Public Information Notice: IMF Concludes 2001 Article IV Consultation with Japan

August 10, 2001

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On August 3, 2001, the Executive Board concluded the Article IV consultation with Japan.1


The Japanese economy expanded by 1.5 percent in 2000 mainly on account of a turnaround in business investment and net exports. Business fixed investment made the largest contribution, buoyed by an expanding high-tech sector, and underpinned by a double-digit pickup in profits. Exports of IT products also surged, turning the external contribution to growth from a small negative figure in 1999 to a sizable positive number in 2000. Private consumption was stagnant, however, as ongoing corporate restructuring depressed households' take-home pay and the decline in the stock market and pessimism about longer-term prospects dampened consumer sentiment. Public investment underwent a sharp contraction, especially in the second half of the year reflecting the waning impact of the November 1999 supplementary budget.

The underlying pace of activity slowed during the course of 2000, and growth turned negative in the first quarter of 2001 as business investment and exports were undermined by the downturn in overseas markets (especially for high-tech products). Private consumption was flat despite a boost coming from purchases of home appliances ahead of the introduction of a new recycling law on April 1, while residential investment declined. Strong growth in public investment related to the November 2000 supplementary budget provided some support to the economy.

For 2001 as a whole, activity is expected to be broadly flat. Private consumption is likely to be stagnant, depressed by payback from the spending brought forward to the first quarter, and the drag from corporate restructuring, high unemployment, and declining incomes. Leading indicators of business investment suggest that capital spending will continue to decline through the summer and fall, reflecting the cyclical deterioration in sales and the outlook for corporate profits. Net exports—which have contributed negatively to growth since mid-2000—will continue to be adversely impacted by the external environment, especially for IT products, although the yen's depreciation may soften the impact. Public investment, which picked up early in 2001, is expected to fall back from the third quarter, reflecting the waning impact of last November's stimulus package.

On most measures, deflationary pressures intensified during 2000 and early 2001. Excluding perishable food and energy, year-on-year changes in the CPI rose fell from -0.2 percent in the first quarter of 2000 to -0.7 percent in the first quarter of 2001. Nominal monthly earnings, which were rising in the first half of 2000, began to turn down in the second half of the year in line with the deterioration in labor market conditions. Indicators of excess capacity have also worsened since the middle of last year, while the unemployment rate has hovered near its year-end peak of 4.9 percent.

The trade balance narrowed in 2000, while capital outflows rebounded. Export volumes slowed and then declined in early 2001, while imports picked up as a result of higher oil prices. However, a pickup in investment income, reflecting a recovery in profits by Japanese overseas subsidiaries, helped to offset the impact on the current account surplus. Following the retrenchment in 1999, outward direct investment increased last year, while net portfolio outflows also rose, reflecting a reassessment of prospects for Japan's stock market and a widening of the interest rate differential against Japan.

Deteriorating prospects took their toll on equity prices and the yen. From a peak of nearly 20,000 in March 2000, the Nikkei index shed about two-fifths of its value over the following year (bringing it to a 16-year low). The Topix—whose composition was constant over this period (unlike that of the Nikkei)—fell by about a third. The downturn reflected not only the worldwide sell-off in technology stocks, but also unwinding of cross-shareholdings in Japan and increasing concern about slow progress with restructuring and boosting corporate rates of return. Japan's equity market rebounded following the easing of monetary policy in March and the election of a pro-reform Cabinet in April, although prices have since fallen back. The economy's cyclical deterioration and recent monetary policy easing have also contributed to a significant weakening of the yen since early 2000.

Faced with a weakening economy, the BoJ sought to ease the stance of monetary policy in early 2001. In February, a Lombard facility to provide loans on demand at the official discount rate (ODR) was established, the ODR was reduced from 0.5 percent to 0.25 percent, and the target for the uncollateralized overnight call rate—the BoJ's main policy instrument which determines funding costs in the interbank market—was lowered to 0.15 percent. In mid-March, concerned that the recovery had "paused", the BoJ adopted a new framework for monetary policy. The framework sets a target for current account balances at the BoJ, initially at around ¥5 trillion (about ¥1 trillion above the average balance held in previous months), a move that brought the overnight call rate effectively back down to zero. The BoJ indicated that the new policy will remain in place until year-on-year changes in the CPI excluding perishables rise stably to zero or above, and that outright purchases of long-term government bonds (so-called "rinban" operations) will be increased if needed to achieve the reserves target.

