Public Information Notice: IMF Concludes Article IV Consultation with Japan
IMF News, August 13, 1998
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- Published: August 13, 1998
Background and recent developments
- After a substantial strengthening in 1996 and early 1997, the Japanese economy fell into recession. Real GDP dropped sharply in the second quarter of 1997, with a modest rebound in Q3 1997 followed by declines in Q4 1997 and Q1 1998; monthly data suggest continued weakening in Q2 1998.
- Financial sector strains materially contributed to the slowdown: long-standing balance sheet fragilities in the banking sector, tighter credit conditions ahead of a stricter regulatory framework in April 1998, failures of several major financial institutions in late 1997, turbulence in short-term money markets, and a sharp increase in the Japan premium.
- Activity was further dampened by a shift toward fiscal consolidation in 1997 and the Asia crisis, including tax increases (a 2 percentage point hike in the consumption tax rate on April 1, 1997 and withdrawal of earlier income tax relief in June 1997), cuts in public investment, and erosion of external demand support.
- Private consumption and residential investment fell sharply in response to fiscal measures, deteriorating labor market conditions, and uncertainty; business investment faltered owing to tighter credit and weaker profit outlooks.
- Employment growth surged in early 1997 but then fell sharply; the unemployment rate rose to a post-war record of 4.3 percent in June 1998.
- Deflationary pressures emerged: core CPI fell by just over ½ percent during the first six months of 1998.
- The yen depreciated significantly against the U.S. dollar over the past year and by June 1998 had returned to early-1990s levels; the depreciation was more moderate on a trade-weighted basis.
Policy response to date
- Fiscal: February 1998 supplementary budget for FY1997 included a ¥2 trillion income tax cut (effective in the first half of 1998) and commitments to frontload public works spending. April 1998 stimulus package included around ¥12 trillion (2½ percent of GDP) in measures with direct impact on domestic demand. Structural deficit of the general government projected to increase by 1¼ percent of GDP in FY1998. Authorities later announced plans for further fiscal stimulus including ¥10 trillion of additional spending and at least ¥6 trillion in tax cuts.
- Financial sector: Public funds totaling ¥30 trillion (6 percent of GDP) made available to strengthen the deposit insurance system and inject capital into the banking system. Accounting and capital adequacy standards were relaxed to ease regulatory pressure. In July authorities announced a comprehensive plan including bad loan disposal measures, increased transparency and disclosure, and a "bridge bank" facility.
- Monetary: The target for the overnight rate remained unchanged since September 1995; the Bank of Japan injected substantial liquidity into money markets, particularly in late 1997 and early 1998.
- Exchange rate intervention: Coordinated intervention by Japanese and U.S. authorities after yen depreciation.
IMF staff outlook and projections
- IMF staff projects that real GDP is likely to decline significantly in 1998 as a whole given the sharp Q1 drop in activity.
- Expected drivers:
- Further weakening in business investment in line with recent surveys and depressed profit outlook.
- Deterioration in household confidence and labor market conditions likely to dampen consumption and residential investment.
- Reduction of record-high inventories.
- Subdued contribution from net external demand due to the regional crisis.
- Activity expected to begin to recover in the latter half of the year, mainly reflecting anticipated impact of recent stimulus packages on public investment.
Executive Board assessment — overarching messages
- The recent downturn and related yen weakness are especially worrisome because they exacerbate economic difficulties elsewhere in Asia and add instability to financial markets.
- Directors stressed the need for swift and decisive measures to reverse the deterioration and place Japan on a sustained domestic demand-led growth path.
- The overall response to date was considered welcome in parts but insufficiently timely, comprehensive, and forceful given the seriousness of the situation.
- Critical priorities: early implementation of far-reaching measures to deal with bad loans in the banking sector and restoration of the financial system’s health; ensuring fiscal support remains in place until recovery takes hold.
Banking sector — specific recommendations and concerns
- Directors acknowledged progress but noted considerable uncertainty about the extent of balance sheet problems and sufficiency of the authorities’ restructuring strategy.
- Key recommendations:
- Rigorous enforcement of the self-assessment framework so banks recognize and provision against the full extent of bad loans; publication of results for individual banks to increase transparency (suggested by several Directors).
- Recapitalization of the core banking system should link injections of public funds to strong restructuring plans; most Directors called for a more proactive approach and noted limited use of available funds to date.
- Aggressive resolution of problem loans, including placement with specialized asset management units with strong incentives to maximize value; improved institutional mechanisms for debt workouts, including reform of bankruptcy laws.
- For the "Bridge Bank" scheme to be effective, require transparent guidelines for new lending and steps to identify buyers for bridge banks on a timely basis.
- Strengthen the new financial supervisory authority by rapidly increasing its resources, providing independent funding, and enhancing its autonomy.
Fiscal policy — recommendations and considerations
- Immediate priority is to provide adequate support for aggregate demand; the risks of a deepening recession outweigh the costs of a further temporary fiscal stimulus.
- Measures should at least avoid any withdrawal of fiscal stimulus in the next fiscal year; a few Directors suggested an even more expansionary stance is warranted.
- To support medium-term fiscal consolidation goals:
- Additional tax measures in the 1998 stimulus package should improve tax system efficiency and not be merely one-off effects on activity.
- Reductions in tax rates for individuals and corporations seemed warranted given the high level of top marginal rates.
