Mission Concluding Statement 

Japan: Staff Concluding Statement of the 2019 Article IV Mission

November 25, 2019

The Japanese economy continues to grow above potential. However, moderate growth in domestic demand is being eroded by the weaker external environment, and downside risks have increased. Moreover, macroeconomic challenges will increase as demographic headwinds intensify. While the strategy of Abenomics remains appropriate, reinvigorated policies are needed to boost potential growth, reflate the economy, and make public debt sustainable. A comprehensive and coordinated effort to achieve these objectives should entail: (i) continued accommodative monetary policy that is better coordinated with financial sector policies which mitigate s growing financial stability risks , and may enhance monetary policy sustainability; (ii) a well-specified medium-term fiscal framework, involving identified revenue and expenditure measures; and (iii) an ambitious effort toward labor, product market, and corporate reforms.

RECENT ECONOMIC DEVELOPMENTS AND POLICIES

Growth remains above potential despite increasing external headwinds, but inflation momentum remains modest. Private consumption (helped by extended holidays) and public spending supported growth in H1 2019. Exports and export-driven investment have softened in line with weaker external conditions and rising uncertainty. Relative to 2014, consumption has been less affected by the October 2019 consumption tax rate increase, owing in part to government countermeasures. Real GDP growth is projected to be above potential at 0.8 percent in 2019. While unemployment is at its lowest rate since 1993, total hours worked are declining and the output gap remains negative. Inflation expectations and wage growth remain weak. Headline inflation momentum has eased, and core-core inflation (excluding food and energy) remains stable at around 0.5 percent.

The consumption tax rate was increased by two percentage points as planned on October 1, and accompanied by measures to smooth demand volatility and mitigate the impact on the economy, including: (i) a point-reward program for cashless payments in SMEs; (ii) a tax allowance for automobile and house purchases; (iii) infrastructure investment; and (iv) additional spending for childcare and tertiary education. Together with a smaller rate increase (2 versus 3-percentage points in 2014), and exemption of food, non-alcoholic beverages and newspapers, these measures appear to have made frontloading of demand smaller than in 2014. However, a pickup in demand for some durable goods was observed in September.

The monetary policy stance has been largely unchanged since 2016 but pressure is rising to provide more stimulus in line with other major central banks. Since 2016 the Bank of Japan (BoJ) has maintained a negative short-term interest rate (at -10 bps) and a zero-percent yield target for 10-year Japanese Government Bonds (JGBs). Meanwhile, under its Yield Curve Control (YCC) framework, the BoJ has reduced JGB purchases. In April, the BoJ clarified its forward guidance for policy rates taking into account risks related to the overseas economy. In October the BoJ renewed forward guidance for policy rates to clearly relate to the momentum toward achieving the price stability target and to clarify that there was “a downward bias” in policy rates. Relative to one year ago, the JGB yield curve has flattened with yields up to the 10-year maturity falling into negative territory. This has reduced net lending margins of banks, and investment income of insurers and pension funds, spurring them to adopt riskier asset allocations. Financial conditions remain loose and financial stability risks are rising.

Structural reforms are moving forward gradually, while the benefits of some measures await fuller implementation. Plans to implement "equal pay for equal work" regulations starting in April 2020 include guidelines to eliminate “irrational gaps” between regular and non-regular workers in the same firm, with oversight by national labor bureaus. A regulated cap on overtime has been in effect for large firms since April 2019, but it is relatively high and may only increase productivity and wages over time. A new residency status for foreign workers was enacted in April 2019, allowing higher inflows of specified skilled workers into select industries. However, the relatively strict qualification requirements appear to have limited the inflow of foreign workers. Revisions to the 2015 Corporate Governance Code have not substantially reduced cross-shareholdings, although shareholders have reportedly increased activism and votes against management. On the other hand, through its ETF purchases the Bank of Japan has become one of the largest shareholders of listed companies, leaving less scope for activist investors. Further, the Financial Services Agency (FSA) plans to ease restriction on bank’s investments in other banks by relaxing capital requirements only for non-internationally active banks, in order not to discourage them from providing financial assistance to potentially distressed banks. The government has moved ahead with plans to subject foreign investment in national security-related industries to greater scrutiny through streamlined procedures.

