## 1. Effectiveness and Limitations of the Negative Interest Rate Policy (NIRP) in Japan (_cr16267)

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---

### Abenomics: context and overall assessment
- Initial achievements:
  - Narrowed the output gap, reversed undue yen appreciation, eased financial conditions, boosted corporate profits, lifted actual and expected inflation into positive territory, improved corporate governance and boosted labor force participation.
- Remaining shortcomings three years after introduction:
  - Inflation has lost forward momentum.
  - Public debt remains unsustainable.
  - Record corporate profits and rising employment have not generated sufficient base wage growth.
  - Investment and consumption growth remain weak amid uncertainty.

### Recent developments and monetary context
- Growth and labor:
  - Economic growth slowed to 0.5 percent in 2015 due to weak private consumption.
  - Base wages rose by 0.4 percent in the spring wage negotiations, compared to 0.6 percent the previous year.
  - Employment growth concentrated in less productive service sectors; firms preferred to hold on to their workforce.
- Inflation:
  - Average headline inflation (excluding the consumption tax) declined from 1.2 percent in 2014 to 0.3 percent in 2015.
  - May 2016 numbers showed a 0.4 percent (y/y) decline in the price level.
  - BoJ core-core inflation reached 1.3 percent at end-2015, but fell to 0.9 percent thereafter.
- Financial conditions:
  - Nominal yield curve shifted down and flattened in H1 2016, with the 10-year benchmark JGB falling into negative territory.
  - Domestic credit growth picked up in 2015; NPL ratios declined further.
- Policy responses in H1 2016:
  - A 0.6 percent of GDP supplementary package was approved for FY2016.
  - The consumption tax hike was postponed; decisions combined additional stimulus with maintaining the FY2020 primary surplus target.

### NIRP: observed effects, transmission, and limits
- Observed effects:
  - Reinforced the BoJ’s commitment to its inflation target and added another tool to the policy framework.
  - Successful in lowering the entire yield curve to date.
  - Has not adversely impacted market functioning beyond expected effects on JGB liquidity and bank profitability.
- Immediate market impacts (Box 1):
  - Yield curve shifted down and flattened; 10-year benchmark yield fell below zero.
  - The interbank funding rate (3-month TIBOR) fell from 17 bps at the beginning of the year to 6 bps.
  - Lending and deposit rates have fallen, with heterogeneous impacts across banks.
  - Financial institutions accelerated portfolio rebalancing; corporate debt issuance picked up, especially in long maturities.
- Limits and open questions:
  - More time is needed to see the full transmission of NIRP to the real economy; second-round effects on credit demand and economic activity have yet to be fully observed.
  - Weak credit demand, already very low interest rates, and weak inflation expectations limit prospective stimulus from lower interest rates.
  - Japanese banks’ higher dependence on customer deposits (customer deposits account for over 70 percent of banks’ total liabilities in Japan but only 40 percent in euro area) may make pass-through harder.
  - Three-tier reserve system: only the top tier receives -0.1 percent (currently accounting for 10 percent of total reserves), muting direct incentives to deploy excess reserves into riskier assets.
  - Practical market frictions: transactions and amounts outstanding declined as money market rates dropped into negative territory; investment trusts and money market funds reduced lending; IT systems need upgrades for negative-rate trading.
- Bank profitability and offset needs:
  - Staff estimates: to completely offset the decline in net interest income, domestic loans need to grow at an annual rate of about 4 percent, which is higher than most euro area measures and above the 3 percent average growth rate since QQE in April 2013.
  - Major banks could partly offset losses via higher fee income or cutting costs; regional banks’ room may be limited.

### Authorities’ and BoJ views (as reported)
- Authorities acknowledged slow change in the public’s deflationary mindset and structural impediments to growth.
- BoJ emphasized QQE and NIRP significantly reduced real interest rates and encouraged risk-taking by banks through portfolio rebalancing away from JGBs.
- Authorities highlighted they had met commitment to cut the primary deficit in half compared to 2010 while facilitating higher nominal growth through flexible fiscal policy implementation.
- Authorities cited structural reforms and three consecutive years of base wage increases as evidence of progress.

### Outlook and key risks
- Growth projections:
  - Economy projected to grow 0.5 percent in 2016 and slow to 0.3 percent in 2017 (excluding possible effect of a yet-to-be-adopted supplementary budget).
- Sectoral outlook:
  - Consumption: modest growth in 2016 supported by lower commodity prices, targeted fiscal transfers, and rising labor force participation.
  - Public spending and taxation to drag on growth in 2017 due to withdrawal of past stimulus and waning reconstruction spending.
  - Net exports: expected to be dampened by slow global recovery and yen appreciation.
  - Investment: mixed — high profits, aging capital stock, supportive credit conditions vs. heightened uncertainty, sustained yen appreciation, and shrinking domestic markets.
- Demographics and income composition:
  - Rising ratio of retirees to workers increased share of non-wage income to total net disposable income, currently at 50 percent.
- Risk summary:
  - Continued weak inflation dynamics and policy uncertainty could stall transmission of monetary easing.
  - Achieving fiscal sustainability while supporting reflation is challenging; postponing tax hikes and adding stimulus may affect medium-term fiscal targets unless abrupt consolidation occurs.

---

### 2. Getting Abenomics Back on Track — Policy Recommendations

### Overview
- Under current policies, the high nominal growth goal, the inflation target, and the primary budget surplus objective all remain out of reach within authorities’ timeframes.
- Two strategic options:
  - Reload Abenomics with a comprehensive, coordinated package centered on income policies.
  - Reset targets and policies for a long haul if ambitious upgrade is absent.

### A. Reload package — core design and rationale
- Core design:
  - Place income policies at the fore to raise inflation, combined with further near-term demand stimulus via a temporary, modest fiscal expansion and further monetary easing.
- Rationale:
  - Coordinated demand support plus labor market reforms and removal of policy uncertainty create synergies; enshrine policies in stronger frameworks and high-impact structural reforms.

Subtheme — Invigorating wage-price dynamics (income policies and labor reforms)
- Income policy levers:
  - Replicate “comply or explain” approach from corporate governance reform to ensure profitable companies raise wages by at least three percent (the inflation target plus average productivity growth).
  - Back this by stronger tax incentives or penalties as last resort.
  - Commit to raising administratively controlled wages annually in line with the inflation target and ensure similar policies at the prefectural level.
  - Support measures: supplementary wage rounds in addition to the “Shunto” and conversion of bonuses to base pay.
- Fiscal note:
  - In FY 2014, about 78,000 enterprises used the tax incentives leading to foregone fiscal revenue equivalent to 0.05 percent of GDP.
- Labor market and corporate governance reforms:
  - Promote “intermediate” contracts; accelerate “equal-pay for equal work”; eliminate disincentives to full-time/regular work (e.g., spousal deduction and allowance); raise child-care availability; more ambitious outside director requirements; greater transparency of beneficial ownership; explicit limits on cross-shareholdings.

Subtheme — Coordinated demand support and monetary policy
- Fiscal recommendation:
  - Modest near-term fiscal expansion calibrated to accelerate closing of the output gap.
- Monetary recommendation:
  - Coordinated further monetary easing with all tools on the table: some overall increase in asset purchases; some shift to purchases of assets held outside the banking system; a modest further cut in deposit rates.
- Coordination:
  - Fiscal and monetary actions should be closely coordinated in timing, mix, and level of stimulus; deeper consultations through the Council on Economic and Fiscal Policy suggested.

Subtheme — Risks and constraints of income policies
- Risks:
  - Firms could increase hiring of non-regular workers; timing and coordination problems; insufficient compliance with “comply-or-explain”; perceptions policies can be reversed.
  - Potential adverse near-term impacts on competitiveness and profitability, especially for labor-intensive SMEs and export-oriented companies.
  - Political resistance to increasing public wages given ongoing fiscal consolidation.

### Achieving fiscal sustainability — recommendations
- Commit to gradual increase in consumption tax towards at least 15 percent, e.g., in increments of 0.5–1 percentage points over regular intervals.
- Operational guidance:
  - Determine precise path mindful of political buy-in; start increases as soon as possible and replace the currently planned 2019 hike with a pre-announced gradual path.
  - Maintain single rate structure as much as possible; address low-income households with targeted cash transfers.
- Fiscal arithmetic:
  - A steady consolidation by 0.5 percent of GDP per year through 2030 would be sufficient to put public debt-to-GDP on a downward path.
  - Additional measures: broaden tax base; contain nominal social security spending growth to 0.5 percent; implement other expenditure reforms.

### Complementary structural reforms
- Priorities:
  - Expand labor force: boost labor supply of women and older workers; allow more foreign labor.
  - Increase productivity: promote trade, FDI, and technology sharing (support TPP implementation); reduce barriers to entry in retail, professional services, and network industries; expedite SEZ deregulation.
  - Enable capital deepening: encourage securitization and private-equity funds; reduce government guarantees to SME lending; foster business succession.

### Strengthening fiscal and monetary frameworks
- Fiscal framework recommendations:
  - Avoid relying on optimistic growth assumptions for FY2020 primary surplus plan.
  - Adopt rules to curb expenditure (especially social security); limits on supplementary budgets; publish independent assessments.
  - Establish an independent fiscal institution (IFI) to prepare short- and medium-term macro-fiscal forecasts and monitor fiscal policymaking.
- Monetary policy credibility:
  - Improve communication and forward guidance, including publishing BoJ staff forecast.
  - BoJ could signal willingness to overshoot the inflation target and maintain a large balance sheet even once objectives are achieved.
  - Gradually phase out pre-specified time horizon for meeting the inflation target as expectations become better anchored.

### B. Reset option (if reload absent)
- Implies weaker nominal growth, higher and prolonged fiscal consolidation needs, and greater vulnerability to fiscal confidence/financial shocks.
- Fiscal consolidation under reset:
  - A drawn-out consolidation by about ¼ to ½ percent of GDP per year in structural terms would be needed.
- Monetary framework under reset:
  - BoJ should abandon a specific calendar date for achieving the inflation target; transition must be well communicated.

### C. Unorthodox policies: risks and trade-offs
- Examples: monetized fiscal expansion; sharp fiscal expansion with continued low interest rates; price level path target supported by exchange rate policy.
- Major risks:
  - Monetized fiscal expansion could provoke an inflation scare and spike in interest rates, worsening debt dynamics.
  - If interest premium does not decline under foolproof proposals, inflation may not converge and debt dynamics could worsen.
- Staff judgement:
  - Reload package offers better risk-return trade-off than more unconventional alternatives.

---

### 3. Fiscal Outlook, Debt Sustainability, and Key Numerical Indicators

### Fiscal outlook and baseline projections (selected items)
- Nominal GDP growth rate: 1.4 percent (implied).
- Primary deficit will decline to around 3 percent of GDP in 2021.
- Fiscal consolidation assumed in baseline: around 0.6 percent of GDP in 2017.
- Average fiscal multiplier for the baseline consolidation: 0.5.
- Japan’s gross financing need in 2015: 53 percent of GDP.
- Projected gross financing needs over the medium term: around 50 percent of GDP.
- Foreign holdings of JGBs: 11 percent.
- Financial-assets-to-GDP ratio assumed stable at around 120 percent.

