - Encourage asset-based lending; remove SME entry/exit barriers.
  - Revise GPIF investment strategy to provide risk capital.
  - Consider extending the 5-year term limit and gradually raising the maximum contribution limit for individual savings accounts (NISA context).
  - Japanese household financial assets referenced: US$16 trillion.
- Corporate governance (Box 3):
  - Complement Stewardship Code with a corporate governance code for firms.
  - Expand use of independent outside directors.
- Deregulate agriculture and domestic services; use SEZs as laboratories for reform.
- TPP potential: staff estimate growth could gain about 0.2 percent per year if TPP eliminates most tariffs and barriers.

### Fiscal outlook, sustainability, and recommended adjustments
- Recent fiscal metrics and projections:
  - Structural primary deficit: -7.0 percent of GDP in 2013.
  - Structural primary deficit estimated to shrink by an annual average of 1 percent of GDP during 2014–16.
  - Commitments to current public expenditure containment: 2¼ percent of GDP.
  - Staff estimate of additional fiscal adjustment needed after 2015: 6¼ percent of GDP.
  - Staff estimate: fiscal consolidation in 2015 would slow growth by ½ percent, leaving growth in 2015/16 still above potential under the baseline.
- Fiscal policy recommendations:
  - Confirm second consumption tax increase to 10 percent in 2015 with a uniform rate.
  - Urgently adopt a post-2015 medium-term fiscal consolidation plan including revenue measures and entitlement reforms.
  - Options: gradually increase consumption tax to at least 15 percent, broaden personal income tax base, contain pension and health care spending, review spousal deduction and dependent spouse social security exemption.
  - Reduce untargeted wage deductions scheme that incentivizes payroll expansion to reduce CIT liabilities.
  - Strengthen fiscal framework with medium-term rules and limits on supplementary budgets.
- Corporate income tax (CIT) considerations:
  - Japanese statutory CIT rate: 34.6 percent.
  - Corporate income tax revenue to GDP ratio: 3.4 percent.
  - Government decided to move ahead with a CIT rate cut to below 30 percent; revenue losses from a CIT cut estimated: -0.5 to -1.0 percent of GDP.
  - Staff: a CIT cut raises investment and growth but is unlikely to be self-financing; ACE considered as alternative.

### Monetary policy, QQE, and staff views
- QQE effects and indicators:
  - Banks reduced JGB holdings from 22 percent in end-2012 to below 19 percent of total assets by end March 2014.
  - Market and survey measures of long-term inflation expectations risen to between 1¼–1½ percent.
  - Each year QQE is maintained the BoJ will add approximately 5 percent of the outstanding stock of JGBs to its existing holdings (estimated at 23 percent at end 2014).
- Staff recommendations:
  - Monetary policy is appropriately accommodative; no further easing needed at this point.
  - Preserve policy space for downside risks; clarify asset-purchase plans post end-2014 to enhance transparency.
  - BoJ should act quickly if inflation stagnates or growth disappoints (expand purchases, lengthen maturities, expand special lending facilities).
  - Indemnification against capital losses (example: as large as 1¼ percent of GDP for a 100 bps rise) could be considered but creates fiscal contingent liabilities.

### Financial sector developments, portfolio rebalancing, and spillovers
- Portfolio rebalancing drivers and figures:
  - Households hold more than 55 percent of assets (about 875 trillion yen or 180 percent of GDP) in bank deposits.
  - GPIF assets under management: 27 percent of GDP.
  - Negative real returns on household deposits given headline inflation estimated at 2¾ percent this year.
- Illustrative capital outflow scenarios:
  - Additional outflows could range between USD 80–260 billion under different behavioral assumptions for institutional investors.
  - Only about 20 percent would likely go to emerging economies in the scenario.
- External and current account:
  - Current account surplus: 0.7 percent of GDP in 2013 (projected to rise to around 2 percent of GDP over medium to long term as temporary effects fade).
  - Yen depreciated by about 23¾ percent between October 2012–April 2014.
  - Goods trade deficit: 1.8 percent of GDP in 2013.
  - Staff assessment: yen broadly consistent with medium-term fundamentals; current account norm estimated at around 2 percent of GDP (about 1½ percentage point lower than assessed last year).
- Spillovers:
  - Spillovers have been "mild" during first year of Abenomics.
  - Portfolio rebalancing and capital outflows expected to increase near- to medium-term; scenario up to US$260 billion illustrative outflows.

### Debt Sustainability Analysis — key baseline outcomes and stress tests
- Key baseline assumptions:
  - Real growth projected to slow to 1 percent during 2015–19 and remain at that level beyond.
  - Monetary policy accommodative until 2 percent inflation reached around 2017/18.
  - Long-term interest rates on new bond issuances projected to pick up to 3.5 percent.
  - Average maturity around 6.5 years, nominal effective interest rate on public debt rising to 1.7 percent in 2019.
- DSA baseline key figures (selected):
  - Gross nominal public debt (percent of GDP): 2013: 238.8; 2014: 243.4; 2015: 243.2; 2016: 242.7; 2017: 241.2; 2018: 240.1; 2019: 239.0 / 238.2.
  - Public gross financing needs: 2014: 54.8; 2015: 55.9; 2019: 52.3 / 52.35.
  - Net public debt: 2014: 134.2; 2019: 139.0 / 138.9.
  - Real GDP growth (percent): 2014: 1.5; 2015: 1.6; 2016: 1.1; 2017: 0.9; 2018: 1.0; 2019: 1.0 / 1.1.
  - Effective interest rate (percent): 2014: 0.8; 2015: 0.8; 2016: 0.8; 2017: 1.0; 2018: 1.2; 2019: 1.4 / 1.7.
- Assessment:
  - Conclusion: Japan’s public debt is unsustainable under current policy settings.
  - Projection: gross debt stabilizes around 240 percent of GDP during WEO period but increases again reaching around 280 percent of GDP by 2030 under complementary analysis.
  - Gross financing needs: 55 percent of GDP in 2014 (highest among advanced economies).
- Stress tests:
  - Growth shock: debt ratio rises to around 255 percent of GDP in 2019 (~10 percentage points above baseline).
  - Interest rate shock (200 bps spike): debt ratio higher by around 7 percentage points in 2019.
  - Combined interest and contingent liability shock: debt ratio increases to around 260 percent of GDP in 2019.

### Authorities’ and staff views; recommended sequencing and priorities
- Authorities:
  - Emphasize economy well positioned to weather consumption tax increase; view the tax increase a success.
  - Plan to cut CIT below 30 percent with details to be determined.
  - Share staff’s risk assessment broadly but express skepticism on some staff external assessment points.
- Staff appraisal and recommendations (summary):
  - Structural reforms are central to sustaining recovery: lift labor supply, reduce labor market duality, enhance risk capital, deregulate agriculture and services, continue corporate governance reforms.
  - A concrete medium-term fiscal reform plan beyond 2015 is "urgently needed"; successive consumption tax increases critical.
  - Monetary policy: currently appropriately accommodative; BoJ should act swiftly if downside risks materialize and clarify post-2014 asset purchase plans.
  - Financial sector: supervisors should proactively monitor rebalancing and overseas-engagement risks; encourage regional bank consolidation and strengthen capital standards.

_Italic: Content summarized from the IMF document _cr14236 (chapter excerpt provided)._

### 1. Structural Impediments to Private-Sector Led Growth __________________________________________ 8

### 1. Structural Impediments to Private-Sector Led Growth

### Background and context
- Japan adopted the “three arrows of Abenomics” about one and half years earlier: aggressive monetary easing, flexible fiscal policy, and structural reforms to end deflation, raise growth, and lower public debt.
- Progress to date:
  - Arrow I — Quantitative and Qualitative Monetary Easing (QQE) executed as planned; BoJ balance sheet grew to 52 percent of GDP by end-May 2014; BoJ forecast of reaching 2 percent inflation in or around fiscal year 2015 maintained.
  - Arrow II — Fiscal policy shifted from stimulus to revenue; consumption tax rate raised to 8 percent with a planned increase to 10 percent in October 2015 (decision expected by end of the year); government reviewing options to reduce the corporate income tax (CIT) rate.
  - Arrow III — Gradual, limited structural reforms: electricity sector reform; bill to encourage farmland consolidation; GPIF governance and investment reforms; corporate Stewardship Code adopted; designation of Special Economic Zones (SEZs); limited progress on labor market reforms except increased childcare facilities. Government unveiled an updated growth strategy on June 24 including plans to lower the CIT rate and additional corporate governance reforms.
- Political environment: ruling coalition has large majorities; Prime Minister Abe’s approval around 50 percent; about two years until next national elections.
- Staff view: comprehensive and sustained reforms are required to secure the inflation target and overcome structural headwinds from a shrinking labor force and large fiscal adjustment needs.

### Abenomics: recent developments
- Q1 2014 GDP growth accelerated to 6.7 percent (q/q, saar); main drivers were rush demand ahead of the consumption tax increase and a sharp rise in private nonresidential investment; net exports were a drag.
- Private consumption:
  - Rose to 9.2 percent (q/q, saar) ahead of the April 1 consumption tax increase; declined in April subsequently.
- Business investment:
  - Private nonresidential investment grew by 34.2 percent (q/q, saar) in Q1 2014; staff estimate ¼ to ⅓ of the increase could be related to temporary factors, remainder to fundamentals (high corporate profitability; aging capital stock—more than 16 years on average in manufacturing; rapidly rising capacity utilization).
- Exports and imports:
  - Real exports of goods declined by 1.0 percent (q/q, sa) in Q1 2014 due to weak external demand and limited passthrough of depreciation to export prices.
  - Imports grew by 4.6 percent (q/q, sa) in Q1 2014, pushed up by pre-tax-hike demand; imports declined sharply in April (9.9 percent, m/m, sa).
- Labor market and capacity:
  - Unemployment declined to 3.5 percent in May 2014; excess capacity shrunk to pre-2008 levels; labor shortages acute in construction, health, hospitality.
- Financial markets:
  - 10-year JGB yields near historic lows of 60–65 basis points; equity markets up 57 percent in 2013 and moderated about 7¼ percent in 2014; BoJ QQE has led to negative real lending rates and a pickup in bank lending including to SMEs.

