Man walks past Bank of Japan with umbrella. BoJ needs to stand ready to ease further, says IMF (photo: Reuters/Thomas Peter/Corbis)
ECONOMIC HEALTH CHECK
The IMF report found that Abenomics’ three-pronged strategy of aggressive monetary easing, flexible fiscal policy, and structural reforms constituted a clear break from previous incremental efforts. But, despite initial positive results, the pace of real GDP growth has remained at about 1 percent—similar to the post-bubble period—and deflation risks remain.
“This is partly due to external shocks, including slower global growth, and the collapse in commodity prices” said Kalpana Kochhar, Deputy Director in the IMF’s Asia and Pacific Department, and head of the mission that conducted the assessment.
In addition, the negative impact of the consumption tax rate hike in 2014 lasted longer than expected, but structural impediments have also played a role, including sluggish wage growth, production increasingly moving to other countries through foreign direct investment, and headwinds from an aging and declining population.
Recovery underway but momentum still fragile
The economy is projected to grow by 0.8 and 1.2 percent in 2015 and 2016, provided higher real wages support consumption, and business investment rises on the back of lower production costs from declining oil prices, record-high corporate profits, ongoing corporate governance reforms, and the abundant availability of credit.
“However, risks are elevated and clearly to the downside, including from a disappointing outcome of the Shunto wage negotiations, and weaker spending of the oil windfall,” said Kochhar.
Japan also faces short-term risks from lower-than-expected growth in China and the United States, and possible yen appreciation in the event of global financial turbulence given its status as a safe-haven currency.
“Over the medium term, weak domestic demand, and incomplete fiscal and structural reforms could result in stagnation, and doubts about fiscal sustainability” added Luc Everaert, Head of the Japan Division in the IMF’s Asia and Pacific Department.
The report suggests accelerating structural reforms is the only effective policy lever to address these downside risks, and maintain confidence in Abenomics.
Wanted: stronger structural reforms
Structural reforms have progressed in a number of areas. Female labor force participation, which had been rising gradually since the mid-2000s, got a further boost with Abenomics.
“Even so, countering the headwinds on labor supply from adverse demographics requires more forceful labor market reforms” said Kochhar. Female labor force participation can be boosted further by eliminating tax-induced disincentives to work, and raising the availability of child-care facilities through deregulation.
The government can also address labor shortages by drawing more aggressively on foreign labor by relaxing immigration restrictions, as well as providing incentives for older workers to remain in the workforce.
New hiring should take place under contracts that balance job security and flexibility to reduce labor market duality, and raise horizontal mobility, contributing to higher productivity and wage growth.
The financial sector should become a catalyst for growth, the report notes. It should take advantage of the recent significant progress with corporate governance reforms to unwind cross-shareholdings, foster consolidation in the enterprise sector, and promote exit of unviable enterprises.
The report recommends that authorities phase out financial sector support schemes for small and medium-sized enterprises that do not invest or hire workers, and promote the expansion of securitization, and the provision of risk capital. Private sector–led consolidation in the financial system, in particular among regional banks, would also be beneficial.
Balanced fiscal adjustment
Low and stable Japanese government bond yields should not be taken for granted as shifts in investor sentiment could happen abruptly. A concrete and credible medium-term plan would remove uncertainties about fiscal intentions, which could be hampering domestic demand, and create space to respond to downside risks.
And stronger fiscal institutions will be necessary to impart credibility to such a strategy. In this context, the announced medium-term plan provides a useful anchor to guide fiscal policy with the planned adjustment between now and 2020 striking the right balance between supporting growth, and making headway with fiscal consolidation.
“However, the use of overoptimistic growth assumptions risks undermining the credibility of the plan, while it also lacks specifics about how to contain social security spending,” said Kochhar.
Supportive and predictable monetary policy
“Raising inflation has proven to be a marathon rather than a sprint,” said Everaert. Market-based measures of inflation expectations have declined since mid-2014, and recently stabilized at around 1 percent, suggesting the hoped for “regime change” has not yet fully materialized.
The report suggests that several factors will put upward pressure on the price level in the near term, including the recovery of oil and commodity prices from their lows, the lagged effect of the recent episode of yen weakening, and the closing of the output gap–or the difference between the potential output of an economy and its actual output. Continued tightening of the labor market could accelerate nascent wage-price dynamics. Under current policies, IMF staff expect inflation to rise gradually to 1½ percent over the medium term.
As a result, the Bank of Japan needs to stand ready to ease monetary policy further, provide stronger guidance to markets through enhanced communication, and put greater emphasis on achieving the 2 percent inflation target in a stable manner.
Further monetary easing should take the form of increased asset purchases, and lengthening their duration. At the same time, further fiscal and structural reforms remain imperative to unburden monetary policy and, together with macroprudential policies, mitigate financial stability risks. This would also help avoid harming direct competitors through excessive yen depreciation.
“The BoJ should communicate more clearly the drivers that underpin its forecasts,” said Kochhar. Similarly, clarifying the conditions that would trigger additional actions would help guide market expectations when there is a need to adjust the asset-purchase program, and facilitate preparations for an eventual exit.
“In this context, the BoJ recently announced helpful modifications to its communication framework, but more needs to be done to enhance transparency, and predictability of monetary policy decisions,” concluded Everaert.