### Debt dynamics — selected figures (nominal gross public debt, percent of GDP)
- 2014: 209.7
- 2015: 249.1
- 2016: 248.0
- 2017: 250.2
- 2018: 252.6
- 2019: 254.6
- 2020: 253.8
- 2021: 253.0

### Additional DSA table highlights
- Net public debt (percent of GDP): 2014: 104.3; 2015: 126.2; 2016: 128.0; 2017: 130.5; 2018: 133.0; 2019: 134.9; 2020: 134.1; 2021: 133.3.
- Real GDP growth (percent): 2014: 0.7; 2015: 0.0; 2016: 0.5; 2017: 0.5; 2018: 0.3; 2019: 0.5; 2020: 0.8; 2021: 0.1.
- Inflation (GDP deflator, percent): 2014: -1.2; 2015: 1.7; 2016: 2.0; 2017: 0.6; 2018: 0.4; 2019: 0.3; 2020: 0.9; 2021: 1.4.
- Effective interest rate (percent): 2014: 1.0; 2015: 0.8; 2016: 0.8; 2017: 0.6; 2018: 0.5; 2019: 0.5; 2020: 0.5; 2021: 0.5.
- Public gross financing needs (percent of GDP): 2014: 52.9; 2015: 52.6; 2016: 51.6; 2017: 50.9; 2018: 50.7; 2019: 50.0; 2020: 49.5; 2021: 48.4.

### Debt sustainability assessment — baseline and stress outcomes
- Overall assessment:
  - Japan’s public debt is unsustainable under current policies.
  - Complementary analysis up to 2030 shows gross debt-to-GDP reaching around 280 percent of GDP in 2030.
- Stress-test scenarios (selected outcomes):
  - Fan chart worst-quartile case: debt-to-GDP could reach around 265 percent of GDP in 2021.
  - Interest rate and contingent liability shock (largest impact): debt ratio increases to around 280 percent of GDP in 2021.
  - Growth shock: debt ratio above 260 percent of GDP in 2021, around 10 percentage points higher than baseline.

---

### 4. Financial Stability, JGB Market Liquidity, and Institutional Recommendations

### JGB market liquidity and measures
- BoJ purchases absorb more than new issuance, diminishing availability of JGBs for collateral and asset-liability management.
- Evidence of increased scarcity of JGBs in the cash market; liquidity appears to have declined after expansion of QQE and NIRP.
- Market liquidity moved into a mid-to-low liquidity state, suggesting large transactions may have more significant price impacts.
- Measures taken:
  - Allowing consecutive use of the Securities Lending Facility for a longer period.
  - Raising the upper limit on the amount of sales per issue in February 2016.
  - Regularly publishing bond market survey and liquidity indicators since 2015.
  - MoF plan to issue additional off-the-run JGBs with remaining maturity of 1–5 years in Auctions for Enhanced-Liquidity in FY2016.

### Financial institutions — risks and recommended focus
- Banks:
  - Flattening yield curve pressures net interest margins and profitability.
  - Nearly 15 percent of banks’ FX lending is funded by short-term market sources, exposing them to rollover risk.
  - Authorities should ensure sufficiently high liquidity coverage for significant foreign currencies if FX loans grow faster than FX deposits.
- Institutional investors:
  - Insurers and pension funds accelerated rebalancing toward riskier assets; surge in USD funding costs raises cost of hedges.
  - Yen appreciation reduced profits from international holdings.
- Regional banks:
  - Need regulatory reform (capital treatment and risk-weighted assets) and consolidation to improve profitability.
- Macroprudential framework:
  - Progress: establishment of a macroprudential office in the FSA; Council for Cooperation on Financial Stability; monthly MoF–FSA–BoJ staff meetings.
  - Further improvements: intensify cooperation, clarify roles of BoJ and FSA in MaPP tools.
- Correspondent banking relationships: no reduction observed but should be monitored.
- Supervisory stance: preference for supervisory dialogue over one-size-fits-all FX liquidity requirements; regional bank consolidation should be voluntary.

### External position, capital flows, and spillovers
- Current account:
  - 2014: 0.8 percent of GDP.
  - 2015: 3.3 percent of GDP.
  - 2016 projection: about 3.5 percent of GDP.
- Capital outflows:
  - Gross portfolio outflows more than doubled in 2015; most outflows to U.S. bonds and foreign equities.
  - Capital outflows expected to strengthen further amid ongoing NIRP and diverging monetary policies.
- Exchange rate intervention:
  - Should not be used to aim at a specific exchange rate level; reserved for disorderly market conditions and preferably coordinated internationally.

### Institutional recommendation
- Next Article IV consultation recommended on the standard 12-month cycle.
- Box 2 recommends creating an Independent Fiscal Institution (IFI) with functions including preparation of short- and medium-term macro-fiscal forecasts and assessment of debt sustainability.

---

### 5. BoJ Communication and Risk Assessment Highlights

### Strengthening BoJ communication (Box 3)
- Problems identified:
  - Persistence of low long-term inflation expectations and low policy predictability.
  - Pre-specified time horizon for meeting the target has, at times, undermined credibility.
- Recommendations:
  - Move away from a pre-specified time horizon for meeting the target.
  - Clarify which inflation measure drives policy decisions.
  - Publish BoJ staff baseline forecast with confidence bands and underlying policy assumptions.
  - Discuss alternative scenarios to clarify implications of shocks and forecast differences.

### Annex I — Risk Assessment Matrix (selected risks and responses)
- Successful reflation following comprehensive reforms:
  - Likelihood (Over next 1–3 years): Low.
  - Impact: High.
  - Policy response: BoJ should prepare a credible exit strategy.
- Protracted slower growth in Euro Area and Japan:
  - Likelihood: High.
  - Impact: Medium.
  - Policy response: Government should deploy additional measures on all policy fronts (including incomes policies).
- Bond market stress from a reassessment of sovereign risk:
  - Likelihood: Medium.
  - Impact: High.
  - Policy response: Strengthen fiscal framework; additional JGB purchases by BoJ; consider unorthodox measures if needed.
- Brexit and other external shocks:
  - Brexit-related tightening led to yen appreciation, equity declines, and USD funding stress; staff advised accelerating the reload package with modest fiscal impulse in 2017 and further monetary easing if needed.

---

*Source: IMF staff report excerpt: "1. Effectiveness and Limitations of the Negative Interest Rate Policy (NIRP) in Japan" (content unit _cr16267).*

### 1. Effectiveness and Limitations of the Negative Interest Rate Policy (NIRP) in Japan ____________ 24

### 1. Effectiveness and Limitations of the Negative Interest Rate Policy (NIRP) in Japan

### Abenomics: context and overall assessment
- Abenomics initially narrowed the output gap, reversed undue yen appreciation, eased financial conditions, boosted corporate profits, lifted actual and expected inflation into positive territory, improved corporate governance and boosted labor force participation.
- Three years after introduction, Abenomics needs a significant policy upgrade: inflation has lost forward momentum, public debt remains unsustainable, record corporate profits and rising employment have not generated sufficient base wage growth, and investment and consumption growth remain weak amid uncertainty.

### Recent economic developments and monetary context
- Growth and labor:
  - Economic growth slowed to 0.5 percent in 2015 due to weak private consumption.
  - Base wages rose by 0.4 percent in the spring wage negotiations, compared to 0.6 percent the previous year.
  - Employment growth concentrated in less productive service sectors; firms preferred to hold on to their workforce.
- Inflation:
  - Average headline inflation (excluding the consumption tax) declined from 1.2 percent in 2014 to 0.3 percent in 2015.
  - May 2016 numbers showed a 0.4 percent (y/y) decline in the price level.
  - BoJ core-core inflation (excluding fresh food and energy) reached 1.3 percent at end-2015, but fell to 0.9 percent thereafter.
  - Weakening inflation dynamics spilled over to medium and long-term inflation expectations.
- Financial conditions:
  - The nominal yield curve shifted down and flattened in H1 2016, with the 10-year benchmark JGB falling into negative territory.
  - Financial conditions remained accommodative but tightened recently due to falling stock prices and yen appreciation.
  - Domestic credit growth picked up in 2015 and the credit cycle continued to expand; NPL ratios declined further.
- Policy responses in H1 2016:
  - A 0.6 percent of GDP supplementary package was approved for FY2016.
  - The consumption tax hike was postponed; decisions combined additional stimulus with maintaining the FY2020 primary surplus target.

### NIRP: effectiveness and limitations (as observed to date)
- Observed effects:
  - The adoption of the Negative Interest Rate Policy (NIRP) reinforced the BoJ’s commitment to its inflation target and added another tool to the policy framework.
  - So far, the NIRP has been successful in lowering the entire yield curve.
  - NIRP has not adversely impacted market functioning beyond expected effects on JGB liquidity and bank profitability.
- Transmission and remaining uncertainties:
  - More time is needed to see the full transmission of NIRP to the real economy.
  - Tightened financial conditions from equity declines and yen appreciation pose challenges to monetary transmission.
  - Weakening inflation dynamics and falling inflation expectations limit the immediate potency of NIRP.

### Structural impediments and policy design challenges
- Structural issues:
  - An aging and shrinking population and low confidence in economic prospects are holding back investment and credit demand.
  - Labor market duality and inflexibility limit pass-through from tight labor market to wage increases.
  - Rising share of non-regular workers reduces average wages and bargaining power, hampering wage growth.
  - Financial sector does not sufficiently support risk-taking; high reliance on fixed asset collateral and slow SME restructuring.
- Policy design and credibility problems:
  - Stop-go fiscal policy, yearly supplementary budgets, discretionary changes in consumption tax timing, and optimistic growth assumptions undermine a credible medium-term fiscal anchor and increase policy uncertainty.
  - Weak monetary transmission, sluggish wage-price dynamics, and a falling natural rate of interest are preventing the needed rise in inflation expectations, creating communication and credibility challenges for the BoJ.

### Authorities’ views (as reported)
- Authorities acknowledged a slow change in the public’s deflationary mindset and structural impediments to growth.
- BoJ emphasized that QQE and NIRP significantly reduced real interest rates and encouraged more risk-taking by banks through portfolio rebalancing away from JGBs.
- Authorities highlighted that they had met their commitment to cut the primary deficit in half compared to the 2010 level while facilitating higher nominal growth through flexible fiscal policy implementation.
- Structural reforms and three consecutive years of base wage increases were cited as evidence of progress.

### Outlook and risks
- Growth projections:
  - Economy projected to grow 0.5 percent in 2016 (in line with potential) and slow to 0.3 percent in 2017, excluding possible effect of a yet-to-be-adopted supplementary budget.
- Sectoral outlook:
  - Consumption to grow modestly in 2016, supported by lower commodity prices, targeted fiscal transfers, and rising labor force participation.
  - Public spending and taxation to pose a drag on growth in 2017 due to withdrawal of past stimulus and waning reconstruction spending.
  - Net exports expected to be dampened by slow global recovery and yen appreciation.
  - Investment environment mixed: high profits, aging capital stock, and supportive credit conditions are favorable, but heightened uncertainty, sustained yen appreciation and shrinking domestic markets will curb demand.
- Demographics and income composition:
  - Rising ratio of retirees to workers has increased the share of non-wage income to total net disposable income, currently at 50 percent, making consumption less dependent on wage developments.
- Risk summary:
  - Continued weak inflation dynamics and policy uncertainty could stall transmission of monetary easing.
  - Achieving fiscal sustainability while supporting reflation remains challenging; postponing tax hikes and adding stimulus may affect medium-term fiscal targets unless abrupt consolidation occurs.

*Source: IMF staff report excerpt: "1. Effectiveness and Limitations of the Negative Interest Rate Policy (NIRP) in Japan" (content unit _cr16267).*

### 13. Inflation will remain well below the BoJ’s inflation target. Average headline inflation is

### _cr16267 - 13. Inflation will remain well below the BoJ’s inflation target. Average headline inflation is

### Inflation outlook
- Average headline inflation is projected to remain at around 0.2 percent in 2016, reflecting drag from low energy prices, the recent yen appreciation, lower inflation expectations, and weakness in demand.
- Over time, inflation will gradually rise, supported by energy price developments and slowly building wage-price pressures, but with adaptive expectations progress will remain slow.
- The BoJ was confident that inflation could still reach its target in FY 2017 conditional on inflation expectations becoming more forward-looking and rising towards the target during their timeframe.