### Outlook and key projections
- GDP projections:
  - GDP is projected to grow 1.6 percent in 2014 and 1.1 percent in 2015.
  - Quarterly profile: Q2 2014 expected -3.7 percent (q/q, saar) payback after Q1 advance.
- Contributions to growth:
  - Business investment forecast to contribute more than 1 percent to GDP growth in 2014.
  - Private consumption expected to contribute 0.4 percent to GDP growth in 2014.
- Inflation and wages:
  - Headline inflation projected to average 2.8 percent in 2014 assuming full pass-through of the consumption tax increase.
  - Underlying inflation forecast at 1.1 percent in 2014.
  - Inflation projected to reach 2 percent by 2017.
  - Nominal labor income growth of 2.5 percent comprises: 1 percent from overtime pay and bonuses; 0.5 percent first rise in base wages for regular workers; 0.5 percent employment growth; reversal of a 10 percent public sector wage cut after the earthquake adds 0.4 percent.
- Potential growth:
  - Potential growth currently estimated at about ½ percent; with investment recovery and some structural reforms potential growth estimated to increase to 1 percent over the medium term.
  - Potential growth projection details: projected increase of 0.5 percent comprises capital stock rise 0.6 percent, productivity improvements 0.1 percent, and declining labor contribution 0.2 percent.
- Output gap and interest rates:
  - Output gap estimated about -1 percent in 2014.
  - Long-term interest rates expected to rise gradually over the medium term; near-term flat due to QQE.

### Box 1 — Structural impediments to private-sector led growth: findings and channels
- Staff projection: potential growth not to increase above the pre-earthquake level of 1 percent by 2017 given declines in the working-age population and structural headwinds.
- Main structural impediments:
  - Labor market and wage growth:
    - Rising share of non-regular and part-time workers, particularly in services, leading to less bargaining power, lower productivity, and lower wages.
    - Low horizontal mobility of regular workers across firms, despite high within-firm mobility, dampens wage responses to tight labor markets.
  - Investment impediments:
    - Weak SME sector: nearly 70 percent of total employment and over half of manufacturing value-added; may not have benefited from Abenomics due to rising import costs.
    - Population aging dampens prospects for future demand—a key determinant of domestic investment.
  - Export displacement and competitiveness:
    - Sales of Japanese subsidiaries abroad now exceed exports from Japan; trend likely to persist under Abenomics, implying slower export growth.
    - Greater import penetration in previously strong sectors (e.g., electrical machinery) raises concerns about structural loss of competitiveness.
  - Energy cost shock:
    - Higher energy costs since 2011 (high natural gas imports) have weakened the trade balance and could spur further offshoring of production.
- Quantitative and illustrative indicators:
  - BoJ balance sheet: 52 percent of GDP by end-May 2014.
  - Inflation readings: headline and core excluding food and energy around 1.7 and 0.7 percent in April (y/y) excluding consumption tax effects; headline CPI rose to 3.4 percent (y/y) in April (consistent with full pass-through).
  - Labor market dynamics: unemployment 3.5 percent in May 2014.
  - Investment age: capital stock >16 years on average in manufacturing.

### Risks, policy implications, and recommended policy responses
- Near-term risks (balanced):
  - Upside: positive investment-inventory cycle could lift growth above baseline; public investment could rise if absorption capacity and access to foreign labor improve.
  - Downside: sharper-than-expected slowdown in China or ASEAN could produce negative inward spillovers given Japan’s supply-chain linkages; geopolitical risks (e.g., Ukraine) could raise energy prices.
- Medium-term risks (tilted to sustainability concerns):
  - Risk that higher growth and inflation cannot be sustained without sustained fiscal consolidation and high-impact structural reforms.
  - Failure to implement reforms or larger-than-expected fiscal consolidation impacts could erode confidence, weaken potential growth, overburden monetary policy, raise JGB risk premia, and create financial stability risks given large JGB holdings by the financial sector.
  - A sudden spike in bond yields is the main tail risk.
- Policy guidance in event of downside outcomes:
  - Continue fiscal reforms to restore confidence; scope for additional fiscal stimulus limited without a concrete medium-term fiscal strategy beyond 2015.
  - If a widespread loss of faith in public finances occurs, further fiscal consolidation would be needed to forestall rising risk premia and interest rates.
  - Monetary and structural policies should respond to restore growth, inflation, and confidence in Abenomics if downside risks materialize.

*1. Structural Impediments to Private-Sector Led Growth*

### 11.      The authorities emphasized that the economy appears well positioned to weather the

### _cr14236 - 11.      The authorities emphasized that the economy appears well positioned to weather the

### Authorities’ assessment of near-term outlook
- Authorities view economy as well positioned to weather the consumption tax increase.
- Fiscal stimulus spending would be frontloaded, limiting the growth slowdown beginning in the second quarter.
- Rise in base wages and bonuses would support sentiment and domestic demand over the coming period.
- Authorities broadly shared staff’s risk assessment but noted many businesses were already anticipating slower growth in China and had begun to adjust investment and expansion plans accordingly.

### Bank of Japan (BoJ) view on inflation and output gap
- BoJ expected a faster rise of inflation in the near term than staff.
- Both BoJ and staff anticipated inflation would stay around 1¼ percent for some time due to waning effects of last year’s yen depreciation.
- BoJ expected inflation to rise again in the second half of this fiscal year as narrowing of the output gap would exert upward price pressure and inflation expectations would be pushed up further with the increase in actual inflation.
- BoJ saw rapid labor market tightening and rising capacity utilization amid sluggish potential growth as signs the output gap was already broadly closed.
- BoJ highlighted the possibility that price stability may come in sight before potential growth picks up, emphasizing the importance of accelerating structural reforms.

### Growth reforms: centrality to Abenomics’ success
- Structural reforms are key for faster growth: raise labor supply and employment to offset aging-related labor force decline; increase flexibility to encourage investment and productivity; lift confidence and improve monetary policy transmission.
- Government adopted a revised growth strategy in June but left many details undefined.
  - Flagship reforms include plan to reduce corporate income tax (CIT) rate from over 35 percent to below 30 percent; exact size, timeframe, and financing to be determined.
  - Other measures lacking specific timeframes: corporate governance reforms, labor market reforms (remove tax disincentives for women to work, greater use of foreign labor in health and household services, incentivize shift from overtime- to performance-based remuneration).
  - Few concrete measures announced on agricultural reform or role of SEZs.
- Staff estimates ongoing reforms could help lift potential growth to around 1 percent; to raise trend growth above 1 percent, more ambitious reforms are needed.
- Authorities estimated real growth to range between 1¼ and 2¼ percent in the medium- to long-term depending on the scenario.

### Policy issues and staff’s recommended additional reforms
- Raise employment of women, older workers, and foreign labor:
  - Fully implement plans to increase availability of child care.
  - Gradually raise the retirement age.
  - Relax immigration restrictions in areas with labor shortages.
  - Address labor market duality between regular and non-regular workers; encourage modified labor contracts to bridge gap.
- Enhance risk capital provision (see Box 2):
  - Improve lenders’ access to credit registries.
  - Encourage more asset-based lending and remove barriers to entry and exit of SMEs.
  - Revise GPIF‘s investment strategy to provide further risk capital.
  - Consider extending the 5-year term limit and gradually raising the maximum contribution limit for individual savings accounts.
- Implement comprehensive corporate governance reform (see Box 3):
  - Complement Stewardship Code for institutional investors with corporate governance code for firms.
  - Expand use of independent outside directors.
- Deregulate agriculture and domestic services sectors to raise productivity and encourage inward foreign investment.
  - Early guidance on modus operandi in designated special zones could reduce uncertainty and boost investment.
- Trans-Pacific Partnership (TPP) benefits:
  - Staff estimate growth could gain about 0.2 percent per year if TPP eliminates most tariffs and non-tariff and investment barriers in Japan.

### Facilitating (risk) capital (Box 2) — measures and rationale
- Context:
  - NISA launch encourages households—with more than US$16 trillion in financial assets—to put more savings into stocks and investment trusts.
  - Extension of BoJ facilities stimulates bank lending; JPX Nikkei 400 encourages ROE focus.
- Policy measures to enhance intermediation and take-up:
  - Securitization: boost activity backed by small business loans via information sharing across credit registries and easing BoJ facility terms (lower funding costs, longer maturity loans).
  - Venture capital: shift in targets toward riskier assets could spur funding for new businesses; note historical example of US 1979 ERISA reform.
  - Restructuring and exit of nonviable SMEs: current SME entry/exit rates ~ one third of those in advanced countries; encourage out-of-court workouts, consolidate regional banks, reduce time and cost to start businesses, and upgrade credit registries and personal credit information.

### Unstash Japan’s corporate cash (Box 3) — findings and reform options
- Japanese firms hold large cash buffers compared with other G-7 countries.
- Corporate governance is a significant determinant of cash holdings; Japan scores lower on board composition, audit quality, shareholder rights, ownership structure, and compensation.
- Staff analysis suggests improving corporate governance (proxied by firm disclosure of governance data) could significantly reduce corporate cash holdings.
- Reform options:
  - Complement Stewardship Code with a corporate governance code for firms.
  - Expand use of independent outside directors beyond current plans.

### Fiscal outlook and sustainability
- Structural primary deficit estimated to shrink by an annual average of 1 percent of GDP during 2014–16 after weakening modestly in 2013 to -7.0 percent of GDP due to new stimulus spending.
- Staff baseline adjustment assumes consumption tax rate will be raised to 10 percent, previous stimulus winds down, and commitments to current public expenditure containment are met (in sum 2¼ percent of GDP).
- Even with these measures, authorities may not achieve G20 goal of halving the primary deficit by FY 2015 to 3.3 percent of GDP (target would slip out of reach with a CIT rate cut or introduction of multiple consumption tax rates).
- No fiscal consolidation plans beyond 2015 announced to reach G20 commitment of primary balance by FY 2020.
- Staff Debt Sustainability Analysis (DSA) assuming both consumption tax increases shows gross debt-to-GDP ratio continues rising beyond medium-term; without further policy measures, fiscal position is unsustainable.
- Staff estimates that after 2015 a further fiscal adjustment of 6¼ percent of GDP is needed under the baseline to put the debt-to-GDP ratio firmly on a downward trajectory.
- Staff recommends a gradual adjustment pace to balance reversing debt dynamics and safeguarding recovery.

