Japan: Staff Concluding Statement of the 2018 Article IV Mission
IMF News, October 4, 2018
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- Published: October 4, 2018
Recent economic developments and policies
- Real GDP growth projected at 1.1 percent in 2018, above estimated potential; headline and core inflation remain well below Bank of Japan’s 2 percent target.
- Domestic demand recovered in Q2 2018 after a temporary soft patch earlier in the year; external demand expected to remain supportive.
- External account:
- Current account (CA) surplus was 4.0 percent of GDP in 2017 and is expected to shrink to 3.6 percent of GDP in 2018.
- The sizable income surplus—about 90 percent of the CA surplus in 2017—reflects Japan’s large net foreign asset (NFA) position and high net returns.
- The 2018 current account balance and the 2018 real exchange rate are preliminarily assessed as broadly consistent with medium-term fundamentals and desirable policies.
- Fiscal framework:
- The “New Plan to Advance Economic and Fiscal Revitalization” (announced June) postponed the primary surplus target from FY2020 to FY2025.
- The framework relies on relatively optimistic GDP and productivity assumptions and lacks a long-term plan to address increasing social security expenditures and ensure debt sustainability.
- The government reaffirmed commitment to the October 2019 two-percentage point consumption tax rate increase; mitigating measures are yet to be specified.
- Structural reform progress:
- Recent labor market legislation passed by the Diet; effectiveness depends on implementation (including equal-pay for equal-work guidelines).
- Female and older-worker participation rising; foreign labor is increasing.
- Slow progress on eliminating disincentives to regular work from tax and social security systems; deregulation progress remains limited in some areas.
- Revisions/guidelines for the corporate governance code completed; trade reforms accelerated (Japan-EU agreement and CPTPP).
- Monetary and financial developments:
- Bank of Japan (BoJ) has pursued Yield Curve Control (YCC) since September 2016 and adopted a more patient approach to the inflation target.
- Reduced reliance on JGB purchases has stabilized bond yields; July monetary policy meeting introduced greater flexibility in long-term yields and forward guidance on interest rates.
- Prolonged low interest rates and demographic change are squeezing financial institutions’ profitability and encouraging search for yield, posing particular challenges for regional financial institutions.
Outlook and risks
- Outlook:
- Underlying growth expected to remain solid despite the scheduled consumption tax increase; consumption volatility likely without effective mitigating measures.
- The consumption tax increase’s adverse effects are expected to carry past 2019 and adversely affect consumption and overall growth in 2020.
- Over the medium term, growth is expected to converge to potential and the small negative output gap to close; following a consumption tax-induced spike in 2020, inflation will rise over the medium term but likely remain below the BoJ’s target.
- Downside risks have increased; balance of risks shifted to the downside in line with the global outlook.
- Near-term risks:
- Sharper-than-expected volatility in private consumption and investment from the planned 2019 consumption tax increase could undermine near-term growth and delay fiscal consolidation.
- Weaker global demand, trade or geopolitical tensions could trigger yen appreciation, equity market shocks, renewed deflationary risks, or a disorderly tightening of global financial conditions.
- A sharp fall in equity prices or spike in JGB yields could increase macro-financial risks; rising foreign currency funding costs could squeeze profitability of internationally-active financial institutions.
- Medium-term risks:
- Continued domestic monetary accommodation alongside tightening elsewhere could encourage excessive risk taking by financial institutions—particularly regional banks.
- Failure of regional banks and life insurers to adapt business models to low interest rates and adverse demographics could threaten viability.
- Fiscal sustainability concerns and bond market stress could feed back adversely on the financial system and real economy.
Challenges and economic policy priorities
- Six years into Abenomics: accomplishments include unemployment at a 25-year low, fiscal deficit halved, higher employment and female labor participation, reduced deflationary risks, and corporate cash reserves at all-time highs.
- Remaining challenges: inflation below BoJ’s 2 percent target, fiscal policies have yet to put public debt on a sustainable path, and stagnant household incomes.
- Demographics: population projected to shrink by 25 percent over the next 40 years—depressing growth and productivity and magnifying fiscal challenges.
- Policy prescription: the strategy of Abenomics remains appropriate but needs reinvigoration so the three arrows (monetary, fiscal, structural) are reinforced and mutually supportive.
Fiscal policy (recommendations and specifics)
- Near-term stance:
- Avoid near-term fiscal tightening; maintain a neutral fiscal stance in 2019 and 2020 to support the planned consumption tax hike and BoJ reflation efforts.
- Implement measures to support reflation and growth momentum while advancing structural reforms.
- Mitigating the 2019 consumption tax increase:
- Design temporary mitigating measures to alleviate adverse consumption impacts from the October 2019 tax increase, especially for durable goods like automobiles and housing.
- Provide clear communication on timing and content to reduce uncertainty.