### Near-term and medium-term risks
- Overall assessment: Risks to the near-term outlook are tilted to the upside from likely additional fiscal demand support, but downside dominates in the medium term.
- Domestic risks:
  - Upside: likely adoption of a substantial supplementary budget for 2017.
  - Downside: incomplete policies may lead to further appreciation of the yen, triggering renewed deflation risks.
- External risks:
  - A sharper-than-expected moderation of growth in China and/or weaker growth in advanced economies – including due to the outcome of the Brexit referendum – could lead to global financial turbulence causing safe-haven yen appreciation, potentially derailing the recovery.
- Financial stability risks:
  - Structural decline in JGB market liquidity could trigger higher volatility in government bond yields.
  - Risk exposures from equity price volatility and rapid expansion of overseas loans could impact financial stability, particularly given global financial volatility and rising USD funding costs.

### Macro-financial linkages and shock amplification
- Core risk nexus: sustainability of low risk premiums in a high public debt environment and a stable financial system amid unprecedented unconventional monetary policies.
- Main amplification channel: loss of fiscal confidence → higher sovereign risk premiums → abrupt fiscal adjustment → adverse feedback loops to financial system and real economy.
- Tail risk: financial imbalances triggering a sovereign backstop with adverse feedback loops.

### Policy buffers and contingent responses
- First line of defense: coordinated fiscal and monetary response to downside growth shocks.
- Fiscal response contingent on sovereign risk premium behavior and impact on financial stability.
- Substantial downward shocks or failure to make progress toward fiscal sustainability could exhaust conventional buffers.

### Authorities’ views
- Authorities confident growth will pick up and the BoJ confident inflation could reach target in FY 2017.
- Government expects modest recovery as investment picks up and employment and income improve; noted decision to postpone the consumption tax and introduce an economic stimulus package.
- Authorities maintain medium-term growth target of 2 percent underlying fiscal consolidation plan and plan to update medium-to long-term projections in summer.
- Authorities broadly agreed with staff’s risk assessment but highlighted external factors as dominant.

### Getting Abenomics back on track — overview
- Under current policies, the high nominal growth goal, the inflation target, and the primary budget surplus objective all remain out of reach within the timeframe set by the authorities.
- A comprehensive and coordinated policy upgrade centered on income policies would significantly increase chances of achieving Abenomics’ targets.
- In absence of such a reload, targets and policy frameworks would need a reset to be consistent with a protracted adjustment process.
- More unorthodox policy packages could pay dividends but entail unacceptable risks at the current juncture.

### A. Reloading Abenomics: Comprehensive and coordinated policy package
- Core design: place income policies at the fore to raise inflation, combined with further demand stimulus near-term via a temporary, modest fiscal expansion and further monetary easing.
- Key rationale: coordinated demand support plus labor market reforms and removal of policy uncertainty create synergies; enshrine policies in stronger frameworks and high-impact structural reforms to raise growth and address demographic headwinds.

Subtheme — Invigorating wage-price dynamics
- Sustained nominal wage increases can trigger positive wage-price dynamics and raise inflation expectations.
- Constraints: deflationary mindset, secular decline in bargaining power of labor, rising share of non-regular workers with lower wages.
- Policy levers:
  - Income policies:
    - Replicate “comply or explain” approach from corporate governance reform to ensure profitable companies raise wages by at least three percent (the inflation target plus average productivity growth).
    - Back this up by stronger tax incentives or penalties as last resort.
    - Commit to raising administratively controlled wages annually in line with the inflation target and ensure similar policies at the prefectural level.
    - Support measures: supplementary wage rounds in addition to the “Shunto” and conversion of bonuses to base pay.
  - Note: In FY 2014, about 78,000 enterprises made use of the tax incentives leading to foregone fiscal revenue equivalent to 0.05 percent of GDP. Applying the incentive to base wages and increasing the amount would raise the effectiveness of the measure.
  - Labor market and corporate governance reforms:
    - Promote “intermediate” contracts balancing job security and wage increases, clarify legal framework, and provide subsidies for converting non-regular workers to such contracts.
    - Accelerate “equal-pay for equal work” program to close wage gap between regular and non-regular workers.
    - Eliminate disincentives to full-time or regular work due to tax and social security system (e.g., spousal deduction and allowance).
    - Raise availability of child-care facilities through deregulation.
    - Further corporate governance reforms: more ambitious requirements for outside directors, greater transparency of beneficial ownership, explicit limits on cross-shareholdings to encourage use of cash reserves for wages, dividends, and investment.

Subtheme — Coordinated demand support and monetary policy
- Need for sustained, balanced, coordinated demand support to ensure pass-through of higher wages to prices.
- Fiscal recommendation: modest near-term fiscal expansion calibrated to accelerate closing of the output gap.
- Monetary recommendation: coordinated further monetary easing with all tools on the table:
  - Some overall increase in asset purchases.
  - Some shift to purchases of assets held outside the banking system.
  - A modest further cut in deposit rates.
- Fiscal and monetary actions should be closely coordinated in timing, mix, and level of stimulus.
- Deeper consultations between Government and BoJ through the Council on Economic and Fiscal Policy are suggested.

Subtheme — Risks and constraints of income policies
- Risks: firms could increase hiring of non-regular workers, timing and coordination problems, insufficient compliance with “comply-or-explain”, perceptions policies can be reversed.
- Potential adverse near-term impacts on competitiveness and profitability, especially for labor-intensive SMEs and export-oriented companies.
- Political resistance likely to increasing public wages given ongoing fiscal consolidation.

### Achieving fiscal sustainability
- Need to chart credible fiscal consolidation course now, including pre-announced path of gradual consumption tax hikes.
- Recommendation: commit to gradual increase in consumption tax towards at least 15 percent, e.g., in increments of 0.5–1 percentage points over regular intervals.
- Operational guidance:
  - Determine precise path mindful of political buy-in, compliance costs, and administrative burden.
  - Start increases as soon as possible and replace the currently planned 2019 hike with such a pre-announced, gradual path.
  - Maintain single rate structure as much as possible and address impact on low income households with targeted cash transfers.
- Fiscal arithmetic:
  - A steady fiscal consolidation by 0.5 percent of GDP per year through 2030 would be sufficient to put the public debt-to-GDP ratio on a downward path.
  - Additional measures: broaden tax base, contain nominal social security spending growth to 0.5 percent, implement other expenditure reforms to balance revenue and expenditure sides.

### Complementary structural reforms to lift potential growth
- Structural reforms are the only viable option to significantly raise growth prospects and improve income policy success.
- Priorities:
  - Expand the labor force: boost labor supply of women and older workers and allow more foreign labor.
  - Increase productivity:
    - Promote trade, FDI, and technology sharing (support full implementation and possible expansion of TPP and proceed with other trade and bilateral investment agreements).
    - Reduce barriers to entry in retail trade, professional services, and segments of network industries.
    - Expedite deregulation in Special Economic Zones (SEZs) and roll out nationwide reforms.
  - Enable capital deepening:
    - Encourage securitization and private-equity funds.
    - Reduce government guarantees to SME lending to promote restructuring and exit of nonviable firms.
    - Foster business succession.

### Strengthening fiscal and monetary frameworks
- Fiscal framework:
  - Authorities’ medium-term consolidation plan of achieving primary surplus by FY2020 should avoid relying on optimistic growth assumptions.
  - Current revitalization scenario expects more than 2 percent real and 3 percent nominal annual GDP growth over the medium-term on average; baseline anticipates a primary deficit of more than 2 percent of GDP in FY2020.
  - Recommend adopting rules to curb expenditure (especially social security), limits on use of supplementary budgets, and publication of more independent assessments of outlook and budget projections.
  - An independent fiscal institution (IFI) could prepare short and medium-term macro-fiscal forecasts and provide real time monitoring of fiscal policymaking.
- Monetary policy credibility:
  - Improve communication and forward guidance, including publishing the BoJ staff forecast.
  - BoJ could provide stronger forward guidance by communicating willingness to overshoot the inflation target and maintain a large balance sheet even once objectives are achieved.
  - Gradually phase out pre-specified time horizon for meeting the inflation target as expectations become better anchored.

### B. Resetting targets and policies to prepare for the long haul
- If ambitious policy shift is absent, push out timeframes for achieving targets and reset policies for steady gradual progress while building risk resilience.
- Reset option implies weaker nominal growth, higher and prolonged fiscal consolidation needs, and greater vulnerability to fiscal confidence and financial stability shocks.
- Policy space will be very limited and should be used sparingly; fiscal stance broadly neutral in near term.
- Monetary policy would need to be reset for the long haul, carefully balancing easing benefits with risks to medium-term financial stability (JGB liquidity, bank profitability, disintermediation, market functioning, limits to JGB purchases and negative rates).
- Fiscal consolidation under reset:
  - A drawn-out consolidation by about ¼ to ½ percent of GDP per year in structural terms would be needed to turn debt dynamics around.
- Monetary framework under reset:
  - BoJ should abandon a specific calendar date for achieving the inflation target; transition must be well communicated to avoid perceptions of reduced commitment.

### C. Unorthodox policies: risks and trade-offs
- Unorthodox options often discussed: monetized fiscal expansion, sharp fiscal expansion with continued low interest rates, price level path target supported by complementary exchange rate policy (Svensson’s “foolproof” proposal).
- Potential benefits: rapid reflation, help reduce government debt.
- Major risks:
  - If fiscal expansion raises the term premium, government debt dynamics could worsen.
  - Under the foolproof proposal, if interest premium does not decline, policy would rely mainly on expenditure switching; inflation may not converge to target and output gains could be temporary, worsening debt dynamics relative to the reload package.
- Staff judgement: reload package offers better risk-return trade-off than the more unconventional alternatives; relying on a broad set of coordinated instruments is preferable from a risk-management perspective.

*Source: IMF staff analysis and recommendations as presented in the provided chapter.*

### 30. Likewise, risks from the oft-discussed monetized fiscal expansion likely outweigh

### _cr16267 - 30. Likewise, risks from the oft-discussed monetized fiscal expansion likely outweigh

### Risks from monetized fiscal expansion
- Monetized fiscal expansion is likely to increase inflation expectations and nominal GDP, thus reducing public debt, but poses a major tail risk of an inflation scare leading to a spike in interest rates.
- The commitment to not resort again to monetary financing may not be credible in an environment of elevated deficits and high debt, potentially producing fiscal dominance.
- The impact on Japan’s prosperity and the global economy (given the role of the yen and JGBs in international markets and Japan’s large NFA position) of such a tail risk scenario would be so severe that a risk-return calculus would favor the reload package.