### Fiscal policy recommendations and specifics
- Confirm the second consumption tax increase in 2015 to 10 percent with a uniform rate.
  - Staff estimates fiscal consolidation in 2015 would slow growth by ½ percent, leaving growth in 2015/16 still above potential under the baseline.
  - Equity concerns for low-income households are best addressed through existing subsidies (improved once new tax identification numbers introduced) rather than reducing rates on essential items.
- A post-2015 fiscal consolidation plan is urgently needed; should include further revenue measures and entitlement reforms and be growth friendly and equitable.
  - Options include gradually increasing consumption tax to at least 15 percent, broadening personal income tax base, and measures to contain pension and health care spending.
  - Review spousal deduction and threshold for dependent spouses’ social security exemption to remove disincentives to female labor force participation.
  - Restructure untargeted wage deductions scheme that incentivizes firms to expand payroll to reduce CIT liabilities.
- Fiscal framework reforms:
  - Strengthen fiscal framework grounded in medium-term rules to curb expenditures and limits on use of supplementary budgets.
- Corporate income tax (CIT) considerations:
  - Government decided to move ahead with a CIT rate cut to below 30 percent; details and exact timeframe to be determined.
  - Reducing CIT would require offsetting fiscal measures to prevent further rise in fiscal risks.
  - Revenue losses from a CIT cut could range between ½ to 1 percent of GDP depending on size of rate reduction.
  - Staff analysis shows a CIT cut raises investment and growth but not sufficiently to be self-financing.
  - Scope for CIT base broadening exists but eliminating distortionary allowances (e.g., for SMEs or R&D expenses) could weaken investment effects and should be avoided.
  - Alternative considered: Allowance for Corporate Equity (ACE) system as a more cost-effective way to encourage investment.

### Quantitative fiscal items and illustrative figures (as reported)
- Structural primary deficit: -7.0 percent of GDP in 2013.
- Estimated annual average structural primary deficit shrink: 1 percent of GDP during 2014–16.
- Commitments to current public expenditure containment: 2¼ percent of GDP.
- Staff estimate of additional fiscal adjustment needed after 2015: 6¼ percent of GDP.
- Staff estimate of fiscal consolidation impact in 2015 on growth: ½ percent.
- Authorities’ medium- to long-term real growth scenarios: between 1¼ and 2¼ percent.
- Potential long-run growth uplift from TPP: about 0.2 percent per year.
- US$16 trillion: Japanese household financial assets referenced in Box 2.
- Revenue loss from CIT cut: -0.5 to -1.0 percent of GDP (estimated range).

*Italic: Content summarized from the IMF document _cr14236 (chapter excerpt provided).*

### 0.5 to 1.0

### _cr14236 - 0.5 to 1.0

### Options for Fiscal Policy Adjustment Until 2020 (Excluding reconstruction spending, in percentage points of GDP)
- Tax measures (staff estimates; '-' and '+' refers to unidentified costs or savings)
  - Eliminate preferential tax treatment for pension benefit income 2/: ¼
  - Collect pension contributions from dependent spouses of workers covered by the employees' insurance 2/: ¼
  - Collect health insurance premiums from dependent spouses of workers covered by the employees' insurance: +
  - Reduce pension payroll tax: -0.5
  - Introduce carbon tax 3/: +
  - Raise inheritance tax further: ++
- Expenditure measures
  - Withdraw the financial crisis fiscal stimulus: 00
  - Withdraw the recent stimulus: ¾
  - Curb growth rate of nominal non-social security spending (excluding interest payments) 4/: ¾
  - Limit annual nominal growth in social security spending (excluding the items below) 5/: -¼
  - Raise pension eligibility age to 67 or higher 2/: ¼
  - Reduce benefits for wealthy retirees 2/: ¼
- Aggregate adjustment magnitudes shown: 1¼ 3¾ and 1.5 and 1¾ in various entries as presented in the source table
- Notes from table
  - 1/ Introducing multiple rates would reduce additional revenue.
  - 2/ Lower bound estimate of Kashiwase, Nozaki, and Tokuoka, 2012 (IMF Working Paper 12/285).
  - 3/ Fiscal savings are assumed to be 0.1 percentage points of GDP or lower and spent on energy saving initiatives.
  - 4/ Freezing expenditure in nominal terms.
  - 5/ Annual nominal growth at ½-1 percent. The authorities plan to use part of additional revenue from the second-stage consumption tax hike to increase social security spending.

### Reforming the Corporate Income Tax (Box 4)
- Context and current metrics
  - Japanese statutory CIT rate: 34.6 percent
  - Corporate income tax revenue to GDP ratio: 3.4 percent
  - Japan’s statutory rate and revenue-to-GDP ratio are among the highest in the OECD; statutory rate is some 5 percentage points higher than in other G7 economies.
- Problems identified
  - The CIT system is relatively distortionary and complex despite recent reforms.
  - Large differences in treatment between debt and equity financing and between incorporated and unincorporated firms create distortions and arbitrage.
  - A large number of special tax incentives reduce transparency and effectiveness.
  - Varying rates by region, firm size, and income level create further distortions.
- Impact of a CIT rate cut
  - International evidence: a 5 percentage point CIT rate cut may increase investment by some 2 or 3 percent.
  - Japan-specific estimates point to potentially smaller effects.
  - FDI is expected to rise, but given inbound FDI is relatively small in Japan, effects via FDI may not be large.
  - A CIT rate cut is unlikely to be self-financing; dynamic long-run effects may be mitigated by perhaps 10–30 percent and will not fully offset revenue losses.
  - Short-run fiscal costs can be reduced by gradually phasing in the tax reduction.
  - In the long run, other taxes need to be raised (example: the consumption tax) or the local CIT could be replaced by local property taxes.
- Base broadening and incentives
  - Tax incentives estimated overall revenue loss of 0.2 percent of GDP at the central government level.
  - Some incentives may be justified (for example, stimulating R&D).
  - The number of tax incentives is very large; many, particularly those applicable to SMEs (including special reduced rates), may be ineffective and distortionary.
- Allowance for Corporate Equity (ACE)
  - Introducing an ACE could stimulate investment with minimal short-run fiscal costs.
  - ACE would reduce the cost of equity financing and eliminate debt bias.
  - Applying ACE only to new equity (as in Italy) would incur revenue losses only gradually, maximizing investment stimulus per yen of tax relief.

### Authorities’ Views on Fiscal Policy
- Consumption tax
  - Authorities considered the increase of the consumption tax a success and agreed that the second rate increase would be an important contribution to restoring fiscal sustainability.
  - Early indications: growth implications of the tax increase were moderate and the decline in consumption had started to level off in May.
  - A decision on the second consumption tax increase expected by the end of this year, taking into account economic conditions in the third quarter.
  - Introduction of multiple rates on basic items under discussion to address equity concerns; careful consideration required given potential administrative and revenue costs.
- Fiscal consolidation beyond 2015
  - Authorities agreed fiscal measures needed beyond 2015 to stabilize and bring down the debt-to-GDP ratio.
  - Fiscal System Council published long-term fiscal projections showing a sizeable required adjustment; public pension expenditure will stabilize but health and long-term care expenditures expected to rise substantially.
  - A concrete medium-term fiscal plan to be formulated in 2015.
- Corporate tax rate reform
  - Costs and benefits of a CIT rate reduction intensively debated within government.
  - Broad agreement that a tax rate reduction was not self-financing.
  - Base-broadening measures under discussion to secure offsetting financial resources; compensating measures seen as necessary to meet the government’s long-term goal of achieving primary balance by FY 2020.

### Monetary Policy: QQE Implementation and Staff Views
- QQE implementation and transmission
  - After initial bond market volatility, 10-year JGB yields have fluctuated around 60 bps since last summer.
  - Rising inflation contributed to a further decline in real lending rates.
  - Banks reduced JGB holdings from 22 percent in end-2012 to below 19 percent of total assets by end March 2014.
  - Market and survey measures of long-term inflation expectations have risen to between 1¼–1½ percent.
- Staff views and recommendations
  - Monetary policy is appropriately accommodative and no further easing is needed at this point.
  - Staff baseline anticipates actual and expected inflation reaching the 2-percent target by 2016–17.
  - Policy space should be preserved to address downside risks.
  - Clarifying asset-purchase plans post end-2014 could enhance transparency.
  - BoJ should act quickly if actual or expected inflation stagnates or growth disappoints; policy options include expanding purchases of private assets and government bonds and lengthening maturities of purchased assets.
  - Room exists to expand special lending facilities (increase size, reduce funding cost, lengthen term beyond current 4 years), though impact may be small given easy financing conditions.
  - Sustained easing without complementary reforms raises risks to financial stability and exit complexity:
    - Each year QQE is maintained the BoJ will add approximately 5 percent of the outstanding stock of JGBs to its existing holdings, estimated at 23 percent at end 2014.
    - Indemnification against capital losses from rising interest rates could be considered (as large as 1¼ percent of GDP for a 100 bps rise), but this creates potential fiscal contingent liabilities.
  - BoJ communication has been effective; it could clarify indicators used to assess whether inflation is on track and spell out criteria for determining whether inflation has been sustainably achieved to guide expectations and exit planning.

### Portfolio Rebalancing and Capital Outflows (Box 5)
- Signs of portfolio rebalancing
  - Moderate shift underway: share of currency, deposits, and central and local government securities has declined for households, public pensions, and other financial intermediaries.
- Factors likely to accelerate rebalancing
  - Rising domestic credit demand: business lending has risen at the fastest pace since 2008; loan officer survey shows continued rise in credit demand in 2014.
  - Ample intermediation capacity: banks’ capital ratios higher than at any time during last decade; loan-loss reserves at pre-global financial crisis levels.
  - Review of investment strategies: Government Pension Investment Fund (GPIF) (27 percent of GDP in assets under management) adjusted targets from JGBs towards other assets including foreign bonds and equities in June 2013.
  - Negative real returns on household deposits: households hold more than 55 percent of their assets, or about 875 trillion yen (180 percent of GDP) in bank deposits; headline inflation estimated at 2¾ percent this year implies negative real returns.
  - Widening interest rate differential with the US raising incentives to expand share of foreign assets.
- Potential capital outflows (illustrative scenario analysis)
  - Additional outflows could range between USD 80–260 billion under different behavioral assumptions for institutional investors.
  - Only about 20 percent would likely go to emerging economies in the scenario; effects could ease financing conditions in recipient markets.
  - Exercise is partial and does not incorporate exchange rate effects or flows associated with household or firm rebalancing (FDI).

