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Japan: Staff Concluding Statement of the 2017 Article IV Mission
June 19, 2017
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IMF Communications Department
MEDIA RELATIONS
PRESS OFFICER: Tomomi Sekioka
Phone: +1 202 623-7100Email: MEDIA@IMF.org
The current momentum in the Japanese economy provides an opportunity to push forward with reforms that will enhance growth and inflation prospects and mitigate medium-term risks. Above-potential growth and low unemployment provide room for actions that would be more difficult in other times. The need for a bolder approach is highlighted by several factors. First, recent growth is grounded in external gains and temporary fiscal stimulus. Second, labor shortages have yet to feed through to wages, and inflation has not shown a durable lift-off. Finally, demographic headwinds and an unprecedented level of public debt will continue to generate significant policy challenges over the medium term. A comprehensive policy package—built around macro-critical structural reforms and income policies—is needed to make the most of monetary accommodation and available fiscal space. This package should include a credible medium-term fiscal consolidation plan, based on gradual adjustment, as well as policies to contain financial risks stemming from the low-interest rate environment and demographic headwinds.
Abenomics has improved economic conditions and engendered structural reforms. Since its inception in 2012, Abenomics has proven successful in easing financial conditions, increasing corporate profits, and boosting employment and female labor force participation. Structural reforms have advanced in the areas of energy and agricultural liberalization, trade and investment promotion, and corporate governance. Revised national accounts data indicate more robust GDP growth during 2013-15 than originally estimated, based largely on stronger private investment and consumption.
Recent economic performance is the strongest in several years. The economy expanded at a pace above potential for the last five consecutive quarters. Private consumption growth turned positive in 2016 and private investment strengthened. Unemployment has fallen to record levels, the job offer-to-applicants ratio is at an all-time high, and survey data point to a steady increase in business and consumer confidence. Exports picked up in the second part of 2016 in line with rising global demand, while imports (driven by energy) weakened. This strengthened the current account balance, which for Japan reflects primarily the income account (accounting for about 90 percent of the surplus in 2016). Similar to the previous year, the 2016 current account balance was assessed as just moderately stronger than the level consistent with medium-term fundamentals and desirable policies. This overall assessment is based on the IMF external balance assessment methodology supplemented by judgement and further analysis. The real exchange rate appreciated substantially between 2015 and 2016 moving it to a level consistent with medium-term fundamentals. Exports, private consumption and investment maintained momentum in Q1 2017, with imports starting to pick up in late 2016.
Positive economic data notwithstanding, the recent gains are vulnerable and key policy objectives have yet to be achieved.
A significant share of recent growth is tied to a favorable external environment and fiscal stimulus —with domestic investment and consumption too weak to sustain positive momentum on their own. Five years into Abenomics there also remain gaps between outturns and targets for inflation and the fiscal position. Household incomes have not shared equally in the gains from stronger growth. Meanwhile, medium- and long-term challenges persist and pose risks to macroeconomic and financial stability. Demographic headwinds continue to generate significant policy challenges and the unprecedented level of public debt remains a concern.
Inflation remains stubbornly low amidst weak pass-through of monetary policy. Widespread labor shortages have yet to translate into sustained wage growth and upward price pressure. Low labor mobility, a strong preference for job security, and wage setting based on past inflation constitute the main bottlenecks for triggering needed wage-price dynamics.
Macro-financial challenges persist. Financial firms face a challenging environment as low interest rates have reduced profitability and led to a search for higher yields—inducing many banks and insurance firms to incur new and less understood risks. Credit growth picked up in the last quarter of 2016, while overseas investment and real estate lending increased. Meanwhile, sovereign-financial linkages remain high. A stronger corporate saving-investment balance contributed to an increase in the current account surplus and a further buildup of already large corporate cash holdings.
Monetary and fiscal policies are providing needed demand support . Monetary policy settled into a more sustainable accommodative stance with the September 2016 introduction of “yield curve control” (YCC), including a commitment to overshoot the inflation target. The upgrade was aimed at raising inflation expectations and signals a strengthened resolve to monetary easing. In mid-2016, near-term fiscal support was boosted by postponing the planned 2 percentage point consumption tax hike (to October 2019), and by a 1.5 percent of GDP supplementary fiscal package that has raised spending mainly in 2017.
The “third arrow” of structural reform remains the lagging element of Abenomics. That said, with labor market bottlenecks at the core of tepid domestic demand, the government’s recently announced Work Style Reform has important potential. Planned measures toward “equal pay for equal work” are designed to address wage gaps between regular and non-regular workers. A cap on overtime is expected to boost productivity and labor force participation, and an expansion in childcare facilities will support further integration of women in the labor market. However, implementation plans have long horizons, with the related laws and regulations yet to be drafted. There are also some gaps in the plan. Introduction of job descriptions is needed for the equal pay for equal work initiative to succeed. Capacity of childcare facilities needs to be targeted to meet expected demand. Efforts to eliminate disincentives to regular work stemming from the tax and social security system have fallen short—with only a minor revision to the threshold for the spousal tax deduction allowance. Deregulation and corporate governance reforms have yet to spur private investment as intended.