### Authorities’ views on policy frameworks and fiscal targets
- Current policy frameworks are judged by the authorities to be broadly appropriate; the delay of the consumption tax and planned comprehensive economic policies aim to accelerate Abenomics in a coordinated manner to achieve promised targets.
- Income and wage policies: public sector wages are set based on private sector developments; income policies are incorporated via tripartite negotiations, increase in minimum wage growth, and tax incentives to firms that raise wages.
- Consumption tax design: authorities recognize the need to consider economic impact and compliance/administrative costs of gradual consumption tax increases.
- Institutional assessments: authorities recognize need for more independent assessments of economic and fiscal developments, preferring to strengthen existing institutions.
- Bank of Japan (BoJ) communication: the BoJ maintained that mentioning timing for reaching its inflation target as a collective forecast of the policy board is useful for communication; removing it was not needed given its forecast and credibility efforts. The BoJ may revisit the communication framework if it judges it would take a considerably longer time to achieve two percent inflation. More extreme unconventional policies, including various forms of monetization, are seen by the BoJ as too risky and, to varying degrees, not feasible within Japan’s current legal and institutional set up.
- Fiscal consolidation commitment: authorities remain determined to achieve the FY2020 primary surplus target and view it as realistic under the current fiscal consolidation plan calling for accelerated structural reforms combined with expenditure reforms.
  - The government will make efforts to enhance efficiency and promote institutional reforms, under the benchmark of levels equivalent to the sum of the expected increase due to population aging (approximately 1.5 trillion yen in 3 years) until FY2018.
  - The delay of the consumption tax should have only a modest impact on the achievement of the fiscal consolidation target in FY2020 as its primary impact is to shift the revenue increases from FY2017 to FY2019.
- Structural reform priorities cited by authorities: improving involuntary non-regular to regular worker transitions; considering equal-pay for equal-work; removing disincentives in tax and social security to full time work for spouses; inviting foreign professionals (including a possible Japanese-version green card for highly skilled foreign professionals); focusing on product and regulatory reform and deregulation in the services sector; considering changes to the credit guarantee scheme.

### Safeguarding financial stability — systemic assessment
- Preservation of financial stability remains essential given prolonged unconventional monetary policy, low growth, and demographic trends.
- Financial system condition: overall sound and resilient, with good capitalization and a declining NPL ratio.
- Short-to-medium term containment: systemic risks from unsustainable public finances are currently contained by strong domestic demand for JGBs and BoJ quantitative easing, which keep sovereign funding cost and refinancing risks to a minimum.
- Medium-term vulnerabilities if reflation fails: absence of progress toward fiscal sustainability could create increasing vulnerabilities from low nominal growth, low profitability, and possible reemergence of risk premia; prolonged unconventional monetary policies could engender financial stability risks.
- Financial sector adaptability: the financial system could help reduce downside risk likelihood and support growth by adapting business models, consolidation, and improving risk management to support more risk-taking by SMEs.

### JGB market liquidity and related measures
- BoJ purchases absorb more than new issuance, diminishing availability of JGBs for collateral and asset-liability management.
- Evidence of increased scarcity of JGBs in the cash market; JGB market liquidity appears to have declined after the expansion of QQE and the introduction of NIRP.
- Market liquidity has become less resilient: probability that the market has moved into a mid-to-low liquidity state has increased sharply, suggesting large transactions may have more significant price impacts than before.
- Increased foreign participation may expose JGB and funding markets to higher volatility.
- Suggested further authorities’ actions: strengthen monitoring by regularly assessing the impact of developments in inventories of primary dealers on their market-making activities.
- Recent measures to enhance liquidity include:
  - allowing for consecutive use of the Securities Lending Facility for a longer period;
  - raising the upper limit on the amount of sales per issue in February 2016;
  - regularly publishing the bond market survey and liquidity indicators in the JGB markets since 2015;
  - the MoF’s plan to issue additional off-the-run JGBs with remaining maturity of 1–5 years in the Auctions for Enhanced-Liquidity in FY2016.

### Financial institutions — risks and recommended focus
- Banks:
  - Flattening of the yield curve pressures net interest margins and profitability, especially for regional banks reliant on domestic activity.
  - Sharp rise in USD funding cost since last year increased FX funding pressure, as nearly 15 percent of banks’ FX lending is funded by short-term market sources, exposing them to rollover risk.
  - Authorities have encouraged banks to secure stable deposit bases in major foreign currencies and should ensure sufficiently high liquidity coverage for significant foreign currencies if FX loans grow faster than FX deposits.
  - Market risk from equity holdings has increased due to higher volatility.
- Institutional investors:
  - Insurers and pension funds have accelerated rebalancing toward riskier assets (foreign bonds and equity).
  - Most principal is hedged against FX risk, but interest and dividend income remain largely exposed.
  - Surging USD funding costs raise the cost of hedges with shorter maturities than underlying assets; some life insurers appear to have increased purchases of unhedged foreign bonds, raising FX risk concerns.
  - Yen appreciation has significantly reduced profits from international holdings.
- Regional banks:
  - Require bolstering resilience through regulatory reforms: reform regulation of regional banks including required level of capital and calculation of risk-weighted assets while enhancing elements of core capital.
  - Consolidation could improve profitability but has been slow.
- Macroprudential framework:
  - Authorities have made significant progress: establishing a macroprudential office in the FSA; launching the Council for Cooperation on Financial Stability between the FSA and the BOJ at management level; holding monthly MoF–FSA–BoJ staff meetings for information sharing.
  - Further improvements: intensify cooperation via enhanced sharing of systemic risk assessments and supervisory findings; ensure clarity of respective roles of BoJ and FSA in managing MaPP tools.
  - The upcoming FY2017 FSAP will make a detailed assessment.
- Correspondent banking relationships (CBRs): no reduction in CBRs has been observed, but the situation should be monitored.
- Authorities’ supervisory stance: preference for supervisory dialogues to enhance banks’ risk management rather than one-size-fits-all FX liquidity requirements; regional bank consolidation should be voluntary managerial decisions; FSA acknowledges progress in MaPP and need for continued inter-agency information sharing.

### External position, capital flows, and spillovers
- Current account developments:
  - 2014 current account: 0.8 percent of GDP.
  - 2015 current account: 3.3 percent of GDP (increase driven by declining oil prices, weaker currency, higher travel service receipts, and a high income balance).
  - 2016 projection: about 3.5 percent of GDP reflecting lower oil prices.
- Capital outflows:
  - Gross portfolio outflows more than doubled in 2015, while FDI flows remained relatively stable.
  - Most portfolio outflows were channeled to U.S. bonds and foreign equities; outflows to emerging markets remained very low and concentrated in the region.
  - Capital outflows are expected to strengthen further amid ongoing NIRP and diverging monetary policies in other advanced economies, with restrained effects from weaker EM outlook and higher USD funding costs.
- Japan’s safe-haven role: Japan has absorbed global shocks during risk aversion episodes as the yen tends to appreciate, offsetting declines in global demand; QQE policies have had modest positive spillovers on emerging Asian economies.
- Policy guidance: strengthening domestic policies is important to mitigate inward spillovers and secure external balance over the medium term. Without bolder structural reforms and credible fiscal consolidation, domestic demand could remain sluggish and further monetary easing could lead to overreliance on yen depreciation.
- Exchange rate intervention: should not be used as a policy tool to aim at a specific exchange rate level; reserved for responding to disorderly market conditions and preferably coordinated with international partners.

### Staff appraisal and outlook
- Growth and inflation outlook: subdued with downside risks dominating in the medium-term.
- Key drivers of subdued outlook: sluggish domestic consumption and investment despite a tight labor market; weakness of the global recovery; yen appreciation; adverse demographics.
- Inflation: will remain subdued amid modest wage growth, rising gradually over the medium term but remaining below the BoJ’s inflation target.
- Policy response: authorities have provided additional monetary and fiscal support and plan additional structural reform.

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

### 49. Following initial success, achieving Abenomics’ ambitious targets now requires a

### _cr16267 - 49. Following initial success, achieving Abenomics’ ambitious targets now requires a

### Policy reload: income, labor, and coordinated demand support
- Income policies and labor market reforms are a priority to generate wage-price pressures and lift nominal growth.
- Companies should be induced to increase base wages while administratively controlled wages should be raised in line with the inflation target.
- Labor market contracts that better balance job security and wage growth should be promoted and disincentives to work full time abolished.
- Coordinated fiscal and monetary demand support will be crucial to facilitate the pass-through of higher wages to prices and the implementation of structural reforms.

### Fiscal consolidation: timing and design
- A credible fiscal consolidation course needs to be charted now, including a pre-announced path of gradual consumption tax hikes.
- Together with social security reform, a gradual but sustained increase in the consumption tax would:
  - address the looming fiscal sustainability problem,
  - reduce policy uncertainty,
  - create policy space.
- A gradual and steady approach is essential to better balance support for growth and progress toward fiscal sustainability.

### Structural reforms and policy frameworks
- Structural reforms and strong policy frameworks are needed to:
  - raise productivity,
  - address the demographic overhang,
  - enhance policy credibility.
- Structural reform priorities:
  - boost domestic labor supply,
  - enhance the financial sector’s role in promoting new growth areas,
  - fully implement trade and bilateral investment agreements.
- Fiscal institutions and credibility:
  - Stronger fiscal institutions, including an independent assessment of the outlook and budget projections, should lend credibility to fiscal policy and help curb expenditure.
- Monetary policy credibility:
  - Clearer communication and better use of forward guidance by the BoJ could strengthen monetary policy credibility and raise inflation expectations.

### Downside scenario if policy upgrade is delayed
- In the absence of a clear policy upgrade, policies will need to be reset for a prolonged adjustment.
- Consequences include:
  - required fiscal consolidation would be larger and take place over a longer time horizon,
  - greater vulnerability to fiscal confidence and financial shocks,
  - the BoJ would have to abandon its pre-specified time horizon for meeting the inflation target and maintain loose financial conditions for an extended period,
  - requiring a careful balancing between benefits of further easing and the costs to medium-term financial stability.

### Financial stability risks
- Financial stability risks could emerge from prolonged unconventional monetary policies or the failure to achieve reflation and fiscal sustainability.
- Current conditions and concerns:
  - The financial sector remains stable overall.
  - JGB market liquidity appears to have fallen.
  - Financial institutions face declining profitability and elevated market and FX risks due to increased risk-taking.
- Recommended safeguarding measures:
  - enhance the monitoring process of JGB market liquidity,
  - strengthen the MaPP framework.

### External balance and spillovers
- Strengthening domestic policies would help mitigate inward spillovers and secure external balance over the medium term.
- Assessment notes:
  - While the 2015 external position was moderately stronger than the level consistent with medium-term fundamentals and desired policies, the appreciation of the yen since the beginning of 2016 has moved it toward a level broadly consistent with medium-term fundamentals and may undermine Japan’s efforts to lower deflation risks.