Japan has made substantial progress on trade relations. The Japan-European Union Economic Partnership and the Comprehensive and Progressive Agreement for Trans-Pacific Partnership took effect in February 2019 and December 2018, respectively. Japan and the U.S. signed agreements in October 2019 regarding market access for agricultural and industrial goods, as well as on digital trade. Negotiations have advanced on the Regional Comprehensive Economic Partnership. Japan’s strengthened procedures for exports to Korea of materials critical for producing semiconductors and displays, as well as reciprocal suspension of streamlined export procedures, have had limited economic effects so far.

OUTLOOK AND RISKS

Growth is expected to moderate, and inflation is expected to edge up slowly but remain below BoJ’s two-percent target over the medium term. Private consumption growth is expected to recover to pre-tax increase levels by end-2021. Growth in 2020-21 will be driven by domestic demand—partly offsetting an expected fall in net exports. Adverse external conditions will dampen export-driven private investment and manufacturing. However, non-manufacturing investment is expected to stay firm due to investment in labor-saving technologies. Over the medium term, external conditions will improve and the output gap gradually close. Expected and actual inflation are projected to remain below target under current policies.

Japan faces a range of risks. Rising economic policy uncertainty, an increase in financial stability risks, and consumer and investor confidence at multi-year lows all suggest a rising risk profile. Given the importance of manufacturing in the Japanese economy, a further slowdown of global manufacturing would hurt Japan’s exports and investment—potentially turning into a significant downside risk to growth if the slowdown spills over to services.

• Near-term risks : A sharp and more-protracted fall in consumption in the wake of the consumption tax rate increase could pose a risk, while a supplementary budget in 2019 would boost domestic demand and growth. External risks are dominated by weaker-than-expected global growth and further de-globalization. An abrupt deterioration in market sentiment could lead to heightened risk aversion, yen appreciation (undermining reflation efforts), equity market volatility, and macro-financial risks. Disruptions in U.S. dollar funding markets could increase the cost of funding for some Japanese banks.
• Medium-term risks : Riskier asset allocations by banks, insurers and pension funds—to support profitability as the population ages and shrinks—may lead to balance-sheet deterioration and tighter capital constraints with negative spillovers to the real economy. Market risks from large adverse variations in equity prices and JGB yields could generate large losses for major banks and life insurers. Demographic trends will increase age-related government spending, particularly mandatory social security expenditures, heightening fiscal sustainability concerns and potentially triggering bond market stress. Higher risk premia could increase debt service costs and refinancing risks for the sovereign—with adverse feedback effects to the financial system and the real economy.

ECONOMIC POLICIES FOR AN AGING AND SHRINKING POPULATION

Japan’s macroeconomic challenges will intensify due to demographic headwinds. Official projections anticipate the population will shrink by over 25 percent in the next 40 years. This will depress growth and productivity due to a reduced labor force and magnify fiscal challenges as age-related spending rises while the tax base shrinks. Furthermore, labor market rigidities also limit productivity growth and hamper pass-through of demand stimulus to real wages and prices. Abenomics—now entering its seventh year—has eased financial conditions, reduced the fiscal deficit, and raised employment and female labor force participation. Nonetheless, reflation efforts have fallen short and under current policies public debt is projected to rise from the mid-2020s. Implementation of the ‘third arrow’ of Abenomics (structural reforms) could have been more expeditious.

Comprehensive and mutually reinforcing policies are needed to lift current and expected inflation, stabilize debt, and raise potential growth.

• Monetary and financial policies : BoJ’s accommodative monetary policy stance should be maintained. Meanwhile, monetary and financial sector policies should be better coordinated to enhance monetary policy sustainability and mitigate growing financial stability risks.
• Fiscal policy : Near-term fiscal and income policies should complement BoJ's reflation efforts and the implementation of structural reforms. The authorities' medium-term fiscal consolidation plan should be based on realistic assumptions and lay out concrete fiscal measures to provide additional near-term fiscal space while ensuring fiscal sustainability.
• Structural reforms : Structural reforms are imperative to lift long-run growth potential and stabilize government debt. Deflationary supply-side effects would be offset by near-term demand—supported by strengthened confidence, enhanced expectations and more effective monetary policy transmission.

