The challenge: flagging momentum
After the initial success of the economic policies designed by Prime Minister Shinzō Abe, or what is known as Abenomics— the three “arrows” of monetary stimulus, fiscal “flexibility” and structural reform—the economy’s momentum is flagging and deflation risks are on the rise again. The yen has appreciated substantially since 2015, which, combined with the global trade slowdown, has dampened exports. At the same time, the positive effects from the commodity price decline have not fed through to the economy. Policy uncertainty and stock market volatility has hampered domestic confidence and demand, while a shrinking and aging population are weighing on growth and investment opportunities.
According to the IMF report, growth is expected at 0.3 percent in 2016 and 0.1 percent in 2017, while headline inflation would rise from 0.2 percent in 2016 to 0.4 percent in 2017. The labor market is a bright spot, with the unemployment rate at an enviable low of 3.1 percent in June 2016. But base wage growth remains sluggish at a paltry 0.4 percent in 2016, and private consumption and investment are anemic.
Looking ahead, the ambitious targets of Abenomics—consumer price inflation at 2 percent, real GDP growth at 2 percent, and a primary budget balance by 2020—remain out of reach under current policies. Japan has limited room for monetary and fiscal stimulus given the high gross and net public debt, a budget deficit at about 5 percent of GDP in 2016, the Bank of Japan’s balance sheet—one of the largest among advanced economies—and policy interest rates dipping into negative territory. The country needs bolder reforms to achieve their targets.
The solution: focus on three key areas
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Reload with income policies that spur firms to raise wages: With favorable wage-price dynamics essential to spur inflation, incomes policies will need a push. In addition to the already adopted decision to increase minimum wage growth by 3 percent per year, the authorities will need to induce private enterprises to raise wages, by mimicking the “comply or explain” mechanism used for corporate governance reform or expanding tax incentives (or introducing penalties as a last resort), as well as raising administratively controlled wages and prices in line with the inflation target.
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Labor market reforms: The report argues that, to be effective, incomes policies need to be accompanied by significant labor market reform, as well as sustained and balanced fiscal and monetary support for demand. The labor market reform should aim to remove the country’s divided labor market between regular employees and lower-paid temporary ones by promoting new hiring under contracts that better balance job security and wage increases. At the same time, the “equal-pay for equal work” program should be accelerated. In addition, the authorities can eliminate the impediments to full-time or regular work through reform of the tax and social security system and an increase in available child care facilities, as well as encourage more foreign workers into the country. The sustained demand support is necessary to facilitate the pass-through of higher wages to prices and to ensure that structural reforms do not create deflationary pressures.
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Renewed focus on fiscal policy: Japan’s key long-term challenge remains—achieving fiscal sustainability. Here, the report recommends that the authorities adopt a gradual but steady path of consumption tax increases, starting as soon as possible, and an explicit expenditure rule to contain social security spending growth. In this context, strengthening fiscal institutions, for example, through more independent macro-fiscal forecasts to ensure that budget projections are built on realistic macroeconomic assumptions, is critical.
Japan’s top five priorities
To fulfill Abenomics’ promise of higher economic growth with an end to deflation, Japan needs the following:
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Implement more ambitious structural reforms, particularly in the labor market to reduce duality and encourage the participation of women, older
workers and foreign professionals.
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Add stronger income policies to the policy mix targeted at enhancing wage-price dynamics, facilitated by sustained and balanced fiscal and monetary
demand support.
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Commit to a credible fiscal consolidation plan, with a pre-announced path of steady consumption tax hikes; broaden the tax base; reform the social
security system; and strengthen the fiscal framework to enhance policy credibility.
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Enhance the effectiveness and credibility of monetary policy; raise inflation expectations through clearer communication and better use of forward
guidance.
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Safeguard financial stability, including by enhancing the monitoring of bank profitability and JGB market liquidity, and bolstering resilience of
regional banks through further regulatory reforms.