The FY2000 budget, together with the supplementary package passed at the end of the previous year, kept the fiscal stance roughly neutral last year, even as public investment continued to decline in relation to GDP. Revenues benefited from receipts related to the maturation of a large volume of 10-year postal saving deposits. Expenditures kept up as a result of the moderate increase in core spending in the annual budget and the sizable stimulus package in November 1999.

Progress by major banks in improving core profitability and disposing of problem loans has continued to be slow. Banks' FY2000 financial results showed weaker operating profits, as interest rate margins narrowed and restructuring efforts, including in the context of recent mergers among major banks, have proceeded slowly. At the same time, loan-loss charges were about triple the rate envisaged at the start of the year, with little reduction in the stock of nonperforming loans. Lack of progress in boosting the major banks' underlying health is compounded by their growing vulnerability to market risk. Outside the major banks, the smaller deposit-taking institutions continue to face serious challenges to improve credit quality, and the life insurance sector remains distressed.

A major package to accelerate bank and corporate restructuring was unveiled in April 2001, and further details—together with an outline of the government's overall structural reform agenda—were provided in a blueprint released at the end of June. The centerpiece of the bank and corporate restructuring package is the accelerated removal of nonperforming loans (NPLs) to bankrupt and near-bankrupt borrowers from major banks' balance sheets within two years, and removal of newly-emerging NPLs within three years of such classification. Banks and firms would be encouraged to agree to out-of-court restructuring in exchange for debt forgiveness or debt-equity conversion, subject to guidelines to be established by relevant ministries and the business and bankers' associations. In addition, banks' aggregate equity holdings would be limited relative to their shareholders' equity, and a Banks' Shareholding Acquisition Corporation (BASAC) would be established to facilitate the scaling down of bank equity holdings.

Executive Board Assessment

Executive Directors noted that last year's modest economic recovery in Japan had now given way to renewed weakness, reflecting the U.S. and global electronics slowdown, the slow progress with bank and corporate restructuring, and questions about the long-term fiscal situation. Directors were concerned that Japan could reenter a cycle of slowing activity, rising bankruptcies, and a deteriorating banking system, which would, in turn, exacerbate the global downturn.

Against this background, Directors welcomed signs that the new government is committed to addressing Japan's deep-seated economic problems. The reform blueprint of the Council on Economic and Fiscal Policy—which emphasizes the importance of revitalizing Japan's economy by addressing problems in the financial sector, undertaking fiscal reforms, and accelerating structural policies to promote competition and enhance the role of market forces—was seen as an excellent basis for action. While Directors recognized that restructuring could adversely affect output and employment in the short run, they stressed that Japan has little choice but to embark on the long-delayed restructuring needed to achieve sustained medium-term growth. They considered that the short-term impact could be contained if the restructuring is accompanied by reforms that open up new investment and employment opportunities, by supportive macroeconomic policies, and by a strengthening of the social safety net.

Directors stressed that addressing the problems in the banking sector, in particular by resolving the long standing problem of a large volume of nonperforming loans, is key to restoring healthy growth in Japan. They noted that turning the sector around will require vigorous implementation of the April Package, together with strong complementary measures. While welcoming the progress already made by the Financial Services Agency (FSA) in strengthening loan classification and provisioning standards, Directors saw room for the banks to improve their credit assessments and to adopt a more forward-looking approach to provisioning. They noted questions raised by private analysts about the magnitude of the bad loan problem, and urged early participation in the FSAP to help shed more light on these issues.