- Consideration could be given to a cut in the consumption tax—to be reversed once recovery is established—to stimulate demand in the short term.
- Accompany tax cuts with a multi-year commitment to gradual base broadening to address concerns about distributional impact and longer-term fiscal effects.
- Broader tax reforms, including reforms relating to the treatment of pensions, are needed.
- Spending-side reforms: improve the efficiency of public works; improve transparency of budgetary policy and establish a more coherent multi-year planning framework.
Monetary policy and exchange rate stance
- Directors endorsed maintaining current short-term interest rate levels for now.
- A few Directors noted that if fiscal stimulus failed to stop the decline in activity in H2 1998, arguments would shift toward using remaining scope to ease short-term interest rates.
- Most Directors did not support a current rate cut given potential to weaken the exchange rate and risk destabilizing regional financial markets; also noted limited impact of a rate cut at already low levels.
- A few Directors favored an explicit commitment to a small, but positive, inflation target to signal determination to resist deflationary pressures; many Directors thought an inflation target would not be particularly beneficial under current circumstances.
- Directors agreed the yen weakness since mid-1997 had been cyclically helpful but cautioned that further significant depreciation would be counterproductive because of negative regional effects; recent intervention appeared to have helped stabilize markets for the time being.
Structural reforms and other recommendations
- Support for "Big Bang" financial sector reforms as a key element in necessary restructuring; despite imperfect timing amid a downturn, avoid slowing the process.
- More ambitious measures recommended to scale back the public sector’s role in financial intermediation, including eliminating preferential treatment of the postal savings system.
- Limit moral hazard associated with any government guarantees, noting vulnerability in the life insurance sector.
- Encourage an ambitious, front-loaded approach to deregulation to address remaining substantial regulatory restrictions that contribute to low productivity and lack of competition:
- Further liberalize telecommunications and power generation sectors.
- Take more ambitious steps toward reducing nontariff barriers.
- Reform labor market and bankruptcy laws to encourage corporate sector restructuring.
- Commendation for Japan’s role as the world’s largest donor of ODA and substantial support to Asian crisis countries; Directors encouraged efforts to maintain Japan’s record of development assistance despite fiscal constraints.
- Improve economic data: enhance timeliness, coverage, and quality of national accounts and fiscal data.
Key economic indicators (selected)
- GDP growth (percent changes):
- 1994: 0.6
- 1995: 1.5
- 1996: 3.9
- 1997: 0.8
- 1998 Proj.: -1.7
- Private consumption (percent changes):
- 1994: 1.9
- 1995: 2.1
- 1996: 2.9
- 1997: 1.1
- 1998 Proj.: -0.9
- Nonresidential investment (percent changes):
- 1994: -5.3
- 1995: 5.2
- 1996: 9.5
- 1997: 4.3
- 1998 Proj.: -7.7
- Residential investment (percent changes):
- 1994: 8.5
- 1995: -6.5
- 1996: 13.9
- 1997: -15.7
- 1998 Proj.: -10.5
- Public investment (percent changes):
- 1994: 2.8
- 1995: 7.2
- 1996: -11.1
- 1997: 6.2
- Stock building (contribution to GDP growth):
- 1994: -0.2
- 1995: 0.2
- 1996: 0.1
- 1997: 0.0
- 1998 Proj.: -0.3
- Exports (percent changes):
- 1994: 4.6
- 1995: 5.4
- 1996: 3.5
- 1997: 10.8
- 1998 Proj.: -1.5
- Imports (percent changes):
- 1994: 8.9
- 1995: 14.2
- 1996: 11.5
- 1997: -5.9
- CPI inflation (percent changes):
- 1996: 1.7
- 1997: 0.5
- Unemployment rate (period average):
- 1996: 3.1
- 1997: 3.4
- 1998 Proj.: 4.1
- Industrial production (percent changes):
- 1994: 0.9
- 1995: 2.3
- 1996: 3.6
- Current account balance:
- Billions of U.S. dollars:
- 1994: 130.6
- 1995: 111.4
- 1996: 65.8
- 1997: 94.1
- 1998 Proj.: 122.6
- Percent of GDP:
- 1994: 2.2
- 1995: 1.4
- General government balances (percent of GDP):
- Balance including social security:
- 1994: -2.3
- 1995: -3.6
- 1996: -4.3
- 1997: -3.3
- 1998 Proj.: -6.0
- Structural balance:
- 1994: -2.5
- 1995: -2.1
- 1996: -3.5
- Balance excluding social security:
- 1994: -5.1
- 1995: -6.8
- 1996: -5.4
- 1997: -4.6
- 1998 Proj.: -5.8
- (Additional row) -4.7
- Monetary aggregates:
- M1:
- 1994: 8.2
- 1995: 13.7
- 1996: 8.8
- 1997: ...
- M2 + CDs:
- 1994: 3.2
- Exchange rates (period average):
- Yen/dollar rate:
- 1994: 102.2
- 1995: 108.8
- 1996: 121.0
- Real effective exchange rate (1990 =100; based on normalized unit labor costs):
- 1994: 142.6
- 1995: 147.8
- 1996: 123.5
- 1997: 114.2
- Interest rates (period average):
- 3-month CD: 4.2
- 10-year bond: 3.0
Source: Public Information Notice: IMF Concludes Article IV Consultation with Japan (August 13, 1998).