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

### Box 1 — Effectiveness and limitations of the Negative Interest Rate Policy (NIRP) in Japan
- Policy design and intent:
  - On January 29, the BoJ complemented its QQE program by announcing a negative interest rate on financial institutions’ excess reserves held at the Bank.
  - Intentions were to (i) put downward pressure on short-term interest rates while reinforcing QQE’s effect on the entire yield curve, and (ii) raise inflation expectations by dispelling concerns that QQE had reached its limit and reconfirming the Bank’s commitment to its inflation target.
  - To mitigate direct impact on earnings of financial institutions – with excess reserves of more than 50 percent of GDP and more than 25 percent of total bank assets – the BoJ introduced a three-tiered reserve deposit system where only the top tier receives a negative interest rate of -0.1 percent (currently accounting for 10 percent of total reserves).
- Immediate effects:
  - The NIRP helped lower market rates and accelerate portfolio rebalancing.
  - The yield curve shifted down and flattened, with the 10-year benchmark yield falling below zero.
  - The interbank funding rate (3-month TIBOR) fell from 17 bps at the beginning of the year to 6 bps.
  - Lending and deposit rates have also fallen, with heterogeneous impact across banks.
  - Financial institutions accelerated portfolio rebalancing; corporate debt issuance picked up, especially in long maturities.
- Limits and open questions:
  - It is too early to assess NIRP’s full impact on the economy; second-round effects on credit demand and economic activity have yet to be fully observed.
  - Higher asset prices and inflation expectation gains were overshadowed by lower stock prices amid yen appreciation, a slowing recovery, and doubts about BoJ’s ability to reach its inflation target.
- Market functioning and profitability concerns:
  - As money market rates dropped into negative territory, transactions and amounts outstanding declined.
  - Investment trusts and money market funds reduced lending due to difficulties managing assets with a negative rate.
  - Practical difficulties in trading at negative rates highlighted the need to upgrade IT systems.
  - Measures constructed from transaction data point to a decline in market liquidity in both futures and cash JGB markets after NIRP.
- Bank profitability and offset needs:
  - While bank profitability is likely to be further squeezed under NIRP, the three-tier system offsets the direct impact to a large extent.
  - Staff estimates: to completely offset the decline in net interest income, domestic loans need to grow at an annual rate of about 4 percent, which is higher than similar measures for most euro area economies, and above the 3 percent average growth rate since the introduction of QQE in April 2013.
  - Major banks could partly offset losses by raising fee income or cutting operational costs; regional banks’ room may be limited due to high competition.
- Key limitations that may reduce NIRP effectiveness:
  - weak credit demand and already very low interest rates and inflation expectations limit prospective stimulus from lower interest rates;
  - Japanese banks’ higher dependence on customer deposits may make it harder to pass through NIRP to lending rates (customer deposits account for over 70 percent of banks’ total liabilities in Japan but only 40 percent in euro area);
  - declining bank profitability could impair credit intermediation, especially for regional banks;
  - the three-tiered system limits direct profitability impacts but does not encourage movement of existing excess reserves into riskier investments, muting the policy impulse;
  - the feasible lower bound and duration of NIRP are constrained by individual and corporate willingness to store cash, which depends on storage, transportation, convenience, and insurance costs.
- Policy conclusion:
  - There is a danger that widespread skepticism about NIRP efficacy could by itself limit effectiveness by preventing inflation expectations from rising; monetary easing must be complemented by other policies and reforms.
- Prepared by Fei Han (MCM) and Niklas Westelius (APD).

### Box 2 — Reforming Japan’s fiscal framework: merits of an Independent Fiscal Council (IFI)
- Rationale:
  - Benefits to improving Japan’s fiscal policy framework include greater credibility and transparency.
  - Japan’s fiscal policy has been mostly discretionary, reflecting political cycles and reactions to shocks, leading to policy uncertainty and unanchored fiscal expectations.
  - Examples of past frameworks and suspensions highlight lack of durability; mid-year supplementary budgets have been frequent—at least one every year and 41 since 1990.
- Role and functions of an IFI:
  - An IFI could provide real-time forward-looking surveillance of fiscal policymaking, assess debt sustainability and risk, and improve the quality and transparency of fiscal policy.
  - Suggested functions: preparation of short- and medium-term macro-fiscal forecasts; analysis of the government’s fiscal policy stance as reflected in the budget bill; oversight of compliance with the government’s own medium-term fiscal goals; assessment of public debt sustainability on the basis of long-term quantitative scenarios, possibly adjusted for risk.
  - The government would be required to respond to reports produced by the IFI.
- Design considerations:
  - Statutory basis: created through informed debate and legislation with broad political consensus; enjoy de facto independence; coverage may need extension beyond the national government.
  - Structure: individual head or collective leadership, with assessments based on impartial, expert opinion.
- Current advisory bodies:
  - Japan already has the Fiscal System Council (FSC) and the Council on Economic and Fiscal Policy, but neither meets the main attributes enumerated in the OECD Principles for IFIs (ownership; independence and non-partisanship; mandate; resources; relationship with the legislature; access to information; transparency; communication; and external evaluation).
- Prepared by George Kopits (Consultant).

*Source: IMF staff report contained in the provided chapter excerpt.*

### Box 3. Strengthening the Bank of Japan’s Communication Framework

### Box 3. Strengthening the Bank of Japan’s Communication Framework

### Role of BoJ communication
- Effective BoJ communication, followed by consistent policy action, is essential to defeat Japan’s deflationary mindset.
- Policy predictability and credibility are crucial for the central bank to impact long-term interest rates, anchor inflation expectations, and reduce excessive asset price volatility.
- Achieving these objectives requires the public to have a good understanding of the policy setting process and underlying assumptions.
- For the BoJ, communication is likely to play a particularly important role because (i) with the policy rate close to the effective lower bound, guidance about future policy actions is vital; and (ii) the BoJ faces the formidable challenge of anchoring inflation expectations at a level well above those observed during the past two decades.

### Background: transparency advances and measures
- The adoption of an explicit inflation target in January 2013 constituted a major advance in transparency.
- In April 2013 the BoJ introduced QQE and a pre-specified time-dependent guidance of achieving the target “at the earliest possible time within a time horizon of about two years,” and “to continue with QQE until 2 percent inflation has been achieved in a stable manner.”
- The initial impact of the regime change was a boost to policy credibility and a rise in inflation expectations.
- The BoJ took further measures to improve its transparency and accountability framework late in 2015, including issuing a quarterly report discussing the baseline outlook and associated upside and downside risks, providing board members’ point estimates for inflation and GDP growth, and disseminating minutes and summary opinions from Monetary Policy Meetings.

### Problem: persistence of low long-term inflation expectations and policy predictability
- However, three years have now past and long-term inflation expectations remain below the 2 percent target.
- Financial markets have been caught off guard repeatedly—when the BoJ adopted new easing measures or made technical changes to its framework and when policy stayed passive despite a deteriorating inflation outlook—indicating a low degree of policy predictability that at times has created uncertainty about the BoJ’s commitment.

### Recommendations to reduce policy uncertainty and impact inflation expectations
- Move away from a pre-specified time horizon for meeting the target.
  - Rationale: This is particularly important in the absence of a coordinated and comprehensive reload of policies. While the time-dependent guidance was intended to demonstrate the BoJ’s strong commitment to reflate the economy, the opposite may have been achieved given the large and persistent gap between BoJ and market forecasts for inflation and the fact that monetary policy has, at times, remained passive in the face of large adverse shocks. Repeatedly pushing out the time horizon for hitting the target has undermined policy credibility.
- Clarify which inflation measure drives policy decisions.
  - Rationale: While the BoJ’s explicit inflation target is defined in terms of headline inflation, board members and staff projections are specified in terms of a core measure that excludes fresh food prices. Declining oil prices induced the BoJ to develop a third measure labeled core-core inflation, excluding both energy prices and fresh food, to flag underlying price pressures. To avoid volatile components such as energy prices from triggering changes in policy expectations or de-anchoring long-term inflation expectations it is important that the BoJ clearly states which measure drives policy.
- Publish the BoJ staff baseline forecast with confidence bands together with underlying policy assumptions.
  - Benefits: (i) enable the Bank to present its detailed near-term outlook without a false sense of precision; (ii) improve the public’s understanding of the relationship between policy instruments and the outlook; and (iii) provide a useful reference point for Board members to discuss dissenting views.
- Discuss alternative scenarios.
  - Benefits: This would clarify implications of selected shocks, or of basic differences in forecast assumptions that may exist among policymakers. It would generate a better understanding of the BoJ’s approach to managing the macroeconomic risks, and thus help improve policy predictability. It also would reinforce that the baseline forecast is conditional.

*Prepared by Dennis Botman (APD) and Niklas Westelius (APD).*

### Annex I. Risk Assessment Matrix

### Annex I. Risk Assessment Matrix

### Key Risks, Likelihood, Impact, and Policy Responses
- Successful reflation following comprehensive reforms  
  - Likelihood (Over next 1–3 years): Low  
  - Impact: High. Credible policy frameworks with incomes policies and short-term demand stimulus would quickly raise inflation and growth and restore confidence in fiscal sustainability and medium-term growth prospects.  
  - Policy response: The BoJ should prepare a credible exit strategy.

- Persistently low energy prices  
  - Likelihood (Over next 1–3 years): Medium  
  - Impact: Low. As a net oil importer (windfall gain of 1.6 percent of 2015 GDP), Japan will benefit from higher real incomes of consumers and lower production costs, but actual and expected inflation would fall further reducing wage growth.  
  - Policy response: The BoJ should ease further to prevent second-round effects, including on wage bargaining, and strengthen its communication framework by clarifying the indicators used to assess whether inflation is on track.

- Protracted period of slower growth in Euro Area and Japan  
  - Likelihood (Over next 1–3 years): High  
  - Impact: Medium. The output gap would widen and growth potential could be adversely affected complicating efforts to restore public debt sustainability.  
  - Policy response: Despite limited policy space, the government should deploy additional measures on all policy fronts (including incomes policies) in order to restore growth and inflation momentum and maintain confidence in Abenomics.

- Bond market stress from a reassessment of sovereign risk in Japan  
  - Likelihood (Over next 1–3 years): Medium  
  - Impact: High. Staff’s DSA analysis shows that an increase in the sovereign risk premium would worsen public debt dynamics gradually as the average maturity is about 7 years. But such a shock could cause distress in the financial sector with possible knock-on effects on debt.  
  - Policy response: Fiscal policy will have to become more contractionary and the fiscal framework needs to be strengthened, which together with additional JGB purchases by the BoJ should contain the immediate rise in bond yields. Unorthodox policy measures need to be considered to support growth and inflation momentum.

- Sharp growth slowdown and financial risks in China over the medium term  
  - Likelihood (Over next 1–3 years): Medium  
  - Impact: High. The recovery of exports would stall not only due to close trade links with China but also because of safe-haven appreciation causing a sharp correction in the stock market and sentiment.  
  - Policy response: If the authorities commit to a credible fiscal consolidation plan by passing concrete measures, the near-term fiscal withdrawal could be made more gradual. Ambitious structural reforms are important to boost domestic demand. Unorthodox options to reflate the economy need to be considered.

- Uncertainty related to Brexit  
  - Likelihood (Over next 1–3 years): High  
  - Impact: Low. The recovery of exports would stall and safe-haven appreciation would cause a correction in the stock market and sentiment.  
  - Policy response: Fiscal and monetary policy space should be deployed if elevated uncertainty starts to pose deflationary risks.

- A severe earthquake hits Japan  
  - Likelihood (Over next 1–3 years): Medium  
  - Impact: High. Growth and confidence would decline, together with safe-haven appreciation, and equity price adjustments could hamper domestic demand. Firms may increase production offshoring. Fiscal position could deteriorate significantly, increasing future adjustment needs and the risk of a jump in the risk premium.  
  - Policy response: Despite limited policy space, the government should deploy additional fiscal and monetary stimulus to restore growth and inflation momentum and maintain confidence. Fiscal expansion should be deployed together with a credible medium-term fiscal strategy and structural reforms should be accelerated to raise potential growth and increase confidence in the medium-term prospects.

### Notes on RAM presentation
- The relative likelihood categories: “low” = probability below 10 percent; “medium” = probability between 10 and 30 percent; “high” = probability of 30 percent or more.
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

### Japan Overall Assessment — External Position
- NIIP and trajectory  
  - Background: The net international investment position (NIIP) has doubled in the last ten years to close to 70 percent of GDP in 2015 (assets: 190 percent; liabilities: 122 percent). In the medium term it is projected to rise close to 75 percent with higher current account (CA) surpluses, before gradually stabilizing due to population aging.  
  - Assessment: Vulnerabilities are limited (equity and direct investment comprise a rising share of liabilities, now at 35 percent of total). The NIIP generates net annual investment income at around 4 percent of GDP, keeping the current account balance positive amid a narrowing trade surplus.