Growth momentum is expected to continue in 2017 but would weaken in 2018 if fiscal stimulus fades as currently planned. Fiscal stimulus will support growth through higher consumption and investment in the near term, while accommodative monetary policy should facilitate a virtuous cycle between credit and economic growth. However, the expiration of fiscal support in 2018 under current policies together with a smaller expansion in foreign demand would reduce growth to less than half of that in 2017. Without additional spending, the fiscal stance could become contractionary in 2018–20 due also to the scheduled consumption tax hike in October 2019. The current account surplus is expected to rise gradually over the medium term under the current policy mix, as an expansion of foreign demand generates a higher goods trade balance. Demographic headwinds will continue to weigh on potential growth over the medium- and long-term, both through a shrinking labor supply and lower productivity.
Inflation is likely to remain below the target. In 2017, average inflation is expected to rise to 0.7 percent, supported by higher energy prices and a narrowing output gap, but modest wage increases will hold back household income and spending, and temper upward pressure on prices. In 2018, average inflation is projected to fall to 0.6 percent as growth slows. Absent reforms to reduce duality and engender a stronger focus on nominal wage increases versus job security, tight labor market conditions will be slow to generate wage-related price pressures. Together with strong backward-looking expectations, this is likely to keep inflation below the 2 percent target over the medium term.
Risks to the outlook are tilted to the downside. Upside risks in the near term relate to a supplementary budget for 2018 and stronger exports stemming from higher-than-expected global demand. Downside risks are linked to a retreat from cross-border integration, deflation from a sharp yen appreciation driven by geopolitical instability, a loss of confidence in domestic policies, market risks from a decline in equity prices or a sharp increase in JGB yields, FX funding liquidity risk in some internationally active regional banks, and the possibility of a disorderly rebalancing in China. In the medium-term, doubts about fiscal sustainability could lead to a jump in the sovereign risk premium forcing abrupt fiscal adjustment. Chronically low bank profitability, driven by low growth and low rates, and underlying demographic headwinds could pose solvency problems for regional and Shinkin banks. Life insurers could also face solvency pressures if low interest rates continue.
The currently favorable economic environment is an opportunity to accelerate reform. The mission recommends a comprehensive and mutually reinforcing package of accelerated structural reform, coordinated monetary and fiscal support, and enhanced financial sector policies. Many of the policy measures needed to bolster economic growth and reduce medium-term risks have already been identified in the government’s reform and growth strategies. These include measures to close wage and other gaps in the labor market, promote a more inclusive labor force, use income policies to bolster wage-price dynamics, spur private investment, enhance fiscal policy formulation, and address and mitigate macro-financial vulnerabilities by enhancing financial oversight and corporate governance. A continued accommodative stance by the BoJ is consistent with the objective of reflating the economy, and needs to be accompanied by bold structural reforms and a credible and specific medium-term fiscal consolidation plan to deliver an external position consistent with medium-term fundamentals. Strengthened financial sector policies to protect against risks from low interest rates and to facilitate the financial sector’s adaptation to adverse demographic trends should be a central element of the policy strategy. Clear communication and consistent policy implementation would help reduce uncertainty and improve economic outcomes.
Reform plans should first prioritize structural policy measures aimed at facilitating reflation, followed closely by those to lift potential growth . The reform agenda should weigh trade-offs and synergies between reforms, and be backed by appropriate monetary and fiscal support:
First priority: Labor market reforms to increase productivity and boost wages . The government’s new Work Style Reform drive recognizes the need for a broad reform effort in this regard. The gap in employment protection between regular and non-regular workers can be reduced by promoting “intermediate” job contracts that better balance job security and wage increases. Worker mobility across firms needs to be enhanced to strengthen productivity and wage pressures. Accelerating “equal pay for equal work” together with the introduction of job descriptions can help close wage gaps and boost overall wages.
Second priority: Reforms to increase private investment and long term growth . Further reform of product and services markets are needed, including removal of barriers to entry (i.e., in the telecoms and gas sectors) and deregulation in professional services. Further corporate governance reforms could help deploy cash reserves and boost investment—such as more ambitious requirements for outside directors and explicit limits on cross-shareholdings. Measures to boost trade and FDI and advance SEZ deregulation are also key. Financial sector policies should aim to reduce SMEs’ financing constraints and promote productivity and investment, including facilitating banks’ move to risk-based lending, and lowering the coverage of public credit guarantees.
Third priority: Measures to diversify and enhance labor supply . Further support for female and older worker labor force participation and increased use of foreign labor will boost long term growth. Eliminating tax and social-security related disincentives to full-time work, increasing availability of childcare and nursing facilities, reducing excessive overtime, and supporting managerial practices rewarding performance will increase labor force participation. Firms should also be discouraged from setting a mandatory retirement age.