### External Position and Current Account Assessment
- Recent outcomes
  - Current account surplus declined to 0.7 percent of GDP in 2013.
  - Yen depreciated by about 23¾ percent between October 2012–April 2014 (reversing a 27¾ percent real appreciation during July 2007–September 2012).
  - Goods trade deficit deteriorated by another 1 percentage point of GDP to 1.8 percent in 2013 due to higher imports of energy products and consumer goods and flat exports.
  - Rising income balance surplus from higher interest income on overseas investment moderated the impact.
- Staff assessment of the yen
  - The yen is assessed as broadly consistent with medium-term fundamentals and desirable policies.
  - Structural factors reducing trade balance responsiveness to the yen:
    - Rising share of offshore production—exceeding 20 percent of overall manufacturing output—reduces export sensitivity to the yen.
    - Japan’s upstream position in global supply chains.
    - Lower domestic nuclear power supply implying a portion of elevated energy imports will persist.
    - Soaring imports of consumer electronics and IT devices structurally increased import share in domestic final demand.
  - Staff estimate these effects lead to a permanent trade deficit more than offset by a surplus on the income account; the current account norm is estimated at around 2 percent of GDP—about 1½ percentage point of GDP lower than assessed last year.
  - Temporary factors (e.g., rush demand ahead of the consumption tax increase) have weakened the trade balance; expectation that external balance will strengthen—to a surplus of around 2 percent of GDP over the medium to long term—as these effects fade and exports pick up in line with past lags.

*Source: _cr14236 - 0.5 to 1.0 (IMF staff report content excerpt).*

### 38.      For the time being, there is large uncertainty about Japan’s external assessment. In

### _cr14236 - 38.      For the time being, there is large uncertainty about Japan’s external assessment. In

### External assessment and uncertainty
- The assessment of Japan’s external position is subject to "large uncertainty".
- The assessment assumes full implementation of all three arrows of Abenomics.
- The effects of the new policies on the external balance are uncertain because policies aim to:
  - accelerate growth,
  - lift inflation,
  - lower public debt.
- The assessment will be revisited as policy outcomes become clearer.
- Japan’s external position is assessed as "broadly in balance" compared to "moderately undervalued" last year.
- Factors limiting the trade response to the yen depreciation:
  - offshoring of production,
  - losses in competitiveness in specific sectors,
  - sustained high energy import needs.

### Spillovers
- Spillovers have been "mild" during the first year of Abenomics:
  - Exports changed little despite a weaker yen.
  - Capital flows via overseas bank lending and FDI remained broadly in line with past trends.
  - Net capital outflows by Japanese investors picked up in the second half of 2013—mainly to advanced countries—but were more than offset by non-resident inflows into Japan (particularly into equities).
  - Net inflows turned positive again after outflows in January/February (year not restated).
- Near-term spillovers are likely to rise as exports and imports adjust to the weaker yen and as Japanese investors diversify abroad.
- Scenario analysis: portfolio rebalancing by banks and institutional investors could lead to additional capital outflows of up to US$260 billion—almost doubling the size of foreign portfolio investment and bank lending relative to past trends—over the near to medium term (Box 5).
- Some of these outflows would go to EMs, moderating tightening financial conditions there.
- Global downside risks scenario (2014 Spillover Report) assumption:
  - a sooner than expected tightening of financial conditions (by 100 basis points largely through higher term premia) in advanced economies, combined with a deeper than expected structural slowdown in EMs of ½ percentage point annual growth over the next three years.
- Under that downside scenario, growth would slow substantially in Japan with negative feedback via trade and supply-chain channels, affecting regional trading partners and suppliers to Japanese exporters.

### Authorities’ views on external assessment and spillovers
- Authorities expressed skepticism about staff’s external position assessment:
  - considerable uncertainty whether the current account would rise to around 2 percent of GDP as expected by staff.
  - cited factors: persistently high oil prices, continued relocation of production abroad, declining competitiveness in some manufacturing sectors.
- Authorities agreed that spillovers of successful Abenomics would likely be positive:
  - noted spillovers had been benign so far,
  - potential capital outflows could help ease financing conditions of EMs in the region.
  - trade-channel spillovers would be more limited than in past episodes of large depreciations due to structural factors including offshoring.
  - skeptical about staff’s estimates that growth spillovers from EMs were larger for Japan than for other advanced economies.

### Financial sector: rebalancing risks and conditions
- Financial sector health has improved, but further gains may be more challenging.
- Banks:
  - Benefitted from higher equity valuations and growing loan books.
  - Lower credit costs and declining loan loss provisioning strengthened capital positions.
  - Internationally-active banks remain on track to meet Basel III capital requirements.
  - QQE reduced interest rate risk for major banks which sold part of their JGB holdings to the BoJ; regional banks have been slower to shed JGB holdings.
- Insurance companies:
  - Maintained solvency margin ratios "well above 200 percent" (the regulatory threshold to take corrective actions).
  - Investments in overseas assets and domestic stocks remained broadly the same over the last year.
- Risks from search for higher yield by investors:
  - Declining net interest margins on domestic loans and rising excess reserves pressure banks’ core profitability.
  - Interest rate risk for regional banks remains high; profitability pressures most evident there (2012 FSAP Update).
  - As banks rebalance, new risks may arise, especially from greater overseas engagement.

### Policy issues and staff recommendations for the financial sector
- Major banks expanding abroad:
  - Encourage securing stable and long-term dollar funding by:
    - reducing reliance on foreign exchange swaps,
    - issuing longer term dollar-denominated bonds,
    - building a depositor base in overseas operations.
  - Cross-border collateral arrangements (in place with Singapore and Thailand; agreed to be established with Indonesia) could reduce local currency funding risks.
- Regional banks:
  - Authorities should continue to strengthen capital standards for domestically-active banks, including reassessing the treatment of unrealized losses in capital.
  - Consider developing a strategy to establish a stronger regional banking sector, including private sector-led consolidation (recommendation from 2012 FSAP Update).
- Japan Post bank:
  - With plans to sell part of the government’s share through Japan Post Holdings, due care should be given to implications of any potential expansion into new lending given limited expertise and implications for other financial institutions.
- AML/CFT:
  - Remaining AML/CFT deficiencies should be addressed swiftly in line with the Public Statement on Japan published by the Financial Action Task Force in June 2014.

### Authorities’ views on financial-sector issues
- Authorities highlighted improved financial system soundness:
  - rising capital adequacy ratios,
  - low Nonperforming Loan (NPL) ratios.
- Authorities attentive to profitability and risk-management practices of major and regional banks, including interest rate risk from JGB holdings and foreign exchange funding risk from overseas expansion.
- Banking supervisor agreed core business profits were decreasing and called for continuous efforts to increase earnings domestically and abroad with appropriate risk management.
- On regional banks:
  - Authorities recognize need for mid- and long-term business strategies in response to structural challenges (e.g., demographic trends).
  - Business consolidation should be voluntary, with the FSA encouraging top management to lead recognition of business challenges.
- On treatment of unrealized losses:
  - Authorities view current treatment as necessary to mitigate pro-cyclicality of capital levels.
  - They argue it does not incentivize increased exposure to securities and that transparency is ensured through accounting disclosure.
- FSA focus: strengthening the role of the financial sector in supporting growth, encouraging banks to nurture new businesses and provide high quality financial services.

### Staff appraisal and policy recommendations
- Near-term growth and risks:
  - Economy expected to grow at an above potential pace in 2014, but medium-term risks remain substantial.
  - An inevitable Q2 contraction will follow elevated pre-consumption-tax-increase demand, but underlying momentum is strengthening (tight labor markets, strong investment in Q1).
  - A sustained private demand-led recovery requires further actions.
- Structural reforms needed:
  - Lift labor supply,
  - Reduce labor market duality,
  - Enhance risk capital provision,
  - Continue agricultural and services sector deregulation,
  - Continue corporate governance reforms to reduce firms’ preference for large cash holdings.
- Fiscal policy:
  - A concrete medium-term fiscal reform plan is "urgently needed".
  - Successive consumption tax increases are critical to establish a track record of fiscal discipline given very high public debt.
  - Early adoption of a concrete medium-term fiscal consolidation plan beyond 2015 would build confidence in public finances and allow near-term fiscal flexibility.
  - Plans to lower the corporate tax rate have growth benefits but should proceed only with offsetting revenue measures consistent with restoring fiscal sustainability.
- Monetary policy:
  - Monetary policy is "appropriately accommodative".
  - With inflation and inflation expectations increasing, no further easing is needed at this point.
  - If downside risks to the inflation outlook materialize, the BoJ should act swiftly through further and/or longer-dated asset purchases.
  - Communication should focus on achieving 2 percent inflation in a stable manner, with a more transparent presentation of the BoJ’s forecast and underlying assumptions, including clarifying post-2014 asset purchase plans.
- Financial sector:
  - Portfolio rebalancing by financial institutions and investors is desirable to support growth by providing more risk capital, but raises new risks from greater overseas engagement.
  - Supervisors should remain proactive in monitoring these risks, especially for regional banks facing limited growth opportunities and low net interest margins that could undermine profitability and capital buffers.
- External spillovers:
  - Launching all three arrows will create benefits for the region and the global economy.
  - Spillovers via trade and capital flows are expected to increase with uncertain net effects—higher exports but capital outflows—in the short term.
  - Continued reforms will raise incomes and reduce fiscal risks, which will be positive for the global economy.