- Overall external position assessment  
  - The 2015 external position was moderately stronger than the level consistent with medium-term fundamentals and desirable policies.  
  - Japan’s external position strengthened moderately relative to 2014, reflecting the reduction in its oil import bill, the REER depreciation, and some pickup in exports. The REER appreciation compared to the average of 2015 has moved the REER towards a level consistent with medium-term fundamentals while it may undermine the effort to lower deflation risks.  
  - Going forward, continued easing by the BoJ while the US tightens, combined with the lack of bolder structural reforms and the absence of a credible and specific medium-term fiscal consolidation plan, could further strengthen the external position.

- Potential policy responses  
  - A more forceful and coordinated policy package is needed to raise growth and inflation, including: measures to boost wages and labor supply; reduce labor market duality; enhance risk capital provision; and accelerate agricultural and services sector deregulation.  
  - Fiscal consolidation should proceed in a gradual manner anchored by a concrete plan to achieve the medium-term target, and its conduct attuned to economic conditions and prospects. These policies are expected to support growth, imports and prices, without overreliance on yen depreciation, and help prevent the external position from moving out of line with fundamentals over the medium term.

### Current Account and Real Exchange Rate
- Current account (CA)  
  - Background: The 2015 CA increased to about 3⅓ percent of GDP from 0.8 percent of GDP in 2014, due to a significant decline in the energy import bill (by about 2 percent of GDP) and an improvement in the services balance reflecting higher tourism receipts (by ⅓ percent of GDP). Exports of goods increased by 0.9 percent in volume terms. Import volumes were weak, with goods imports declining by 1.1 percent.  
  - Assessment adjustments to EBA estimates:  
    - EBA estimates the 2015 cyclically-adjusted CA at 2.8 percent of GDP which is adjusted to reflect temporary factors, to get an underlying, cyclically-adjusted CA of 3.1 percent of GDP.  
    - EBA estimates the 2015 CA norm at 3.4 percent of GDP. Staff adjusts this to a norm of 1.4-2.7 percent of GDP to reflect structurally lower exports and permanently higher domestic demand and imports under structural reforms.  
  - Conclusion: The underlying CA in 2015 is therefore assessed to be 0.4-1.7 percent of GDP higher than the norm and moderately stronger than the level consistent with desirable policies and medium-term fundamentals. The 2016 surplus is expected to rise to about 3.5 percent of GDP under the current policy mix and due to lower oil prices.

- Real effective exchange rate (REER)  
  - Background: The REER depreciated 6.7 percent between 2014 and 2015. As of June 2016, the REER has appreciated 15 percent relative to its 2015 average.  
  - Assessment: The EBA REER Level model estimates the 2015 average REER to be 27 percent weaker (EBA Index REER model: 33 percent weaker) than the level consistent with fundamentals and desirable policies. Because of missing Japan-specific factors in the model, staff instead uses the CA gap range as reference and assesses a 2015 REER gap midpoint of -11 percent with an indicative range of -4 to - 17 percent.

- Capital and financial accounts; FX intervention and reserves  
  - Background: There has been a pick-up in portfolio outflows and increased FDI outflows. Net short yen positions have eased and recently turned into net long yen positions.  
  - Assessment: Vulnerabilities are limited. So far there have been no large spillovers from QQE to domestic financial conditions in other economies. If outflows from Japan accelerate, they could offset tighter domestic financial conditions in the region due to normalization elsewhere.  
  - FX intervention and reserves: Reserves are about 30 percent of GDP. The exchange rate is free floating with isolated interventions (last in 2011) to reduce short-term volatility and disorderly movements.

### Debt Sustainability Analysis — Summary Findings
- Overall assessment  
  - Japan’s public debt is unsustainable under current policies.  
  - Although the gross debt-to-GDP ratio is projected to rise only marginally during the WEO projection period (up to 2021) due to an improving primary balance and a favorable differential between interest and growth rates compared to past values, complementary analysis up to 2030 shows that the rise in the debt ratio will accelerate after 2020, reaching around 280 percent of GDP in 2030.  
  - The debt outlook is vulnerable to various shocks, especially when financial sector shocks cause spillovers to growth, the deficit, and the interest rate. Persistent shocks to growth and inflation and larger than projected public health spending are important downside risks. While all debt profile indicators are below early warning benchmarks, Japan’s extremely high financing needs point to vulnerabilities to changes in market perceptions especially over the medium term once the Bank of Japan’s purchases of JGBs ends.

- Baseline assumptions and realism of projections  
  - Potential growth will trend down from the current 0.5 percent to 0.4 percent by 2021 assuming that moderate gains from currently approved structural policies will partially offset demographic headwinds, with actual growth being somewhat volatile in part due to fiscal policy. Potential growth is estimated to decline further to 0.1 percent by 2030.  
  - Monetary policy is assumed to remain accommodative during the entire projection period, with CPI inflation gradually rising to above 1 percent over the medium term.  
  - Fiscal policy assumes the rise in the consumption tax rate from 8 to 10 percent in October 2019 with the introduction of multiple rates. Offsetting measures, including to counter the expiration of the FY2016 supplementary budget, have not yet been announced and therefore are not included.  
  - No hikes in risk premia are assumed in the baseline; long-term interest rates are projected to only gradually pick up, in tandem with rising inflation, to around 1¼ percent on new long-term bond issuances. Because the average maturity of government bonds is about 7 years (including financing bills), the nominal effective interest rate on public debt rises only gradually.

*Source: _cr16267 - Annex I. Risk Assessment Matrix*

### 0.6 percent in 2021. This implies a favorable interest-growth differential of -0.8 with a nominal

### _cr16267 - 0.6 percent in 2021. This implies a favorable interest-growth differential of -0.8 with a nominal

### Fiscal outlook and baseline projections
- Nominal GDP growth rate: 1.4 percent (implied by a favorable interest-growth differential of -0.8 and effective interest rate assumptions).
- Primary deficit will decline to around 3 percent of GDP in 2021, helped by the second stage of the consumption tax hike.
- Fiscal consolidation assumed in baseline: around 0.6 percent of GDP in 2017.
- Average fiscal multiplier for the baseline fiscal consolidation: 0.5.
  - Rationale: (i) about half of the adjustment comes from revenue measures (mainly the consumption tax increase to 10 percent with a multiplier of about 0.7); (ii) offsetting rate reductions in corporate income tax; (iii) expenditure reductions in areas with relatively lower multipliers such as pension spending.

### Financing needs and debt indicators
- Japan’s gross financing need in 2015: 53 percent of GDP (defined as the public sector deficit, plus all maturing debt), highest among advanced economies.
- Projected gross financing needs over the medium term: around 50 percent of GDP.
- Government intends to lengthen average maturity of JGBs; baseline assumes maturity structure similar to FY2016 initial budget (no specific plans incorporated).
- 10-year bond yield: at a record low; spread against the US is negative at around 190 basis points.
- Foreign holdings of JGBs: relatively low at 11 percent.
- External financing requirement (incorporating current account surplus): well below lower threshold at 5 percent of GDP.
- All public debt denominated in yen; no direct exchange rate risks assumed.
- Financial-assets-to-GDP ratio assumed stable at around 120 percent.
  - Major items as of end-2014: Social Security Funds assets about 47 percent of GDP; foreign currency reserve about 31 percent of GDP; shares and other equities held by central and local governments about 25 percent of GDP.

### Debt dynamics and public DSA baseline (selected figures)
- Nominal gross public debt (percent of GDP):  
  - 2014: 209.7  
  - 2015: 249.1  
  - 2016: 248.0  
  - 2017: 250.2  
  - 2018: 252.6  
  - 2019: 254.6  
  - 2020: 253.8  
  - 2021: 253.0
- Public gross financing needs (percent of GDP):  
  - 2014: 52.9  
  - 2015: 52.6  
  - 2016: 51.6  
  - 2017: 50.9  
  - 2018: 50.7  
  - 2019: 50.0  
  - 2020: 49.5  
  - 2021: 48.4
- Net public debt (percent of GDP):  
  - 2014: 104.3  
  - 2015: 126.2  
  - 2016: 128.0  
  - 2017: 130.5  
  - 2018: 133.0  
  - 2019: 134.9  
  - 2020: 134.1  
  - 2021: 133.3
- Real GDP growth (in percent):  
  - 2014: 0.7  
  - 2015: 0.0  
  - 2016: 0.5  
  - 2017: 0.5  
  - 2018: 0.3  
  - 2019: 0.5  
  - 2020: 0.8  
  - 2021: 0.1
- Inflation (GDP deflator, in percent):  
  - 2014: -1.2  
  - 2015: 1.7  
  - 2016: 2.0  
  - 2017: 0.6  
  - 2018: 0.4  
  - 2019: 0.3  
  - 2020: 0.9  
  - 2021: 1.4
- Nominal GDP growth (in percent):  
  - 2014: -0.5  
  - 2015: 1.6  
  - 2016: 2.5  
  - 2017: 1.1  
  - 2018: 0.7  
  - 2019: 0.8  
  - 2020: 1.7  
  - 2021: 1.4
- Effective interest rate (in percent):  
  - 2014: 1.0  
  - 2015: 0.8  
  - 2016: 0.8  
  - 2017: 0.6  
  - 2018: 0.5  
  - 2019: 0.5  
  - 2020: 0.5  
  - 2021: 0.5
- Change in gross public sector debt (cumulative):  
  - 2014: 7.1  
  - 2015: 4.6  
  - 2016: -1.1  
  - 2017: 2.3  
  - 2018: 2.4  
  - 2019: 2.0  
  - 2020: -0.8  
  - 2021: -0.8
- Identified debt-creating flows (cumulative): 9.4, 3.7, 0.6, 3.7, 4.1, 3.4, 1.0, 0.9 (2014–2021 sequence).
- Primary deficit (percent of GDP, annual entries contributing to cumulative above): 6.4, 5.6, 4.9, 5.0, 4.4, 4.2, 3.9, 3.1 (2014–2021).
- Primary (noninterest) revenue and grants (percent of GDP, annual entries): 29.1, 32.1, 32.5, 32.4, 32.5, 32.5, 32.7, 33.5 (2014–2021).
- Primary (noninterest) expenditure (percent of GDP, annual entries): 35.5, 37.7, 37.4, 37.3, 36.9, 36.8, 36.6, 36.6 (2014–2021).
- Automatic debt dynamics (interest rate/growth differential contribution, cumulative): 3.0, -1.9, -4.3, -1.2, -0.3, -0.9, -2.9, -2.3, -2.0, -9.6 (series shown in table).
  - Of which: real interest rate contributions and real GDP growth contributions are shown explicitly in the baseline tables.
- Residual, including asset changes: -2.3, 0.9, -1.7, -1.5, -1.6, -1.4, -1.8, -1.7, -1.4, -9.4 (series shown in table).

### Realism of baseline assumptions and forecast track record
- Forecast errors (median) and percentile ranks versus all countries for 2007–2015:  
  - Real GDP growth forecast error: -0.62 (Japan median forecast error), percentile rank 42%.  
  - Primary balance forecast error: -0.47 (Japan median forecast error), percentile rank 52%.  
  - Inflation (GDP deflator) forecast error: -0.78 (Japan median forecast error), percentile rank 20%.
- Past assumptions on real growth: generally neither too optimistic nor pessimistic compared to peer countries, except optimistic projections in 2011 due to the earthquake.
- Past assumptions on primary balance: neither too optimistic nor pessimistic; underperformance a few years ago due to global financial crisis and 2011 earthquake, overperformance since start of Abenomics.
- Assessment of CAPB (cyclically adjusted primary balance): Japan’s 3-year adjustment on CAPB basis is close to the top quartile historically for high-debt market access countries; but the CAPB level is in the lowest quartile due to large deficit.