Most Directors observed that targeted capital injections may be needed to offset the impact on bank capital of more aggressive provisioning and loan disposal. While unviable financial institutions should be encouraged to exit, undercapitalized banks with healthier prospects are likely to need public funds to prevent a credit crunch and maintain systemic confidence. Some Directors expressed concern that more generous capital injections might reduce banks' efforts to raise capital in the market. To minimize moral hazard, most Directors emphasized that receipt of such funds should be conditional on strong restructuring plans involving participation in debt workouts and achieving satisfactory returns on equity within a defined period. In cases where banks fail to meet these agreed conditions, it will be critical for the government to take appropriate action, including through the conversion of preferred shares to ordinary shares and the replacement of bank management. Given the scheduled removal of the blanket deposit guarantee next March, Directors noted the importance of moving quickly on these issues.

Directors emphasized that the long-term success of the program to accelerate bad loan disposal depends on achieving the restructuring of distressed firms and the prompt exit of nonviable entities. Some Directors saw risks that the informal workout agreements now being considered could result in the continued postponement of serious restructuring. They underlined the need for restructuring plans to be rigorous enough to achieve a durable turnaround in corporate performance. Directors viewed the FSA as having a key role to play in this area, as appropriate loan classification requires an assessment of the borrower's viability under the proposed business plan. They also saw benefit from having restructuring agreements vetted by credible outside experts.

Directors stressed that removal of existing impediments to the efficient allocation of resources is a vital part of the reform agenda. In the view of many Directors, vigorous pursuit of structural reforms on a broad front is needed to help generate new investment and employment opportunities, and to boost productivity growth over the medium term. In this regard, Directors stressed the need to broaden the competition policy framework and strengthen its enforcement, and to overhaul the regulatory apparatus in key areas such as telecommunications, electricity, and gas. They also noted the need to strengthen corporate governance through comprehensive amendments to the Commercial Code to place a greater emphasis on the role of external directors and to improve managerial accountability. Amendments to existing employment protection legislation are desirable, to provide companies with greater scope to adjust employment levels, including in the context of informal debt workouts. Complementary measures to strengthen the social safety net, including by expanding resources for retraining, would help to cushion the impact on retrenched workers. Directors recommended the implementation of measures to increase the efficiency of the real estate market, including by liberalizing zoning regulations and laws on rentals and land-leases, while accelerating the disposal of land collateral (including by the Resolution and Collection Corporation) to help land prices to finally bottom out.

Directors supported the authorities' focus on developing a medium-term fiscal strategy to put government and social security finances on a firm footing. In their view, such a strategy should aim to establish medium-term debt and deficit objectives, as well as set out the broad objectives and directions of tax, expenditure, and social security policies. Within this framework, detailed short-term targets could be affirmed in annual budgets, providing flexibility to respond to evolving economic conditions.

In the near term, most Directors emphasized that fiscal policy should remain responsive to changing economic circumstances, and cautioned the authorities against getting locked into commitments that could result in too rapid a pace of fiscal consolidation. A few were less convinced about the need for a supplementary budget in the near term, remarking that a clear departure from the pattern of stimulating fiscal packages may be a strong confidence-boosting move. Nevertheless, most Directors agreed that, should a supplementary budget be needed later this year, it should focus as far as possible on measures that support restructuring, including steps to expand the social safety net, rather than on low-quality public works programs.

Directors identified a number of areas where they believe that upfront fiscal reforms could help provide the building blocks for, and establish the credibility of, the authorities' medium-term consolidation program. Measures to improve the quality of government expenditure was seen as essential, including through the elimination of the earmarking of revenues for specific purposes (e.g., road construction). Directors also saw benefits from increasing the market orientation of the Fiscal Investment and Loan Program by requiring a greater proportion of project financing to come directly from private capital markets. Directors noted that a further round of pension reforms will be necessary to eliminate the still sizable projected net unfunded liabilities of the system without a large increase in contribution rates, while next year's proposed medical care reform package will need to include significant initiatives to contain the growth in medical costs. They considered that the early introduction of taxpayer identification numbers would improve tax administration and facilitate the needed broadening of the tax base down the road. Steps to reduce the imbalance between the spending and revenue-raising authority of local governments to improve expenditure management and accountability at the local level are also desirable. Directors also encouraged the authorities to address the shortcomings in fiscal transparency that were highlighted in the ROSC report.