*Source: _cr14236 - 38.      For the time being, there is large uncertainty about Japan’s external assessment. In*

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

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

### Economic developments and outlook
- Growth rebounded sharply in 2014Q1 on consumption frontloading and strong business investment; payback from consumption frontloading was substantial in April.
- Replacement investment has accelerated due to an aging capital stock and strong corporate earnings.
- Imports are falling with unwinding frontloading demand, but export recovery remains subdued.
- Implementation of public works has been delayed in recent months due to labor shortages.
- Selected growth figures (Table 1, real GDP and components):
  - Real GDP: -5.5 (2009), 4.7 (2010), -0.5 (2011), 1.4 (2012), 1.5 (2013), 1.6 (2014), 1.1 (2015, projection)
  - Domestic demand: -4.0 (2009), 2.9 (2010), 0.4 (2011), 2.3 (2012), 1.8 (2013), 1.8 (2014), 0.8 (2015)
  - Private consumption: -0.7 (2009), 2.8 (2010), 0.3 (2011), 2.0 (2012), 2.0 (2013), 0.7 (2014), 0.7 (2015)
  - Gross Private Fixed Investment: -14.7 (2009), -0.5 (2010), 4.3 (2011), 3.5 (2012), 0.3 (2013), 6.7 (2014), 3.9 (2015)
  - Net exports contribution to growth: -2.0 (2009), 2.0 (2010), -0.8 (2011), -0.7 (2012), -0.2 (2013), 0.0 (2014), 0.2 (2015)
- Unemployment rate (annual average): 5.1 (2009), 5.0 (2010), 4.6 (2011), 4.3 (2012), 4.0 (2013), 3.9 (2014), 3.9 (2015 projection)
- Inflation (annual average CPI): -1.3 (2009), -0.7 (2010), -0.3 (2011), 0.0 (2012), 0.4 (2013), 2.8 (2014), 2.1 (2015 projection)

### External developments
- Exports have risen by less compared to model predictions; J-curve effects are more drawn out after large depreciations (trough after 6–8 quarters).
- Weak trade balance linked to unchanged export prices in contract currency and elevated import demand for energy products.
- Other export headwinds: acceleration of overseas production and increased competition in traditional sectors (e.g., electronic imports).
- Balance of payments and trade (Table 3, US$ billions and percent of GDP):
  - Current account balance: 144 (2008), 145 (2009), 217 (2010), 127 (2011), 59 (2012), 36 (2013), 64 (2014), 72 (2015 projection)
  - Trade balance (goods, US$ billions): 56 (2008), 58 (2009), 108 (2010), -4 (2011), -5 (2012), -90 (2013), -63 (2014), -59 (2015 projection)
  - Exports of goods (US$ billions): 751 (2008), 546 (2009), 734 (2010), 789 (2011), 776 (2012), 695 (2013), 716 (2014), 766 (2015 projection)
  - Imports of goods (US$ billions): -695 (2008), -489 (2009), -625 (2010), -793 (2011), -830 (2012), -785 (2013), -779 (2014), -826 (2015 projection)
- Exchange rate and oil price assumptions (Table 3, Global assumptions):
  - Exchange Rate (¥/US$): 103.49 (2008), 93.68 (2009), 87.87 (2010), 79.88 (2011), 79.89 (2012), 97.6 (2013), 101.7 (2014 projection), 99.7 (2015 projection)
  - Oil prices (US$/barrel): 97.06 (2008), 61.87 (2009), 79.01 (2010), 104.0 (2011), 105.0 (2012), 104.1 (2013), 99.6 (2014 projection), 95.1 (2015 projection)

### Monetary policy transmission
- The monetary base has expanded rapidly, flattening the yield curve further.
- Portfolio rebalancing has mainly occurred among banks, which have reduced their JGB holdings.
- Excess reserves have risen while bank lending has increased only partially; real lending rates declined since Abenomics.
- Monetary and yield indicators:
  - Monetary base and currency in circulation rose sharply from January 2013 to March 2014 (figures shown as percent of GDP in charts).
  - JGB yield curve: comparison January 2013 vs April 2014 shows lower term premia across maturities (1y–40y).
  - JGB holders composition (2013 Q4): Bank of Japan 18.4% (+6.5), Banks 33.4% (-4.2), Insurance 19.6% (+0.3), Corporate and other pension 3% (+0.3), Public pensions 7% (0), Others 18.3% (-3.0).

### Financial markets developments
- Equities rose almost 80 percent from September 2012 to May 2013; corrected in 2014.
- Sovereign bond yields remain near historic lows despite normalization of interest rates abroad.
- Dollar funding cost remains stable; financing conditions for firms are highly accommodative.
- Corporate credit spreads and lending:
  - USD LIBOR (3M) and BOJ USD funds-supplying operations rate tracked with limited spikes.
  - Corporate-government bond spreads for 5Y: AA-, A-, BBB-rated series shown in charts.
  - Consolidated foreign claims for Japanese banks increased across regions (Asia, US, Europe).
  - YoY Growth in Bank Lending to Corporates shows recovery since second half of 2012 across Total, Large corporations, SMEs, Individuals.

### Corporate sector developments
- Business fundamentals are strong across a wide range of sectors; corporate savings are high.
- Since late 1990s, firms increased overseas investment and cash holdings while reducing debt.
- Non-residential investment was slow to recover until recently, acting as a drag to growth after the crisis.
- Corporate sector indicators:
  - Private nonfinancial corporates financial surplus/deficit (assets minus liabilities as percent of GDP, 4QMA) showed large positive financial surpluses in recent years.
  - Cash and overseas investment (percent of GDP): cash and deposits and foreign securities holdings increased from 1982 to 2012.
  - Corporate gross debt (percent of GDP): loans, securities, and gross debt series shown with rising securities holdings over time.
  - Business fixed investment: Investment to GDP ratio series with 1980Q1–2014Q1 average and 1994Q1–2014Q1 average shown.

### Inflation and inflation expectations
- Price increases are becoming more broad-based as the consumption tax increase is being fully passed through, extending to consumer durable goods and capital input prices.
- Real earnings declined as prices rose in April due to the consumption tax increase.
- Professional forecasters are gradually adjusting expectations upwards.
- Key figures:
  - Japan CPI core inflation (CPI ex. fresh food): series Jan-13 to Apr-14 showing rising YoY percent change; annual CPI in Table 1: 0.4 (2013), 2.8 (2014), 2.1 (2015 projection).
  - IMF and Consensus Inflation Forecasts 5–10 Years Ahead: plotted series Oct 2012, Apr 2013, Oct 2013, Apr 2014, IMF (latest) for 2013–2020 with values between -0.5 and 3 (chart).
  - Cumulative VAT pass-through: panel estimate with 95% confidence interval indicating cumulative sum of pass-through coefficients.

### Labor and wages
- Real wage growth has lagged productivity growth for the last twenty years and is exceptionally low compared to other G-7 countries.
- The share of non-regular workers increased rapidly in the last two decades, moderating productivity growth and depressing wage growth.
- Other factors depressing wages include a waning influence of annual Shunto wage negotiations on aggregate wage growth.
- Labor indicators:
  - Labor productivity and average wages growth (YoY percent change) series from 1992–2012 show divergence between productivity and wages.
  - Share of non-regular workers increased markedly from 1986 to 2013.
  - Contributions to wages YoY growth decompose the effects of changes in part-time and full-time wages.
  - Japan: Wage Growth series (1991–2013) show Shunto wage and nominal wage trajectories.

### Fiscal developments and tax reform
- A modest consolidation is in the pipeline, but deficits are projected to remain.
- Social security benefits have risen steadily, and the gap with social contributions is expanding.
- Non-social security spending has remained the lowest among OECD economies.
- Tax reform is crucial: Japan’s revenue is relatively low; cutting the corporate income tax rate could make consolidation more growth-friendly but would not be self-financing.
- Estimated effects of a hypothetical lower CIT rate by 1 percent of GDP (as summarized):
  - Long-run effect on Investment: 5½ (percent change)
    - Cost-of-capital effect: 4
    - Cash-flow effect: 1
    - Foreign direct investment: ½
  - Wages: 3½ (percent change)
  - GDP: 2 (percent change)
  - Revenue implications: Short run (static/assumption) 1; Long run 0.7-0.9
- Fiscal balances and public debt (Table 4, medium-term projections and Table 2):
  - Overall fiscal balance (percent of GDP): -8.7 (2012), -8.3 (2013), -7.0 (2014), -5.9 (2015), projected -4.8 (2016), -4.6 (2017)
  - Primary balance (percent of GDP): -7.8 (2012), -7.6 (2013), -6.3 (2014), -5.0 (2015), projected -3.8 (2016), -3.4 (2017)
  - General government gross debt (percent of GDP): 238.8 (2012), 243.4 (2013), 243.2 (2014), 242.7 (2015), projected 241.2 (2016), 240.1 (2017)
  - Social security benefits and contributions (percent of GDP): series FY1990–FY2011 with benefits rising and contributions lagging (chart)

### Selected economic indicators and projections
- Table 1 summary highlights:
  - Nominal GDP: US$ 4,900 Billion (2013)
  - Population: 127 Million (2013)
  - GDP per capita: US$ 38,478 (2013)
  - Quota: SDR 15.6 Billion (2013)
  - Total reserves minus gold: 1,022.2 (2008), 1,061.5 (2009), 1,258.2 (2010), 1,227.2 (2011), 1,237.3 (2012)
  - Yen/dollar rate (annual average): 93.68 (2009), 87.87 (2010), 79.88 (2011), 79.89 (2012), 97.6 (2013)
  - Trade and current account metrics as reported in Table 1 and Table 3.

### Medium-term projections (Table 4)
- Real GDP growth: 1.4 (2012), 1.5 (2013), 1.6 (2014), 1.1 (2015), 0.9 (2016), 1.0 (2017), 1.0 (2018), 1.1 (2019)
- Headline CPI inflation (average): 0.0 (2012), 0.4 (2013), 2.8 (2014), 2.1 (2015), 2.7 (2016), 2.0 (2017), 2.0 (2018), 2.0 (2019)
- Output gap (percent of potential output): -3.1 (2012), -2.1 (2013), -1.1 (2014), -0.7 (2015), -0.4 (2016), 0.0 (2017–2019)
- National savings and investment (percent of GDP) series for 2012–2019 provided in Table 4.