### Stress tests, shocks, and scenario outcomes
- Fan chart worst-quartile case: debt-to-GDP ratio could reach around 265 percent of GDP in 2021, more than 10 percentage points higher than baseline.
- Ruling out positive primary balance shock (given recent experience) could raise debt-to-GDP by an additional 5 percent of GDP in 2021.
- Primary balance shock: underperformance equal to half of the 10-year historical standard deviation of changes in the primary balance; assumed additional borrowing cost of 25 basis points per 1 percent of GDP worsening of the deficit. Outcome: gross debt-to-GDP higher by around 4 percent of GDP in 2021 than baseline.
- Growth shock: real output growth rates lower by half of the 10-year historical standard deviation for 2 years starting in 2017; assumed decline in inflation of 0.25 percentage point per 1-point decrease in growth. Outcome: debt ratio above 260 percent of GDP in 2021, around 10 percentage points higher than baseline (second-largest impact).
- Interest rate shock: assumed 200 basis points spike in JGB yields in 2016, persisting for the period; effective interest rate higher by more than 1 percentage point in 2021 than baseline; debt ratio higher by around 10 percentage points.
- Interest rate and contingent liability shock (largest impact): one-time capital injection equivalent to about 3.5 percent of banking sector assets (approximately 10 percent of regional banks assets) increasing government spending by around 6.0 percent of GDP; interest rate assumed to rise by 25 basis points for each percentage point increase in the primary deficit; combined with real GDP growth shock. Outcome: debt ratio increases to around 280 percent of GDP in 2021, almost 30 percentage points higher than baseline.
- Stress-test table highlights (selected scenario values for 2016–2021):  
  - Baseline primary balance path: -5.0, -4.4, -4.2, -3.9, -3.1, -3.0 (2016–2021).  
  - Primary balance shock path: -5.0, -5.7, -5.6, -3.9, -3.1, -3.0 (2016–2021).  
  - Real GDP growth shock path (2016–2021 real GDP growth): 0.5, -1.1, -0.8, 0.8, 0.1, 0.6.  
  - Real interest rate shock: effective interest rate path 0.6, 0.6, 1.1, 1.4, 1.7, 2.0 (2016–2021).

### Longer-term projections and risks
- Longer-term projection headline: gross and net debt-to-GDP ratios projected to start increasing faster after 2020 and reach around 280 percent and 160 percent of GDP by 2030, respectively.
- This increase reflects a gradual rise in the interest rate-growth differential towards the historical average.
  - Footnote: differential currently lower than historical average, estimated at around -0.4 in 2016, and assumed at around 0.5 in 2030.
- Downside risks highlighted:
  - Larger increase in public health spending than assumed: with same macro assumptions, would imply debt ratio of 295 percent of GDP by 2030, about 15 percentage points higher than baseline.
  - Less favorable interest rate-growth differential due to disappointing growth or interest rate hikes upon BoJ exit or both.
  - Changes in investor base toward foreign funding that demand higher risk premia.

*Source: IMF staff (Japan Public Sector Debt Sustainability Analysis, baseline and stress-test tables, as presented in the supplied content).*

### Annex IV. Main Recommendations of the 2015 Article IV Consultation

### Annex IV. Main Recommendations of the 2015 Article IV Consultation

### Policy Coordination
- All arrows of Abenomics need to be strengthened to lift Japan out of its entrenched deflationary mindset and enhance growth.
- Although Abenomics has intended to fire all three arrows, in reality the third arrow has lagged behind, reducing the effectiveness of monetary and fiscal policies.
- There remains scope to improve policy coordination.

### Fiscal Policy
- Recommendation: The second consumption tax rate increase in 2017 should be implemented with a single rate structure and its adverse impact on low-income households should be addressed through improving the existing cash transfer mechanism.
- Actual policy action: The government has postponed the April 2017 consumption tax hike to October 2019, when a reduced rate of 8 percent is scheduled to be introduced.
- Planned adjustment for 2015-16 strikes a good balance between reducing fiscal risks and maintaining growth momentum, but mitigating measures of about 0.3 percent is necessary in 2017 given the planned consumption tax hike.
- Developments and actions:
  - FY2015 supplementary budget was approved by the Diet in January 2016, which is expected to boost growth in FY2016 by about 0.5 percentage point, and help maintain the growth momentum. Together with the FY2016 budget, the envisioned fiscal stance in 2016 is appropriate. With the tax delay no mitigating measures for 2017 are needed.
  - The authorities formulated FY2016 supplementary budget for the Kumamoto earthquake, and plan to adopt another one to address growth concerns this fall.
- Further fiscal consolidation after 2018 is necessary to put debt on a downward path. Consolidation should be balanced in terms of its pace (about ¾ percent of GDP per year) and should comprise both expenditure and revenue measures as outlined in the 2014 Staff Report.
- A concrete medium-term fiscal plan should:
  - use prudent and realistic economic assumptions;
  - adopt a long-term goal of putting debt on a downward path;
  - specify adjustment in terms of structural fiscal balance; and
  - identify upfront structural revenue and expenditure measures.
- Authorities’ stance and actions:
  - The authorities have identified specific expenditure measures with the aim to improve the efficiency of public spending, especially in the area of social security, but their fiscal impacts are unknown. They are not considering any revenue-side measures.
  - Stronger fiscal institutions will be necessary to restore fiscal credibility. Consider rules to curb expenditures, limits on the use of supplementary budgets, and publication of independent assessment of the outlook and budget projections by the FSC.
  - The Fiscal System Council has updated in October 2015 its analysis of the long-term fiscal sustainability.

### Monetary Policy
- Recommendation: The BoJ should stand ready to ease further and reiterate that it remains open to all further avenues of easing when and if appropriate by increasing asset purchases, lengthening their duration, broadening their range, and further lowering the deposit rate on excess reserves into negative territory.
- Action: In January 2016, the BOJ introduced a negative interest rate on marginal excess reserves to complement QQE.
- Recommendation: Enhance communication to focus on achieving 2 percent inflation in a stable manner aided by a more transparent presentation of the BoJ’s forecast and underlying assumptions. Clarify the indicators used to assess inflation developments and spell out the criteria for judging whether the inflation target is sustainably achieved, and triggers for additional actions.
- BoJ communication framework modifications (announced June 2015, effective January 2016):
  - Preparing the Outlook for Economic Activity and Prices on a quarterly rather than a semi-annual basis;
  - Releasing each board member’s forecasts for growth and prices with a risk assessment and extending the forecast period to 4 years;
  - Issuing the “Summary of Opinions” in about a week after the monetary policy meeting (MPM), providing information about the policy board's debates; and
  - Reducing the frequency of MPMs to 8 times a year from the current 14 times a year.

### Financial Sector Policy
- Close monitoring of liquidity, especially in the JGB market, is essential given the potential spillovers to other financial market segments. Ensuring resilience of the financial sector to higher volatility is critical.
- BoJ and MoF measures for JGB market liquidity:
  - BoJ supplementary measures for QQE announced in December 2015 allowed for consecutive use of its Security Lending Facility (SLF) for a longer period.
  - BoJ raised the upper limit on the amount of sales per issue in February 2016.
  - MoF planned to issue additional off-the-run JGBs with remaining maturity of 1–5 years in the Auctions for Enhanced-Liquidity in FY2016 to correct demand-supply imbalances and enhance market liquidity.
- Strengthen bank risk management and adjust business models to raise profitability. Capital standards for domestically oriented banks need strengthening by reassessing the treatment of unrealized losses in capital.
- Insurance sector: Insurance companies need to enhance profitability to work through the legacy of guaranteed return products.
- FSA actions:
  - Announced a new interview survey to one thousand regional companies (mainly SMEs and other users) on 105 regional banks’ lending attitude; summary published in August 2015.
  - Approved Business Strengthening Plans of financial institutions pursuant to the “Act on Special Measures for Strengthening Financial Functions”.
  - Encouraged the three megabanks to increase their capital to comply with the implementation of Basel III, and to reduce cross-shareholdings.
  - Considering strengthening regulation on insurance companies by 2020 assuming that large insurance companies will adopt international standards set by FSB and IAIS.
- Mitigate foreign-exchange funding risks for banks with overseas activities by securing robust funding sources.
- Macroprudential readiness:
  - Implement the countercyclical capital buffer (CCB) but note it has been maintained at zero percent.

### Growth Strategy
- Raise labor supply by:
  - fully implementing plans to increase the availability of child care;
  - eliminating tax-induced disincentives to work;
  - incentivizing older workers to remain in the workforce; and
  - relaxing immigration restrictions in areas with labor shortages.
- Policy developments:
  - On September 24, 2015, PM Abe announced a nominal GDP target of 600 trillion yen, and added new arrows focused on social security, child rearing support, and demographic growth.
  - On August 28 the Diet approved a bill (which took effect on April 1, 2016) to promote the role of women in the workplace. The act requires large companies (with 301 or more employees) to set numerical targets for the employment and promotion of women.
- Labor market duality:
  - Clarify the legal and regulatory environment surrounding “intermediate” contracts that balance job security and flexibility to reduce labor market duality and raise horizontal mobility.
  - Amendments to the Worker Dispatch Law were approved by the Diet, ending a requirement for companies to upgrade their temporary workers to regular employees after three years (or otherwise terminate the contract). The amendments also obligate staffing agencies to provide training and work to transition temporary workers into permanent employment.
- Strengthen wage growth momentum by raising administratively controlled wages and prices, calling for a supplementary wage round, converting some permanent bonuses into base wages, and encouraging a stronger-than-usual winter bonus round. Consider higher-than-usual minimum wage increases and strengthening tax incentives for firms that raise wages.
  - Minimum hourly wage was raised by JPY 18 (15 cents) in 2015 and the government announced a floor of 3 percent on minimum wage increases with a goal to reach 1000 yen/hour (a cumulative increase of 25 percent).
- Enhance risk capital provision: increase credit to new growth projects, unwind cross-shareholdings, promote consolidation in the financial system, phase-out financial sector support schemes for SMEs that do not invest or hire workers, and promote the expansion of securitization.
- Public pension investment and household portfolio rebalancing:
  - GPIF governance: In light of important changes in GPIF’s portfolio allocation, its governance structure can be strengthened. The government approved GPIF’s reform plan to introduce more consensus-based decision-making by establishing an investment committee. GPIF announced to disclose stock holdings for the first time on July 29 when it will report the investment results for fiscal 2015.
  - To promote portfolio rebalancing of households, consider extending the 5-year term limit of tax-exempt individual savings accounts and raising the maximum contribution limit.
  - Junior NISA was introduced in April 2016, where parents and grandparents can set up account for children who are 19 or below with an annual limit of JPY 800 thousand.
- Corporate governance and deregulation:
  - Implement comprehensive corporate governance reform: include more ambitious requirements for independent directors, greater transparency of beneficial ownership, regulatory limits to discourage excessive cross-shareholdings, remove takeover bottlenecks, and introduce pre-packaged reorganization plans for bankruptcy procedures.
  - Deregulate agriculture and domestic services sectors, eliminate most tariffs and non-tariff and investment barriers, and expedite deregulation in SEZs.
- Trade developments: Twelve countries including Japan and US struck the Trans-Pacific Partnership (TPP) trade deal on October 5. Japan will lower tariffs on several agricultural products (e.g., lowering tariff on beef from 38.5 percent to 9 percent in 16 years). Discussions to ratify the TPP are ongoing in the Diet.