While Directors welcomed the Bank of Japan's (BoJ) new monetary policy framework, most Directors thought that the present policy stance was unlikely to eliminate downward pressure on prices within a reasonable time frame. Most Directors therefore suggested that the BoJ should not delay in raising its quantitative target for current account balances, while being prepared, if necessary, to increase purchases of longer-term government securities to meet the higher target. However, as the banking sector is already highly liquid and there is uncertainty as to whether the low level of bank credit stems from supply or demand factors, some Directors were skeptical about the effectiveness of a further easing of monetary policy. It was noted that an easier monetary policy stance could give rise to further weakening of the yen, but that a depreciation would aid the economic recovery. Most viewed such a development as more manageable now for the Asian region than during the Asian crisis, due to the adoption of flexible exchange rates in many countries and their healthier external debt profiles. A few Directors expressed concern about the potential impact of persistent easing of the yen on Japan's neighboring countries, in view of Japan's important influence in the region.

Some Directors argued that the effectiveness of monetary policy could be enhanced if the BoJ were to specify a reasonable timeframe for eliminating deflation. They saw benefits from adopting a modest positive medium-term inflation target to reduce the risks of getting stuck in a deflationary trap. Others doubted, however, that such a target would be credible in the current environment, as it is not clear that policymakers have the instruments needed to achieve such a target.

Directors welcomed the progress that has been made in upgrading the quality of economic statistics, but expressed concerns that remaining weaknesses continue to undercut the monitoring of developments and the formulation of policy. They particularly emphasized the need to improve the estimates of private consumption in the national accounts and the quality and timeliness of fiscal data.

Directors welcomed recent measures to ease market access for developing countries, and strongly commended the authorities for the continued high level of ODA provided by Japan. They stressed that further efforts to reduce agricultural protection are desirable, and noted that leadership and flexibility on the part of Japan will be critical in achieving the consensus needed to successfully launch the new global trade round and to help contain protectionist pressures that could seriously damage the prospects for global growth.

Japan: Selected Economic Indicators

  1998 1999 2000 2001  

(Percent changes, unless otherwise noted)
GDP -1.1 0.8 1.5 -0.2  
Private consumption 0.2 1.2 0.5 0.2  
Nonresidential investment -2.3 -4.3 4.4 1.6  
Residential investment -13.9 0.8 1.6 -4.0  
Public investment -2.6 6.1 -7.3 -4.1  
Public consumption 1.9 4.0 3.6 2.0  
Stockbuilding (contribution to growth) -0.6 -0.2 0.1 0.1  
Foreign balance (contribution to growth) 0.3 -0.1 0.4 -0.5  
Exports of goods and services -2.3 1.3 12.1 -2.9  
Imports of goods and services -6.8 2.9 9.9 2.4  
GDP deflator -0.1 -1.4 -1.7 -0.9  
CPI 0.6 -0.3 -0.6 -0.7  
Unemployment rate (period average, percent) 4.1 4.7 4.7 5.0  
Industrial production -7.2 1.0 5.4 ...  
Current account balance          
Billions of U.S. dollars 121.0 106.8 116.9 102.2  
Percent of GDP 3.1 2.4 2.5 2.4  
General government balances (percent of GDP)          
Balance including social security -4.5 -6.8 -8.0 -6.9  
Balance excluding social security -6.5 -8.6 -9.2 -7.7  
Structural balance 1/ -3.6 -5.4 -5.5 -5.2  
Money and credit (end period)          
M2 + CDs 3.9 2.6 2.2 3.2 2/
Bank lending -4.7 -5.9 -3.8 -3.8 2/
Exchange rates (period average)          
Yen/dollar rate 130.9 113.9 107.8 125.1 3/
Real effective exchange rate 4/ 107.4 120.1 127.4 120.4  
Interest rates (period average)          
3-month CD 0.6 0.1 0.2 0.01 3/
10-year government bond 1.3 1.7 1.7 1.3 5/

Sources: Nikkei Telecom and IMF staff estimates.

1/ Including social security, excluding bank support.
2/ June 2001.        
3/ July 11, 2001.        
4/ Based on normalized unit labor costs; 1990 = 100.
5/ January-July.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the August 3, 2001 Executive Board discussion based on the staff report.


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