### Financial soundness indicators (Table 5)
- Capital adequacy (All banks, selected ratios):
  - Total capital ratio: 13.3 (2010 Mar), 13.8 (2011 Mar), 14.2 (2012 Mar), 14.7 (2013 Mar), 14.9 (2013 Sep)
  - Tier 1 ratio: 9.9 (2010 Mar), 10.7 (2011 Mar), 11.3 (2012 Mar), 12.2 (2013 Mar), 12.5 (2013 Sep)
- Asset quality:
  - NPL net of provisions/capital: 2.7 (2010 Mar), 2.2 (2011 Mar), 2.2 (2012 Mar), 1.4 (2013 Mar), 1.9 (2013 Sep)
  - Non-performing loans to total loans ratio: 2.5 (2010 Mar), 2.4 (2011 Mar), 2.4 (2012 Mar), 2.3 (2013 Mar), 2.1 (2013 Sep)
- Earnings and profitability:
  - Return on assets: 0.1 (2010 Mar), 0.2 (2011 Mar), 0.3 (2012 Mar), 0.3 (2013 Mar), 0.4 (2013 Sep)
  - Return on equity: 5.5 (2010 Mar), 6.9 (2011 Mar), 6.5 (2012 Mar), 7.6 (2013 Mar), 8.9 (2013 Sep)
- Liquidity and other indicators:
  - Liquid assets/total assets: 22 (2010 Mar), 23 (2011 Mar), 24 (2012 Mar), 24 (2013 Mar), 22 (2013 Sep)
  - Loan/deposit: 77 (2010 Mar), 75 (2011 Mar), 75 (2012 Mar), 75 (2013 Mar), 76 (2013 Sep)
  - Capital/total assets: 4.4 (2010 Mar), 4.7 (2011 Mar), 4.7 (2012 Mar), 5.5 (2013 Mar), 5.6 (2013 Sep)

*Source: IMF staff estimates and projections as presented in the IMF country report content provided.*

### Annex I. Japan: New Growth Strategy and Status of Structural

### Annex I. Japan: New Growth Strategy and Status of Structural Reforms

### Abenomics' Third Arrow: Key Measures and Status (Update of Growth Strategy on June 24, 2014)
- Overview
  - The revised growth strategy approved on June 24, 2014 lays out a roadmap for further “3rd arrow” reforms with a menu of measures many of whose details remain to be defined.
  - Key announced measures include plans to reduce the corporate income tax rate from over 35 percent to below 30 percent (size, timeframe and financing under discussion) and further corporate governance reforms to encourage more productive use of corporate savings.
  - The strategy mentions labor market reforms (removal of tax disincentives for women, greater use of foreign labor in health and household services) and measures to incentivize a shift from overtime- to performance-based remuneration. Few concrete measures were announced on agricultural reform or the role of Special Economic Zones.

- Labor Market
  - Female labor participation
    - Key measures/status: Increase childcare facilities and childcare leave benefits (implementation ongoing). Removal of tax and social security disincentives for working spouses (under discussion). Expanded internship program for reemployment of women.
    - IMF advice: Increasing the availability of child care. Eliminating tax and social security distortions.
    - Size of impact: "An increase in the FLP rate to the G-7 average-- combined with a rise in old age labor force participation--could raise potential growth by 0.25 percent per year (Source: 2013 Art. IV Report)."
  - Foreign labor
    - Key measures/status: Relaxation of current points-based preferential immigration system (under discussion). Expanding trainee program for immigrant workers in construction from 2015 (decided). Expanding trainee program beyond construction and including nursing (under discussion). Use SEZs to encourage use of foreign human resources (under discussion).
    - IMF advice: Relaxation of immigration requirements, especially in sectors with labor shortages.
    - Size of impact: "Immigration equivalent to a rise of Japan's labor force by 1 percent distributed over a decade could increase potential growth by 0.1-0.2 percent per year (2013 Art. IV)."
  - Reducing labor duality
    - Key measures/status: Encourage use of 'limited regular' contracts to reduce labor market duality (under discussion). Expand subsidies for job mobility (decided from budget 2015). Discussion underway to ease non-regular work rules (Bills related to dispatched workers and fixed-term workers submitted to the current Diet).
    - IMF advice: Implement steps to reduce labor market duality and increase productivity, including clarifying the legal framework for limited regular contracts.
    - Size of impact: "Substantial reduction in labor market duality would increase productivity and would be likely to have a substantial impact on potential growth, but difficult to quantify (Aoyagi and Ganelli IMF WP 13/202)."

- Deregulation
  - Special Economic Zones (SEZs)
    - Key measures/status: Six areas designated on March 28, 2014--including Tokyo and Osaka--accounting for about 40 percent of GDP. Expected deregulation includes easing restrictions on land use and medical practices, agriculture reform, and creation of new businesses. SEZs to propose specific measures to be vetted by a national committee.
    - IMF advice: Use SEZs as a laboratory for reforms to be implemented at the national level.
    - Size of impact: "Unlikely to have a significant growth effect in short term. Potentially laboratory for country-wide reform."
  - Agricultural reform
    - Key measures/status: Land banks to increase farm size established. Review of rice production adjustments ongoing (gentan system to end by FY 2018). Various strategies for opening agricultural markets being discussed.
    - IMF advice: Fully deregulating agriculture to raise productivity and competition.
    - Size of impact: "Full deregulation in agriculture could boost productivity by up to 30 percent albeit sector size is small in percent of GDP (IMF estimates)."

- Deregulation (sector-specific)
  - Electricity sector reform
    - Key measures/status: First fundamental reform in 60 years to be completed by 2020, including (i) a gradual opening of grid, (ii) liberalization of the retail electricity sector, and (iii) legal separation between electricity generators and distributors and abolish retail price regulation. Legislation regarding part (i) and (ii) passed.
    - IMF advice: —
    - Size of impact: "Likely to have a substantial impact on potential growth. Economic impact difficult to quantify."

- Business Sector
  - Corporate governance reform
    - Key measures/status: Published Japan’s Stewardship code for institutional investors, which 127 institutional investors have agreed to adopt as of end May 2014. Current Diet session amended the Companies Act with measures strengthening corporate governance (strengthening audit functions and introducing outside independent directors on a "comply or explain" basis). Introduction of a corporate governance code for firms (under discussion).
    - IMF advice: Implement comprehensive corporate governance reform, including complementing the Stewardship Code with a corporate governance code for firms and adopting measures to expand use of outside directors beyond current plans.
    - Size of impact: "More efficient corporate decision making by raising shareholders' power could result in unlocking excessive corporate savings. Economic impact difficult to quantify but likely to be substantial (see Aoyagi and Ganelli 2014, forthcoming IMF WP)."
  - Corporate taxation
    - Key measures/status: Reduction of corporate tax rate (from 34.6 percent) with offsetting measures (intention to go ahead publicly announced by PM Abe but with details to be specified later). Government internal discussions ongoing about elimination/reduction of existing tax incentives.
    - IMF advice: CIT reform is desirable as part of a comprehensive medium term fiscal consolidation package.
    - Size of impact: "CIT rate cut is likely to be good for investment and growth, but not self-financing, so compensatory measures will need to be identified."

- Trade
  - Trade negotiations (TPP)
    - Key measures/status: Started participating in negotiation of the ambitious 12-nation free trade plan in July, 2013; more negotiating to do after multilateral talks failed in Singapore in February, 2014. Japan-US remain far apart on tariff reduction/elimination of Japan’s “sacred” agricultural products.
    - IMF advice: Joining the TPP Agreement and use it as an opportunity to deregulate protected sectors.
    - Size of impact: "Comprehensive deal: 0.1- 0.2 higher growth p.a. (Peterson Institute)."

- Financial Sector
  - Financial sector reform
    - Key measures/status: GPIF to shift away from JGBs towards other assets (proposed in November 2013). New stock market index including only profitable companies (launched in January 2014). Tax-free investment accounts (NISA) to encourage shifting household savings away from cash (launched in January 2014).
    - IMF advice: Phasing out the full credit guarantees to SMEs. Strengthening capital standards of domestic banks and monitoring risks from overseas activities of internationally active banks.
    - Size of impact: "Financial sector reforms that raise risk capital and induce a restructuring of the SME sectors could lift long-term growth by about 0.2 percentage points (Source: 2013 Art. IV Report)."

- Wage Policy
  - Coordination of wage setting
    - Key measures/status: Tripartite Commission. Tax incentives for increasing wages introduced in 2013.
    - IMF advice: Tax incentives could be expanded and better targeted. A higher than usual increase in the minimum wage could be considered to raise base wages.
    - Size of impact: "Likely to have a substantial impact on short term growth and help Abenomics transition to a private-sector lead phase."

(Source: Staff estimates.)

### Annex II. Japan: Risk Assessment Matrix (selected risks, likelihood, impact, and staff policy responses)
- Successful reflation following comprehensive reforms
  - Likelihood (Over next 1–3 years): Medium
  - Impact: High
  - Staff view: Aggressive monetary policy easing and a credible medium-term fiscal and growth strategy could lead to a virtuous cycle of high growth and positive inflation, sustaining 2-percent inflation and improving debt dynamics.
  - Policy response: BoJ should prepare a credible exit strategy and the government should save any fiscal overperformance.

- Protracted period of slower growth in advanced and emerging economies
  - Likelihood: High
  - Impact: High
  - Staff estimate: "GRAM simulations show that Japanese GDP growth could be lower by 2–3 percent relative to the baseline."
  - Policy response: Recalibrate BoJ’s QQE (pace and composition). Commit to concrete and credible fiscal consolidation to make 2014–15 fiscal withdrawal more gradual while proceeding with the second-round consumption tax increase as planned.

- Bond market stress from a reassessment in sovereign risk in Japan
  - Likelihood: Medium
  - Impact: High
  - Staff view: An increase in the sovereign risk premium by 200bps could undermine financial stability and worsen debt dynamics (2012 FSAP Update).
  - Policy response: Increase BoJ bond purchases, frontload fiscal adjustment, implement ambitious structural reforms, and confirm the second-round consumption tax increase.

- Surges in global financial market volatility triggered by revised market expectations on UMP exit
  - Likelihood: High
  - Impact: Low
  - Staff view: Strong U.S. growth supports exports but safe-haven effects, lower exports to EMs, and falling confidence could offset gains.
  - Policy response: BoJ could recalibrate QQE depending on markets; bold structural reforms to boost domestic demand and confidence.