Monetary and Financial Policies

The BoJ’s Yield Curve Control (YCC) framework has made monetary accommodation more sustainable, but inflation remains below target. The BoJ should maintain its short- and long-term interest rate targets to support growth and inflation while considering measures to further enhance policy credibility to permanently lift inflation expectations. Specifically:

• Reviewing the price stability target . Given increased attention to structural drivers of low inflation—both global (e.g., technological progress) and domestic (e.g., demographic trends)—an updated assessment of the inflation level consistent with the price stability objective could be carried out. Moreover, the BoJ could consider increasing policy flexibility by introducing an inflation range target while emphasizing the medium- to long-term nature of achieving the price stability objective. This could allow the BoJ to more flexibly address competing policy objectives such as financial stability.
• Strengthening the conduct of monetary policy . BoJ could consider enhancing its current “two perspective” policy strategy by adopting Inflation Forecast Targeting (IFT). IFT could improve policy credibility and predictability by making monetary policy respond more systematically to deviations of BoJ’s inflation forecast from the price stability target.
• Further improving communication with financial markets and the public . Following the welcome clarification of the link between the policy rates and the price stability target in BoJ’s October monetary policy statement, policy guidance could be simplified by: (i) abandoning the quantity guidance on JGB purchases; and (ii) delinking the overshooting commitment from the monetary base. Moreover, consistent with an IFT strategy, Board members’ forecasts currently published in the BoJ’s Outlook Report could be replaced by a BoJ staff forecast consistent with the agreed policy instrument paths.

The continued low yield environment and population aging are creating macro-financial challenges. To safeguard financial stability, the FSA—in coordination with the BoJ—should further enhance its financial oversight and strengthen its macroprudential policy framework to mitigate the buildup of systemic risk. Specific policy measures could include:

• Adjusting the YCC framework . The BoJ could mitigate the impact of its prolonged accommodative monetary policy stance on financial institutions’ profitability by shifting its zero percent YCC target from the 10-year JGB yield to a shorter maturity, while reducing its purchases of JGBs with longer term residual maturities, which should steepen the JGB yield curve.
• Activating the countercyclical capital buffer (CCyB) . Total credit growth has been above nominal GDP growth, financial conditions remain loose, and financial vulnerabilities are rising. In this context, the authorities should consider raising the CCyB above its current zero percent level to pro-actively build-up the resilience of the banking sector to rising systemic risk, while expanding its coverage to the domestic credit exposures of all domestic banks, not just internationally active ones.
• Strengthening prudential supervision and regulation . As the financial cycle matures, the FSA should continue to strengthen its financial sector supervision and regulation, by intensifying its risk assessment process and completing its macroprudential policy toolkit to better identify and mitigate the build-up of systemic risk. It should also continue encouraging banks to improve their risk management and resilience through robust microprudential supervision and regulation—by tailoring capital requirements to fit risk profiles and fostering more forward-looking loan-loss provisioning.
• Supporting business model adjustment by regional banks . The FSA should continue to encourage regional banks to ensure their soundness through revenue diversification, better utilization of IT/Fintech, and consolidation.
• Addressing other financial sector policy issues . The FSA should strengthen its crisis management and resolution framework, for example, by extending the coverage of Total Loss-Absorbing Capacity requirements to all D-SIBs. It should also continue to take steps towards introduction of an economic-value-based solvency regime for the insurance sector.