- Income and administered prices:
- Strengthen corporate tax incentives for wage increases.
- Raise minimum wages further.
- Increase administratively-controlled wages and social transfers to reflect consumption tax impact.
- Consider reforming price-setting of administered prices to better reflect costs, with safeguards for low-income households.
- Medium- and long-term fiscal framework:
- Establish a well-specified medium-term fiscal framework relying on independent and realistic assessments, specifying consolidation measures, and limiting supplementary budgets; an independent fiscal institution could be important.
- Medium-term consolidation recommendation: annual consolidation of about 0.5 percent of GDP in the structural primary balance, starting from 2021.
- Gradual and steady increases in the consumption tax rate beyond 10 percent, with consolidation centered on increases until the rate reaches at least 15 percent; maintain a unitary rate structure as the rate moves beyond 10 percent.
- Reform healthcare to contain total spending with a focus on efficiency; consider increasing out-of-pocket shares with safeguards for low-income households.
- Address income inequality: protect disadvantaged elderly groups when curbing social security outlays; fiscal policy should support opportunities for women and eliminate disincentives to full-time and regular work in tax and social security systems.
Structural reforms (recommendations and potential impact)
- Overall:
- Reinvigorated reforms to boost productivity, labor supply, and investment are critical; credible implementation, combined with accommodative monetary policy and public debt stabilization, could boost real GDP by as much as 15 percent over 40 years.
- Labor market reforms (largest impact):
- Provide training and career opportunities to non-regular workers, including via contract reform, to raise productivity and real wages.
- Complement equal-pay for equal-work legislation with detailed job descriptions and a stronger reporting framework.
- Increase labor participation by women, older workers, and foreign workers by eliminating tax and social security disincentives, expanding childcare and nursing facilities, and reducing the gender wage gap.
- Reduce excessive overtime, encourage managerial practices that reward productivity, and consider abolishing firms’ right to set a mandatory retirement age.
- Product market and corporate reforms:
- Facilitate exit of non-viable SMEs and entry of higher-potential firms; reduce coverage of the credit guarantee system; incentivize alternative SME financing; support SME R&D and business succession for high-growth firms.
- Continue deregulation to lower barriers to entry and remove incumbent protections in some industries (telecom and gas), deregulate professional services, and expedite deregulation in economic zones.
- Deepen corporate governance reform to deploy cash reserves and boost investment; promote broader adoption of automation and AI.
- Trade liberalization and FDI:
- Further removal of tariff and non-tariff barriers within multilateral trade agreements would boost investment and growth.
Monetary and financial policies (recommendations)
- Bank of Japan:
- Maintain long-term interest rate target while strengthening inflation expectations and policy credibility.
- Clarify relationship between forward guidance on long-term interest rate target and the inflation target.
- Remove quantitative guidance on JGB purchases.
- Consider moving closer to a full-fledged inflation targeting framework by publishing BoJ’s staff baseline forecast together with underlying policy assumptions to strengthen communication and credibility.
- Financial sector resilience:
- Japanese Financial Services Agency (JFSA) should enhance financial oversight, including macroprudential framework strengthening, to prevent systemic risk build-up.
- Encourage financial institutions, particularly regional ones, to improve risk management and adapt business models to demographic trends via revenue diversification, IT and Fintech utilization, and consolidation.
- Strengthen crisis management and resolution frameworks to reduce public support expectations and facilitate orderly exits of unviable institutions.
- Facilitate Fintech uptake to reduce costs and improve efficiency; increase cybersecurity for Fintech firms (including crypto-asset exchanges) and regional financial institutions.
- JFSA needs adequate human and IT resources and should promote use of RegTech; enhance cross-border supervisory collaboration to prevent regulatory arbitrage.
Spillovers and resilience
- External spillovers:
- Continued multilateralism and bolder domestic policies are needed to mitigate inward spillovers, including from trade-war escalation.
- A global retreat from cross-border integration would likely reduce Japan’s net exports, investment, and growth—channels include global value chains and financial sector spillovers; cars and car parts trade would be particularly significant.
- Japan’s leadership in multilateralism can help mitigate trade-war effects.
- Alternatively, credible structural reforms and medium-term fiscal consolidation supporting growth and domestic demand would mitigate inward spillovers that could otherwise increase external imbalances.
- Outward spillovers:
- Rising global interest rates amid Japan’s accommodative policy could amplify outward spillovers.
- Speculation over early policy normalization in Japan could rattle bond markets and increase volatility.
- Growing differentials between global and domestic interest rates could encourage unhedged yen carry trade; a sharp reversal could cause large yen appreciation and hurt BoJ’s reflation efforts.
Closing
- The IMF team thanks authorities and interlocutors in Tokyo, Sendai and Osaka for hospitality and discussions.
Japan: Staff Concluding Statement of the 2018 Article IV Mission