- Geopolitical risks (Russia/Ukraine; East Asia incidents)
  - Likelihood/Impact: Varies (see matrix: Russia/Ukraine Medium likelihood, Low impact; East Asia Low likelihood, Medium impact)
  - Staff view: Oil and gas price shocks from Russia/Ukraine tensions could worsen the trade balance by about 0.6 percent of GDP in 2014 if global oil and gas prices increase by 15 and 10 percent, respectively.
  - Policy response: Accelerate pace of BoJ asset purchases if needed; allow automatic stabilizers to operate; pursue ambitious structural reforms and confirm fiscal consolidation path.

(Notes: The RAM classifies probabilities: "low" indicates probability below 10 percent, "medium" between 10 and 30 percent, and "high" 30 percent or more.)

### Annex III. Assessment of Japan’s External Sector (key findings and policy implications)
- Overall assessment
  - NIIP and trajectory
    - Background: NIIP rose to over 60 percent of GDP in 2013 (from 35 percent ten years ago). Projected to stabilize around 70 percent of GDP in the medium term despite valuation effects as private saving declines with aging.
    - Assessment: Vulnerabilities limited. Positive NIIP generates sizable investment income (average 3 percent of GDP over the past five years). Risks on assets and returns diversified.
    - Overall Assessment: "The external position is broadly consistent with medium-term fundamentals and desirable policies. However, a large degree of uncertainty around specific estimates must be acknowledged."
    - Policy responses: Full implementation of fiscal and structural reforms of Abenomics to close policy gaps. Fiscal consolidation would raise national savings above the baseline forecast, more than offsetting decline in private saving from aging, and raise the current account surplus. Ambitious structural reforms including liberalizing trade through approval of trade agreements could partially offset this by boosting productivity, domestic income, and imports.

- Current account
  - Background: 2013 current account surplus narrowed to 0.7 percent of GDP (0.8 percent cyclically-adjusted). Exports recovered only sluggishly despite yen depreciation due to higher share of overseas production, competitiveness issues, and slow pass-through of depreciation to export prices. Imports remained elevated due to temporarily high fossil fuel demand and greater import penetration.
  - 2014 projection: Current account projected to rise to 1.2 percent of GDP as exports recover and fiscal deficit declines, though energy imports likely to remain high near term.
  - Staff assessment: Correcting for temporary factors, staff estimates the underlying cyclically-adjusted CA to be about 1-1 ¼ percentage point higher than estimated by the EBA CA regression model. Adjusting for Abenomics and structurally lower export elasticities, staff estimates the CA norm to be 2 percent of GDP, just under 1 percentage point lower than the EBA estimate.
  - Staff conclusion: Underlying CA is in line with fundamentals and desirable policies (compared to the EBA estimated gap: 2 percent). Uncertainty implies a wide range of +/-1½ percent of GDP around a midpoint of zero.

- Real exchange rate (REER)
  - Background: REER depreciated close to 20 percent between 2012 and 2013 and a further 5 percent by May 2014 relative to 2013 average. Drivers include sustained trade deficit and widening long-term interest rate differentials relative to the U.S.
  - Assessment: EBA REER regression model assesses 2013 average REER to be 14 percent weaker than level consistent with fundamentals and desirable policies, primarily from a large unexplained residual while policy gap is close to zero. Model does not capture unusual factors (short speculative positions hedging long equity exposures, temporary higher energy imports, sudden widening of long-term sovereign spreads). Staff instead assesses a midpoint of zero with indicative ranges of -15 percent undervaluation to +15 percent overvaluation for 2013.

- Capital and financial accounts; FX intervention and reserves
  - Background: Yen appreciation and depreciation since global financial crisis not associated with notable capital in- or outflows; main driver of exchange rate movements appears to be derivative positions (hedging and speculative). Scale of new monetary easing could result in spillovers to regional economies.
  - Assessment: Safe haven flows imply limited vulnerabilities to global financial instability.
  - Reserves: Reserves are higher than in other reserve asset issuers (about 20 percent of GDP) due to legacy accumulation. Exchange rate is free floating and market-determined.
  - Staff assessment: Isolated FX interventions during safe-haven periods are directed at reducing short-term volatility, with ambiguous effects on the level of the exchange rate.

- Technical background highlights (selected)
  - The new macro policy framework under Abenomics will translate into higher domestic demand, inflation, and productivity, leading to a smaller required fiscal adjustment than under the EBA CA model.
  - Export elasticities are structurally lower because offshoring of production and higher share of intermediate goods exports make Japanese exports less sensitive to yen fluctuations.
  - The CA norm is positive because of high corporate saving in excess of domestic investment opportunities, low residential investment, and a sizable income account owing to the large NFA position and favorable return differential on assets relative to liabilities.
  - Large bands around the CA midpoint (+/-1.5 percent of GDP) arise from uncertainty in reversing temporary effects (fossil fuel imports), difficulty quantifying Abenomics’ macro effects, and uncertain long-run trade-balance effects of structural changes (each contributing about ½ a percent of GDP).

(Source: Staff estimates.)

### Annex IV. Japan: Main Recommendations of the 2013 Article IV

### Annex IV. Japan: Main Recommendations of the 2013 Article IV Consultation

### Fiscal Policy
- Fund recommendation: Implementation of the consumption tax rate increase to 10 percent by October 2015 while avoiding multiple rates.
- Policy actions:
  - The consumption tax rate was increased to 8 percent in April.
  - The Diet passed a supplementary budget in early 2014 to support near-term growth (1.2 percent of GDP over two years).
  - In March 2014 the Diet repealed a temporary increase of the corporate tax rate and brought the corporate income tax rate back to 34.6 percent (by about 3 ppt).
- Fund recommendation: An ambitious and concrete consolidation plan beyond 2015 to bring public debt firmly on downward path. The medium-term fiscal plan should be as growth friendly as possible, including:
  - Increasing the consumption tax gradually to a uniform rate of at least 15 percent.
  - Broadening the personal income tax base, including by reducing the exemption for pension income and eliminating tax deduction for dependent spouses.
  - Lowering the corporate tax rate to improve investment incentives and reducing payroll tax to simulate labor effort.
  - Reducing pension spending by raising pension retirement age to 67, collecting contributions from dependent spouses, and clawing back benefits from wealthy retirees.
  - Strengthening the fiscal framework by adopting medium-term rules to curb expenditure and limiting the conditions under which supplementary budgets can be used.

### Monetary Policy
- Fund recommendation: The BoJ should continue with QQE but recalibrate its easing policies in the event inflation does not pick up or JGB market volatility rises.
- Fund recommendation: The BoJ should begin planning early to address exit risks, including considering indemnification against capital losses on bond holdings.
- Policy actions:
  - The BoJ maintains the pace of asset purchases under its QQE framework.
  - In March 2014, The BoJ extended the loan support program by another one year and doubled the size of its funding amount.

### Financial Sector Policy
- Fund recommendations:
  - Strengthening capital standards for domestically oriented banks by including unrealized losses from capital adequacy ratio (FSAP update).
  - Mitigating foreign-exchange funding risks for banks with overseas activities by raising deposits overseas and by issuing long-term foreign-denominated debt.
  - Assessing the solvency of insurers on economic valuation (FSAP update).
- Policy actions:
  - The FSA strengthened CAR standards from March 2014, which will raise the quality of capital by setting "core-capital" as regulatory capital, while keeping the minimum ratio of 4 percent.
  - The authorities are monitoring forex funding risks, including through frequently checking liquidity positions.
  - The BoJ established cross-border collateral arrangements with Singapore and Thailand, and agreed to establish one with Indonesia, to help reduce local-currency funding risks in overseas markets.

### Growth Strategy
- Fund recommendations:
  - Deregulating agriculture and domestic services sectors to raise productivity and competition, and to encourage inward foreign investment.
  - Enhancing the dynamism of the SME sector, including by phasing out costly government support measures (e.g., full value credit guarantees) and increasing risk capital for start-ups.
  - Implementing steps to reduce labor market duality and increase flexibility, including clarifying the legal framework for limited regular (“gentei seishain”) contracts.
  - Building on the recent relaxation of immigration requirements by expanding it to areas where there are labor shortages, such as in long-term nursing care.
- Policy actions:
  - The Diet approved several bills, including ones to designate national strategic special zones, facilitate farmland consolidation, and reform the electricity sector and employment system (see Annex I).
  - On June 24, the government unveiled an update of its growth strategy. Main measures included plans to lower the corporate income tax rate and further corporate governance reforms.

*Annex IV. Japan: Main Recommendations of the 2013 Article IV Consultation*

### Annex V. Japan: Debt Sustainability Analysis

### Annex V. Japan: Debt Sustainability Analysis

### Key Assumptions
- Real growth projected to slow to 1 percent during 2015–19 and then remain at that level beyond the medium-term.
- Monetary policy assumed accommodative until the 2 percent inflation target is reached around 2017/18.
- Fiscal policy assumes implementation of the second stage of the consumption tax rate increase, with only small further adjustments after 2015.
- Long-term interest rates on new bond issuances projected to pick up to 3.5 percent.
- Average maturity of government bonds around 6.5 years (including financing bills) implies a nominal effective interest rate on public debt rising gradually to 1.7 percent in 2019.
- Nominal GDP growth rate of 2.4 percent implied; interest-growth differential of -0.7 percent.

### Assessment of Sustainability
- Conclusion: Japan’s public debt is unsustainable under current policy settings.
- Gross debt to GDP ratio:
  - Projected to stabilize at around 240 percent of GDP during the WEO projection period.
  - Complementary analysis up to 2030 shows debt ratio starting to increase again in 2020, reaching around 280 percent of GDP in 2030.
- Net debt to GDP ratio assumed to move similarly but is lower by around 100 percent of GDP due to large financial assets.

### Financing Needs and Debt Profile
- Gross financing needs:
  - 55 percent of GDP in 2014 (highest among advanced economies).
  - Estimated to be 52 percent of GDP in 2019.
- Assumption on maturity: No specifics provided by the government on lengthening maturity; projection assumes similar maturity structure to 2014.
- Market conditions aiding financing:
  - 10-year bond yield at record low; spread against the US negative at around 200 basis points.
  - Foreign holdings of JGBs low at 7 percent.
  - External financing requirement (incorporating current account surplus) well below the lower threshold at 9 percent of GDP.
  - No debt denominated in foreign currencies; no direct exchange-rate debt risks assumed.