Fiscal policy

A neutral fiscal stance should be maintained in 2020 and, if warranted, 2021—coordinated with continued monetary accommodation. The 2019 increase in consumption tax revenue will be largely offset by expenditure increases and revenue losses from mitigating measures, making the 2019 fiscal stance broadly neutral. However, without accounting for the stimulus package under consideration, the 2020 and 2021 fiscal stance is projected to be contractionary. Given clear downside risks and the need to avoid a pro-cyclical fiscal tightening that might undermine growth momentum, a neutral fiscal policy stance should be maintained in 2020, and potentially in 2021 depending on data outturns. Additional fiscal measures in the near term could include:

• Extending consumption tax countermeasures in 2020. Extending the temporary measures to cushion the impact of the consumption tax rate increase should be considered.
• Further increasing wages of workers in the childcare, health and long-term care sectors. While it is critical to contain growth in social security spending, rising demand for these services needs to be matched by supply-side measures to ensure adequate staffing and quality of service.
• Reinforcing income policies and protecting the most vulnerable. A clear government commitment is needed for more effective corporate tax incentives for wage increases, higher minimum wages, and an increase in administratively-controlled wages and social transfers. Administered prices should be set by a mechanism that better reflects costs, with safeguards for low-income households.
• Supporting structural reforms. Fiscal measures should raise childcare availability and strengthen firms’ incentives to further increase firms’ provision of childcare and nursing-care, enhance non-regular workers’ productivity, and boost R&D investment.

A well-specified framework to ensure fiscal sustainability is needed to reduce debt, lower uncertainty, and support reflation and growth. While the government has set a primary balance target for FY2025, credibility would benefit from realism of assumptions and specificity of measures to achieve the target. The presence of a clear and credible fiscal anchor would help diminish policy uncertainty, and likely bolster corporate investment and reduce households’ precautionary saving. Several key steps are needed to bolster the credibility of fiscal policy:

• Adopt realistic growth and fiscal projections . Realistic assumptions for TFP growth and public spending growth would set policies in a realistic context.
• Factor in aging costs . It is important to continuously assess and incorporate aging costs in macro-fiscal projections. IMF staff scenarios suggest that to finance aging costs, the consumption tax rate would need to increase gradually to 15 percent by 2030 and to 20 percent by 2050. The cost of postponing adjustment is substantial and would benefit the current elderly to the detriment of future generations.
• Strengthen redistribution effects . Japan’s capital gains tax (part of the Financial Income Tax which also covers dividends and interest) is a flat rate of 20 percent, with some exemptions intended to promote household financial investment. The rate of taxation on capital gains should be gradually increased to 30 percent, starting in 2022. Alternatively, re-introduction of a wealth tax could be considered. A new wealth tax with zero or very few exemptions, a high threshold, and a low flat rate would minimize administrative costs and help limit capital flight, while addressing inequality and collecting meaningful revenue.
• Raising the carbon tax . To strengthen incentives to reduce energy use and shift to clean energy sources, a higher carbon tax should be considered, together with measures to support vulnerable households.
• Improving the transparency of the budgetary framework . The government should limit the frequency and size of supplementary budgets to reduce policy uncertainty and increase the effectiveness of macroeconomic demand support.

Reform of public social security programs is the essential second leg of fiscal consolidation. Without meaningful change to pension, health, and long-term care spending, fiscal sustainability may remain out of reach. The authorities’ plan to draw up a comprehensive reform package by mid-2020 is welcome, and should involve the following:

• Pension. Recent projections indicate the presence of a funding gap under conservative scenarios if the committed replacement ratio (of 50 percent) is maintained. Reforms should focus on improving pension sustainability and intergenerational equity. Potential options include increasing flexibility for pension drawdowns, and expanding the contributions base.
• Healthcare and long-term care. The prospect of continually rising healthcare expenditures, driven by population aging and use of advanced and expensive health-technology, present a sizeable challenge to Japan’s fiscal sustainability. Reforms should focus on: (i) improving efficiency through, for example, wider use of generic drugs and rationalization of in- and out-patient care; (ii) increasing the share of out-of-pocket spending for those over 75 years old and the wealthy elderly, with safeguards for vulnerable households; and (iii) reducing the scope of covered services and drugs. On long-term care, the authorities should explore measures to contain costs, including rationalizing services to those with lower-care needs.