Effective and coordinated near-term support from monetary and fiscal policies, combined with income policies to spur wage-price dynamics, is needed to reflate the economy.
Monetary policy should maintain a sustained accommodative stance. The BoJ should carefully calibrate its yield curve policy, if downside risks materialize, to provide additional monetary easing. Maintaining credibility in the new monetary policy framework will be crucial for its success. To this end, the BoJ should further strengthen its communication framework, including by publishing staff forecasts of inflation and phasing out references to annual JGB purchase targets. Such measures to improve the public’s understanding of monetary policy would help reduce uncertainty and ensure policy credibility.
Fiscal policy needs to balance near-term demand support with a medium-term shift to address the challenge of high public debt. The near-term fiscal stance should be at least broadly neutral in 2018, avoiding the scheduled withdrawal of fiscal stimulus. An expansionary fiscal stance could be considered depending on the ambition of reforms, macroeconomic conditions, and credibility of the medium-term fiscal framework. Regarding the latter, the interim fiscal review planned for 2018 provides an opportunity to strengthen the framework, including by limiting reliance on supplementary budgets and using more independent and realistic growth assumptions. To balance the objectives of protecting growth and putting debt on a stable path, the medium-term fiscal consolidation plan should embed a gradual approach, with an annual consolidation in the structural primary balance of 0.5 percent of GDP on average in accordance with the evolution of the economy. The plan should place emphasis on a gradual, pre-announced schedule of consumption tax rate hikes (of 0.5 to 1.0 percentage points in regular intervals, starting as soon as possible and continuing until the rate reaches at least 15 percent) while preserving the unitary structure of the tax. Social security spending should be curbed through fundamental reforms to avoid its rapid increase putting serious pressures on fiscal sustainability.
Exploiting the full range of synergies between monetary, fiscal, income, and structural policies is critical. Income policies should be used to complement and amplify monetary and fiscal policies. For example, raising administratively controlled wages annually in line with the inflation target and further incentivizing profitable companies to raise wages by at least three percent each year will help spur wage-price dynamics. Additional measures aimed at prioritizing fiscal incentives for intermediate contracts, active labor market policies to support worker mobility, and increased provision of childcare will support the structural reform agenda. Demand support will also be important to ensure that structural reforms to boost labor supply do not create deflationary pressures.
Bolder domestic policies are needed to mitigate spillovers. Accelerated structural reform and a credible medium-term fiscal consolidation plan would support growth, domestic demand, imports, and prices—mitigating inward spillovers from external developments that could increase external imbalances. Desired policies would also limit the impact from a retreat from cross-border integration, sharp yen appreciation driven by geopolitical instability, and possible disorderly rebalancing in China. There have been no significant spillovers from YCC to financial conditions in other economies. Capital outflows continued during most of 2016 as institutional investors maintained a strategy of overseas diversification while FDI outflows continued, with no significant shifts expected in these trends.
Enhanced financial oversight frameworks would help contain emerging risks. Internal processes need to be further developed to support full risk-based prudential supervision, and corporate governance needs to be strengthened across the banking and insurance sectors. Moreover, capital requirements need to be more tailored to individual bank risk profiles. Further steps should be taken to implement an economic-value-based solvency regime for the insurance sector as certainty about the future regime would help companies to adjust their business and investment strategies. The macroprudential framework could be further strengthened by clarifying the mandate of the Council for Cooperation on Financial Stability (CCFS) and proactively expanding the macroprudential toolkit.
It is important to continue engaging with financial institutions on the implications of macroeconomic and demographic trends, and to take timely action when viability concerns are identified. The authorities are encouraged to (i) further engage with bank boards and senior management to ensure banks fully understand the implications of underlying trends for future viability, and act promptly to facilitate the exit of unviable firms; and (ii) facilitate the transition of regional banks to higher fee-based income. Consolidation among regional financial institutions may bring valuable economies of scale, although consolidation alone is unlikely to be sufficient to address the challenges.
The crisis management and resolution framework could be strengthened further. The complexity of the framework and ambiguities regarding the circumstances under which different regimes of the framework would be used, could prove challenging for implementation, and may thereby fuel expectations of public support. Further steps to ensure that supervisory powers are deployed without delay should be embedded more firmly in the authorities’ framework for early intervention. Expansion of the resolution toolkit, enhancement and clarification of the legal framework (including its extension to central counterparties (CCPs)), and improvements in operational aspects would improve authorities’ readiness and help steer market expectations and incentives.
The views in this statement also reflect the findings of the Financial Sector Assessment Program (FSAP), which was conducted by the IMF over the period September 2016-April 2017. Countries with financial sectors that are considered systemically important, such as Japan, must undertake a mandatory stability assessment every five years.
The IMF team would like to thank the authorities and other interlocutors for their gracious hospitality and frank and open discussions.