### Net Debt and Financial Assets
- Financial-assets-to-GDP ratio assumed to decline from 109 percent in 2012 to 99 percent in 2019, partly due to scheduled asset sales to fund earthquake reconstruction spending.
- Net-debt-to-GDP projected to increase more than gross ratio during 2012–19 because some financial assets are not easily liquidated (e.g., assets for future pension payments).

### Realism of Baseline Assumptions
- Past assumptions on real growth: not too optimistic or pessimistic compared to peers; optimistic growth projections for 2011 mainly due to the earthquake.
- Past assumptions on primary balance: neither too optimistic nor pessimistic; Japan’s 3-year adjustment on a CAPB basis is in the top quintile for high-debt market access countries, but CAPB level is on the lowest end (large deficit).
- Staff view: pace of fiscal consolidation in 2014–16 of around 1 percentage point of GDP per annum is appropriate.
- Implicit growth without fiscal adjustment higher than potential during projection due to supportive monetary easing and assumed confidence effects from fiscal consolidation.
- Fiscal multiplier assumed to be 0.5 (lower than default value of 1) for reasons including revenue composition and targeted expenditure reductions.

### DSA Baseline Scenario — Key Figures (as of June 25, 2014)
- Gross nominal public debt (in percent of GDP):
  - 2012: 195.0
  - 2013: 238.8
  - 2014: 243.4
  - 2015: 243.2
  - 2016: 242.7
  - 2017: 241.2
  - 2018: 240.1
  - 2019: 239.0 / 238.2 (table shows both 239.0 and 238.2 in different cells)
- Public gross financing needs:
  - 2012: 58.1
  - 2013: 57.8
  - 2014: 54.8
  - 2015: 55.9
  - 2016: 54.7
  - 2017: 53.3
  - 2018: 52.5
  - 2019: 52.3 / 52.35? (table lists 52.35 in a cell)
- Net public debt:
  - 2012: 93.9
  - 2013: 129.5
  - 2014: 134.2
  - 2015: 136.8
  - 2016: 138.4
  - 2017: 138.8
  - 2018: 139.1
  - 2019: 139.0 / 138.9 (table entries)
- Real GDP growth (in percent):
  - 2012: 0.8
  - 2013: 1.4
  - 2014: 1.5
  - 2015: 1.6
  - 2016: 1.1
  - 2017: 0.9
  - 2018: 1.0
  - 2019: 1.0 / 1.1 (table shows both)
- Inflation (GDP deflator, in percent):
  - 2012: -1.4
  - 2013: -0.9
  - 2014: -0.6
  - 2015: 1.4
  - 2016: 1.6
  - 2017: 1.8
  - 2018: 1.4
  - 2019: 1.5 / 1.3 (table shows both)
- Nominal GDP growth (in percent):
  - 2012: -0.6
  - 2013: 0.5
  - 2014: 0.9
  - 2015: 3.1
  - 2016: 2.7
  - 2017: 2.7
  - 2018: 2.4
  - 2019: 2.5 / 2.4 (table shows both)
- Effective interest rate (in percent):
  - 2012: 1.0
  - 2013: 0.9
  - 2014: 0.8
  - 2015: 0.8
  - 2016: 0.8
  - 2017: 1.0
  - 2018: 1.2
  - 2019: 1.4 / 1.7 (table shows both)
- Identified debt-creating flows (cumulative change in gross public sector debt):
  - Change in gross public sector debt (cumulative): 7.5 (2012), 7.0 (2013), 4.6 (2014), -0.2 (2015), -0.4 (2016), -1.5 (2017), -1.1 (2018), -1.1 (2019), -0.8 (cumulative), -5.1 (total)
  - Primary deficit: 6.1 (2012), 7.8 (2013), 7.6 (2014), 6.3 (2015), 5.0 (2016), 3.8 (2017), 3.4 (2018), 3.2 (2019), 3.0 (cumulative), 24.7 (total)
  - Primary (noninterest) revenue and grants: 28.3 (2012) ... 33.8 (2019) cumulative 199.4
  - Primary (noninterest) expenditure: 34.4 (2012) ... 36.8 (2019) cumulative 224.1
- Automatic debt dynamics (interest rate/growth differential contributions):
  - 2012: 3.2
  - 2013: 0.9
  - 2014: -0.1
  - 2015: -5.3
  - 2016: -4.3
  - 2017: -4.0
  - 2018: -2.9
  - 2019: -2.4
  - cumulative -1.6 and -20.6 (table shows both)
- Residual, including asset changes:
  - -1.8 (2012), -1.7 (2013), -2.9 (2014), -1.2 (2015), -1.2 (2016), -1.3 (2017), -1.6 (2018), -1.9 (2019), -2.2 (cumulative), -9.3 (total)

Note: public sector defined as general government. Effective interest rate defined as interest payments divided by debt stock (excluding guarantees) at end of previous year.

### Composition of Public Debt and Alternative Scenarios
- Under the Baseline, Historical, and Constant Primary Balance scenarios, underlying assumptions include:
  - Baseline Real GDP growth: 1.6 (2014), 1.1 (2015), 0.9 (2016), 1.0 (2017), 1.0 (2018), 1.1 (2019).
  - Baseline Inflation: 1.4 (2014), 1.6 (2015), 1.8 (2016), 1.4 (2017), 1.5 (2018), 1.3 (2019).
  - Baseline Primary Balance: -6.3 (2014), -5.0 (2015), -3.8 (2016), -3.4 (2017), -3.2 (2018), -3.0 (2019).
  - Baseline Effective interest rate: 0.8 (2014), 0.8 (2015), 1.0 (2016), 1.2 (2017), 1.4 (2018), 1.7 (2019).
- Composition charts (by maturity and currency) indicate:
  - Majority of debt is local currency-denominated.
  - Breakdown by maturity shows both short-term and medium/long-term portions (no numeric breakdown provided beyond charts).

### Shocks and Stress Tests — Main Results
- Fan chart:
  - Under worst quartile case, debt-to-GDP could reach around 250 percent of GDP in 2019, more than 10 percentage points higher than baseline.
- Primary balance shock:
  - Improvement underperforms by half of the 10-year historical standard deviation of changes in the primary balance.
  - Additional borrowing cost of 25 basis points per 1 percent of GDP worsening of the deficit assumed.
  - Gross debt to GDP ratio higher by around 3 percent of GDP in 2019 than baseline.
- Growth shock:
  - Real output growth lower by half of the 10-year historical standard deviation for 2 years starting in 2015.
  - Decline in inflation assumed at rate of 0.25 percentage point per 1 point decrease in growth.
  - Debt ratio rises to around 255 percent of GDP in 2019, about 10 percentage points above baseline.
- Interest rate shock:
  - A 200 basis point spike assumed in 2014 and maintained for the period.
  - Due to average maturity of 6.5 years, effective interest rate higher by around 1 percentage point in 2019 than baseline.
  - Debt ratio higher by around 7 percentage points in 2019 relative to baseline.
- Interest rate and contingent liability shock:
  - One-time capital injection equivalent to 2.5 percent of banking sector assets (approximately 10 percent of regional banks assets) increases government spending by 3.4 percent of GDP.
  - Interest rate assumed to rise by 25 basis points each percentage point increase in the primary deficit; combined with real GDP growth shock.
  - Debt ratio increases to around 260 percent of GDP in 2019, more than 20 percentage points higher than baseline.

### Longer-term Projections and Risks
- Despite medium-term stability, gross and net debt to GDP ratios projected to start increasing in 2020 and reach around:
  - Gross debt: 280 percent of GDP.
  - Net debt: 180 percent of GDP.
- Increase reflects a gradual rise in the interest rate-growth differential towards the historical average of 1.
- Downside risks:
  - Larger than assumed increase in public health spending would imply debt ratio of 295 percent of GDP, about 15 percentage points higher than baseline.
  - Stochastic simulations indicate that even with recommended fiscal adjustment, the debt ratio will remain at a high level with a 25 percent probability.

*Source: IMF staff report — Annex V. Japan: Debt Sustainability Analysis (as provided).*

### 1. This statement contains information that has become available since the Staff Report

### 1. This statement contains information that has become available since the Staff Report

### Overview
- This statement contains information that has become available since the Staff Report was circulated to the Executive Board on July 8, 2014.
- This information does not alter the staff’s broad assessment of policy issues and recommendations contained in the staff report.

### Recent economic data and staff assessment
- Recent data releases paint a mixed picture but are broadly consistent with staff’s view that the economic contraction following the consumption tax increase will be short-lived, with the economy returning to a moderate pace of recovery from the third quarter.
- Detailed developments:
  - Private consumption rebounded in May, with the real synthetic consumption index up by 1.3 percent (m/m), and consumer confidence continued to edge up in June (41.1 from 39.3 in May).
  - Private machinery orders (excluding volatile items) fell sharply in May (19.5 percent m/m).
  - Industrial production rebounded in May (0.7 percent m/m).
  - Large firms have upgraded their capital spending plan for this fiscal year (7.4 percent annual, compared to 0.1 percent three month ago), according to the Tankan survey.
  - In line with staff’s baseline, the effects of the latest fiscal stimulus are beginning to be felt, with contract values of public works orders and public machinery orders rising sharply in May (14.0 percent and 22.4 percent m/m, respectively).
  - The current account surplus widened in May (about 0.9 percent of GDP), in line with staff’s expectation of delayed J-curve effects.
  - Headline and core (excluding food and energy) inflation without the effect of the consumption tax increase declined to 1.6 and 0.5 percent (y/y) in May, in line with staff’s projection.

### Monetary policy
- The Bank of Japan kept its policy unchanged during its July 15 monetary policy meeting, noting that Japan's economy is recovering moderately as a trend.

### Financial markets
- Financial market indicators remain stable:
  - The benchmark 10-year JGB yield has declined slightly to 54 basis points.
  - Equities have risen by about 1.4 percent thus far in July.
  - The yen has fluctuated in a narrow range around ¥101 per U.S. dollar.

*Source: IMF staff statement contained in the document circulated to the Executive Board on July 8, 2014.*

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