### Fund Relations (selected institutional and financial data)
- Membership Status: Joined: August 13, 1952; Article VIII.
- General Resources Account:
  - Quota 30,820.50 SDR Million 100.00 percent.
  - IMF's Holdings of Currency (Holdings Rate) 27,111.45 SDR Million 87.97 percent.
  - Reserve Tranche Position 3,709.48 SDR Million 12.04 percent.
  - Lending to the Fund: New Arrangements to Borrow 5,090.49 SDR Million.
- SDR Department:
  - Net cumulative allocation 12,284.97 SDR Million 100.00 percent.
  - Holdings 12,387.16 SDR Million 100.83 percent.
- Latest Financial Arrangements: Stand-By Mar 11, 1964–Mar 10, 1965 Amount Approved 305.00 (SDR Millions), Amount Drawn 0.00; Stand-By Jan 19, 1962–Jan 18, 1963 Amount Approved 305.00 (SDR Millions), Amount Drawn 0.00.
- Overdue Obligations and Projected Payments to Fund (SDR Million; based on existing use of resources and present holdings of SDRs):
  - Charges/Interest: 0.43 each year for forthcoming 2016, 2017, 2018, 2019, 2020. Total per year 0.43.
- Exchange Arrangement: Japan maintains a free floating exchange rate regime. Since the 2015 Article IV consultation, Japan has not had foreign exchange intervention.
- AML/CFT Framework: Japan underwent an assessment in 2008; significant deficiencies identified. Since the 2014 Article IV mission, Japan enacted the Amendment Act on Prevention of Transfer of Criminal Proceeds, the Act to Amend the Terrorism Financing Act, and the Terrorist Assets Freezing Act. Japan will continue to be monitored by the FATF.

### Statistical Issues
- Economic and financial data provided to the Fund are considered adequate for surveillance purposes.
- Japan subscribes to the Special Data Dissemination Standard (SDDS) and meets the SDDS specifications for coverage, periodicity, and timeliness of data.
- A data ROSC mission was hosted in September 12–28, 2005; the Report on Observance of Standards and Codes - Data Module and related documents were published March 17, 2006.
- Table of Common Indicators Required for Surveillance (as of June 20, 2016) — selected entries preserved as in source:
  - Exchange Rates: Date of Latest Observation June 2016; Date Received June 2016; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D.
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of Latest Observation 6/10/2016; Date Received 6/14/2016; Frequency Every 10 days.
  - Reserve/Base Money: May 2016; Date Received June 2016; Frequency M.
  - Broad Money: May 2016; Date Received June 2016; Frequency M.
  - International Investment Position: 2016Q1; Date Received June 2016; Frequency Q.
  - Consolidated Balance Sheet of the Banking System: April 2016; Date Received June 2016; Frequency M.
  - Consumer Price Index: April 2016; Date Received May 2016; Frequency M.
  - Revenue, Expenditure, Balance and Composition of Financing – General Government: 2014; Date Received January 2016; Frequency A.
  - Stocks of Central Government and Central Government-Guaranteed Debt: 2016Q1; Date Received May 2016; Frequency Q.
  - External Current Account Balance: April 2016; Date Received June 2016; Frequency M.
  - GDP/GNP: 2016Q1; Date Received June 2016; Frequency Q.
- Data quality notations (as in source): O, LO, LNO, etc., are recorded in the original table for methodological soundness and accuracy and reliability.

### Supplementary Information / Recent Developments (staff supplement, July 22, 2016)
- Staff marked down the outlook for growth and inflation taking into account weakness in recent high-frequency indicators, financial market volatility, and uncertainty associated with the leave vote in the Brexit referendum.
- Key observations:
  - Short-term indicators point to softness in economic activity; PMI indicators suggest sustained weakness in manufacturing activity reflecting sluggish export demand.
  - Inventory-to-sales ratio in manufacturing has increased and machinery orders data have disappointed.
  - Higher uncertainty following the Brexit vote is expected to contribute to a further drag on growth, especially investment, but also consumption and exports including from recent exchange rate volatility.
  - Direct trade and financial exposures to the United Kingdom are limited, but exposures to the rest of Europe are relatively large and, together with domestic confidence effects, constitute the main channel of impact.
- Compared to the staff report, Japan’s growth projections for 2016 and 2017 have been revised down by 0.2 percentage points to 0.3 and (text truncated in source).

*Source: Annex IV. Main Recommendations of the 2015 Article IV Consultation*

### 0.1 percent, respectively. The outlook for inflation has been

### _cr16267 - 0.1 percent, respectively. The outlook for inflation has been

### Brexit referendum: immediate market impact and transmission channels
- Financial conditions tightened considerably on impact of the Leave vote.
- Yen appreciation and safe-haven flows:
  - The yen appreciated strongly amid safe-haven effects and expectations of further delays in rate hikes by the U.S. Federal Reserve.
  - The 10-year benchmark JGB rate fell by over 14 bps to -0.29 percent within two weeks after the referendum.
  - JGB yield curve shifted down and flattened; long-end yields reversed some decline later.
  - Yen/Dollar annual average rates noted in Table 1: 121.0 (2014), 106.9 (2015), 101.1 (2016), 112.5 (2017).
- Equity markets and sectoral effects:
  - Equity prices slumped, led by financial sector stocks.
  - Stocks of banks and insurance companies had fallen by 14 and 13 percent within two weeks after the Brexit referendum, respectively.
  - Short selling in the Tokyo Stock Exchange (as a share of total selling) increased to historical highs in June.
  - Market volatility rose then fell back: market volatility has fallen back to pre-referendum levels and equity valuations, including of financial institutions, are significantly above these levels.
- USD funding stress:
  - USD funding costs increased sharply.
  - The 3-month JPY/USD basis swap widened from -55 to -68 bps on the day of the Brexit.
  - The BoJ provided USD$1.475 billion on June 28—the largest amount since December 2014.
  - Assurances about availability of USD funding through a joint statement by Finance Minister Aso and BoJ Governor Kuroda helped stabilize markets.
- Trade and financial linkages:
  - Japan’s exports to the United Kingdom and the rest of Europe made up about 2 and 9 percent of its total exports in 2015, respectively.
  - Japan’s FDI and portfolio claims on the United Kingdom are about 7 and 5 percent of Japan’s total foreign claims, compared to 17 and 25 percent for the rest of Europe.

### Outlook for inflation and growth (staff projections and revisions)
- The outlook for inflation has been reduced by 0.1–0.2 percentage points, reflecting:
  - a stronger yen,
  - weaker commodity prices,
  - softer domestic demand.
- Projections assume a gradual waning of uncertainty surrounding Brexit but do not factor in any policy response.

### Policy implications and staff advice
- Staff advice remains broadly in line with the “reload package” and the need for near-term support to address downside risks.
- The reload scenario should be accelerated as it remains the most effective response to recent developments and uncertainty (¶18 of the staff report).
- The realization of downside risk justifies:
  - a fiscal response to target a modest positive fiscal stance in 2017, and
  - some further monetary easing to underscore the BoJ’s resolve to achieve its inflation target (¶16).
- Fiscal policy recommendations:
  - In the near term, fiscal policy should aim for a modest fiscal impulse, using measures with high multipliers.
  - A large stimulus would have merit only as part of the staff’s comprehensive and coordinated “reload” package and support for labor market reforms.
  - To create necessary near-term space and reduce policy uncertainty, the commitment to fiscal consolidation over the medium-term should be enhanced and fiscal policy frameworks strengthened.
- Monetary policy recommendations:
  - Fiscal response should be complemented with additional easing by the BoJ to loosen financial conditions and underscore its commitment to achieve the inflation target in a sustained and stable manner.
  - All easing options should remain on the table, including lowering of the negative interest rate on marginal excess reserves and increasing annual targets for ETF and corporate bond purchases.

### Authorities' views (exchange of views during July 14–15, 2016)
- Authorities consider the impact of Brexit on growth likely to be modest given Japan’s relatively small export exposure to the United Kingdom and the rest of Europe.
- Authorities noted:
  - Impact of Brexit was highly uncertain.
  - The initial steep correction in the Nikkei has reversed and strong appreciation of the yen has moderated.
  - They expected to revise their outlook shortly as the basis for new budget projections and preparation.
  - Details on the size and composition of the planned stimulus package would be formulated soon.
  - The Bank of Japan would not hesitate to take additional easing measures, if necessary to achieve the 2 percent price stability target at the earliest possible time, in terms of the three dimensions: quantitative, qualitative, and interest rate dimensions.

### Key economic indicators (selected figures from Table 1)
- Nominal GDP: US$ 4,124 Billion (2015)
- Population: 127 Million (2015)
- GDP per capita: US$ 32,480 (2015)
- Quota: SDR 15.6 Billion (2015)
- Growth (percent change), Real GDP:
  - 2011: -0.5
  - 2012: 1.7
  - 2013: 1.4
  - 2014: 0.0
  - 2015: 0.5
  - 2016: 0.3
  - 2017: 0.1
- Output Gap:
  - 2011: -3.3
  - 2012: -2.0
  - 2013: -1.1
  - 2014: -1.6
  - 2015: -1.5
  - 2016: -1.7
  - 2017: -2.0
- Inflation (annual average), CPI:
  - 2011: -0.3
  - 2012: 0.0
  - 2013: 0.4
  - 2014: 2.7
  - 2015: 0.8
  - 2016: 0.2
  - 2017: 0.4
- Unemployment rate (annual average):
  - 2011: 4.6
  - 2012: 4.3
  - 2013: 4.0
  - 2014: 3.6
  - 2015: 3.4
  - 2016: 3.2
  - 2017: 3.3
- Government (percent of GDP), Overall Balance:
  - 2011: -9.8
  - 2012: -8.8
  - 2013: -8.6
  - 2014: -6.2
  - 2015: -5.2
  - 2016: -5.1
  - 2017: -4.3
- Public debt, gross:
  - 2011: 231.6
  - 2012: 238.0
  - 2013: 244.5
  - 2014: 249.1
  - 2015: 248.0
  - 2016: 250.7
  - 2017: 254.0
- 10-year JGB yield (end-period):
  - 2011: 1.1
  - 2012: 0.9
  - 2013: 0.7
  - 2014: 0.6
  - 2015: 0.4
  - 2016: -0.1
  - 2017: -0.1
- Current account balance (in billions of US$):
  - 2011: 129.8
  - 2012: 59.7
  - 2013: 45.9
  - 2014: 36.4
  - 2015: 135.6
  - 2016: 159.4
  - 2017: 143.2
- Trade balance (in billions of US$):
  - 2011: -4.5
  - 2012: -53.9
  - 2013: -90.0
  - 2014: -99.9
  - 2015: -5.3
  - 2016: 19.3
  - 2017: 0.7
- Exports of goods, f.o.b.:
  - 2011: 790.8
  - 2012: 776.0
  - 2013: 695.0
  - 2014: 699.4
  - 2015: 621.9
  - 2016: 620.5
  - 2017: 643.0
- Imports of goods, f.o.b.:
  - 2011: 795.3
  - 2012: 829.9
  - 2013: 784.9
  - 2014: 799.3
  - 2015: 627.2
  - 2016: 601.2
  - 2017: 642.3
- Energy imports:
  - 2011: 242.8
  - 2012: 272.2
  - 2013: 257.4
  - 2014: 241.7
  - 2015: 133.7
  - 2016: 112.6
  - 2017: 130.3
- Total reserves minus gold (in billions of US$):
  - 2011: 1258.2
  - 2012: 1227.2
  - 2013: 1237.3
  - 2014: 1231.0
  - 2015: 1207.1

*Source: IMF staff estimates and projections as of July 7, 2016 (content from _cr16267).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16267.pdf_