Strengthening the effectiveness of coordination between monetary and fiscal policy remains a high priority—both to revitalizing the economy and achieving the 2 percent inflation target and—looking forward—dealing with a changing economic environment and potential new shocks. The basis for such coordination has been established in the January 2013 Joint Statement (by Ministry of Finance, Cabinet Office and Bank of Japan), which lays out coordinated measures to revitalize the economy and achieve the 2 percent inflation target, including regular review of the progress in the conduct of macroeconomic policies by the Council on Economic and Fiscal Policy. This mechanism should be used to its full potential to ensure that fiscal and monetary policies work in tandem toward mutually reinforcing objectives of growth and reflation.

Structural reforms

Structural reforms are essential to navigate Japan’s demographic headwinds. Aging and depopulation will depress productivity and growth—shrinking real GDP. IMF analysis finds that worsening demographics could reduce real GDP by 25 percent in four decades under current policies (relative to a scenario where recent performance is maintained). Credible implementation of the structural reforms outlined below, accompanied by a continued accommodative monetary stance and public debt stabilization, could to a large extent offset this effect, boosting real GDP by as much as 15 percent over the same horizon. A high degree of government commitment with respect to the reform program would be key in supporting reflation via confidence effects on consumption and investment. The reform agenda should include:

• Labor market reforms . The authorities should improve the 2018 Work Style Reform to boost productivity and wages, and should introduce measures to further increase labor supply.
• Regulatory and corporate reforms. Product and service sectors deregulation, SME reforms and corporate governance reforms should be advanced to lift productivity and investment. Broader adoption of automation and AI could also boost productivity, but distributional concerns should be considered to ensure gains are spread evenly across occupations and regions.
• Trade liberalization and FDI promotion. Further removal of tariff and non-tariff barriers in the context of high-standard multilateral trade agreements would boost Japanese investment and growth.

External Position and Spillovers to and from Japan

The external current account (CA) surplus decreased by 0.6 percentage points to 3.5 percent of GDP in 2018, but the income balance remained stable. Japan’s income surplus—arising from its large NFA position and high net returns—accounted for the bulk of the 2018 CA surplus. Japan’s income surplus was significantly higher than other G7 countries, mainly due to relatively: (i) high yields on foreign assets; (ii) low FDI and portfolio debt liabilities; and (iii) low yields on portfolio debt liabilities. Higher energy prices were an important driver of the decrease in the 2018 CA surplus, with the goods trade balance falling to 0.2 percent of GDP. Through September 2019, the yen appreciated by 5 percent (in real effective terms) relative to end-2018. Markets remain volatile, reflecting changes in global risk aversion and the monetary policy stances of key central banks. The projected 2019 CA balance is preliminarily assessed as broadly consistent with medium-term fundamentals and desirable policies. Based on this CA assessment, the 2019 real exchange rate is also preliminarily assessed as in line with the real exchange rate level consistent with fundamentals and desirable policies.

Slower growth or a tightening of financial conditions in Japan could have significant adverse outward spillovers. While the size of outward spillovers from Japan have become smaller over time, IMF estimates suggest that a 1 percent decline in Japan’s GDP generates output losses in other Asian countries of about 0.2 percent on average after one year. In addition, a prospective tightening of financial conditions in Japan could slow positive spillovers from Japanese portfolio and FDI outflows and from overseas diversification by Japanese institutional investors. This could lead to a deterioration of global financial conditions and potentially disrupt global capital flows, particularly to regional emerging markets and developing economies.

Further advancement of multilateralism would help mitigate adverse inward spillovers to Japan from an escalation of global trade disputes and yen appreciation. A more accommodative monetary stance by other major central banks, along with heightened global uncertainty from trade and geopolitical tensions, could lead to appreciation of the yen—undermining BoJ’s reflation efforts. Japan’s trade and FDI regimes are relatively open, while agriculture ranks as less open among G20 economies. However, ongoing global trade tensions and any further escalation could reduce Japan’s net exports, investment, and growth—including from direct and indirect effects via global value chains and adverse spillovers to Japan’s financial sector.

The IMF team would like to thank the authorities and other interlocutors in Tokyo, Nagi-chō (Okayama Prefecture) , and Saitama-shi (Saitama Prefecture) for their gracious hospitality and frank and open discussions.