Japan: Staff Concluding Statement of the 2024 Article IV Mission

Mission Concluding Statement

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Japan: Staff Concluding Statement of the 2024 Article IV Mission

February 8, 2024

Washington, DC: The Japanese economy continues to recover from the pandemic. Initially driven by cost-push factors, inflation is becoming demand driven with the output gap closed and labor shortages intensifying . In the near term, the focus should shift to tighten fiscal policy and wind down unconventional monetary policy, while maintaining financial stability. In the medium term, the priority is to rebuild fiscal buffers, strengthen the fiscal framework, and advance structural reforms, with labor market reforms at the forefront, to support potential growth.

RECENT DEVELOPMENTS, OUTLOOK, AND RISKS

The economic recovery picked up in 2023 and the output gap is estimated to have closed. Core inflation (excluding fresh food and energy) seems to have peaked at a high level and is becoming demand driven. Measures of underlying inflation show that the current above-target inflation is broad-based across products and services for the first time in three decades. Wages are rising, albeit less than inflation, amid labor shortages.

The economic recovery is expected to continue. Growth is projected to decelerate in 2024, owing to fading of one-off factors that supported growth in 2023, including a surge in inbound tourism. Japan’s preparedness will help mitigate the economic impact of the Noto Peninsula Earthquake. Core inflation is expected to decline gradually as the effect of higher import prices wanes. A closed output gap and increasing nominal wages will keep core inflation above the two-percent target until the second half of 2025. The primary fiscal deficit will remain sizable in 2024, reflecting the impact of the latest fiscal stimulus package. The current account surplus is expected to increase in 2024, supported by higher exports and lower import prices. The external position is assessed as broadly in line with the level implied by medium-term fundamentals and desirable policies.

Risks to growth and inflation are broadly balanced. For growth, downside risks are mainly driven by external factors, including a slowdown in the global economy, deepening geoeconomic fragmentation, and more volatile food and energy prices. On the domestic side, the main downside risks are continued low real household income growth if inflation continues to outpace wage growth, more acute labor shortages that could constrain activity, and a return to a zero-inflation environment. On the upside, additional recovery of inbound tourism and a stronger global economy could support growth. For inflation, upside risks stem from backward-looking inflation expectations and significantly stronger-than-expected wages following the spring wage negotiations. Downside risks could come from a faster decline in global goods and import prices and weaker-than-expected increases in wages in the spring negotiation.

ECONOMIC POLICIES

Fiscal Policy

Given a closed output gap and high debt-to-GDP ratio, the large, not-well-targeted fiscal stimulus in the November package was not warranted. Additional expenditure should have been offset by higher revenues or expenditure savings elsewhere. Given its temporary nature and Japanese households’ low propensity to consume, the untargeted income tax cut is expected to have a limited impact on growth, while worsening the debt dynamics. In addition, energy subsidies can distort energy consumption and hamper decarbonization initiatives and should be replaced with targeted transfers to vulnerable households.

Under current policies, the public debt-to-GDP ratio will increase steadily in the long term to accommodate age-related spending pressures. Additional planned spending on defense, green transformation, digital transformation, and children-related policies are expected to weigh on the fiscal balance and should be offset by sustainable revenues. In the near and medium term, the real interest rate-growth dynamics will remain favorable and support lower debt levels, despite a gradual rise in interest rates. However, lower potential growth reflecting an aging and declining working age population will push up debt levels in the long term. The sovereign risk and debt sustainability analysis found that gross financing needs are elevated but rollover risks are mitigated by the large domestic investor base and by the debt profile, with the overall risk of debt distress assessed as moderate.

Fiscal consolidation is needed to rebuild fiscal buffers and ensure debt sustainability, underpinned by both revenue and expenditure measures. This can be achieved by limiting untargeted transfers with a low fiscal multiplier or phasing out energy subsidies, while mobilizing revenues to offset additional expenditure policies. Detailed proposals are:

Revenue mobilization. The following options should be considered: i) unifying and increasing the consumption tax rate; ii) strengthening financial income taxation for high-income earners; iii) reinforcing property taxation by eliminating preferential treatment for residential land; iv) rationalizing allowances and deductions in personal income taxation; and v) increasing premiums for social insurance.

Health expenditure.Reforms to contain the cost of health care while preserving its quality should be considered. These include: i) an increase in copayments for high-income or wealthy seniors; ii) higher usage of generic or over-the-counter drugs; iii) increased adoption of prescription refilling; iv) enhanced preventative medical care; and v) more targeted covered services and drugs.

Children-related spending. There is limited evidence that untargeted cash transfers are effective in supporting fertility, based on international experience. The efficiency of children-related spending could be enhanced through a further expansion of childcare facilities and workstyle and labor market reforms, which could also close gender gaps.

SME support. Some pandemic-related measures and subsidies initiated before the pandemic are still in effect. A comprehensive assessment of the necessity and effectiveness of these measures is necessary to rationalize expenditure and to improve productivity.

· The authorities should continue to strengthen the medium-term fiscal framework, as part of the review planned in FY2024:

More realistic assumptions. Fiscal policy planning should be grounded in more realistic assumptions on growth, revenue, and expenditure measures. An independent fiscal council could be tasked with evaluating the realism of macro projections.

Governance of state funds. State funds are typically formed outside the annual budgetary control system by the national government, and approximately one-third of them do not have a specified termination point. This weak governance structure leads to inefficiencies in spending and undermines budgetary discipline. The authorities should set a clear exit plan for each state fund to enhance better fiscal management.

Discipline the formulation of supplementary budgets. Budget expenditure ceilings set in the initial budgets do not work well in controlling final government expenditures given the established practice of adopting supplementary budgets. The budget process should be reformed to ensure that expansionary supplementary budgets are limited to unexpected large economic shocks. Policy priorities with less urgency or those that could be identified earlier should be taken up in the context of the annual budget discussions.

Monetary Policy

Inflation is expected to converge in the medium term to Bank of Japan (BoJ)’s two-percent target. The return of sustained inflation follows a persistently above-target inflation outturn for some time now and reflects: (i) higher inflation expectations for a prolonged period for the first time in decades; (ii) the highest base wage growth since 1995 amid intensifying labor shortages; and (iii) a historical high degree of monetary policy accommodation—with a real interest rate much lower than the estimated neutral rate along with balance sheet accommodation.

The BoJ has been appropriately cautious, given Japan’s history of deflation and mixed signals from recent data. That said, upside risks to inflation have materialized in the past year, with strengthening nominal wages and a closed output gap. The BoJ’s recent policy adjustments are in line with our past policy recommendations. These allowed the 10-year yield to be more flexible and driven by market forces, which: (i) helped curb excessive expansion of the BoJ’s Japanese Government Bond (JGB) purchases and its unintended side-effects on bond market functioning; (ii) will support financial institutions’ profitability as well as stability by potentially reducing the incentives for exposure to riskier asset portfolios in search of higher yields; and (iii) will allow for a smoother exit from unconventional monetary policy in the near future.

The BoJ should consider exiting Yield Curve Control (YCC) and ending Quantitative and Qualitative Easing (QQE) now while gradually raising short-term policy rates thereafter:

Exit the YCC and QQE framework: This framework has already successfully met its intended objective of lowering interest rates below the neutral rate and raising inflation expectations. Officially exiting the framework would simplify communication. The BoJ could continue to reinvest maturing JGBs on its balance sheet to avoid abrupt shifts in bond market conditions and sharp increases in term premiums.

Shift to the short-term policy rate as the main policy instrument: If staff’s baseline inflation forecast bears out, the BoJ should gradually raise the policy rate over its policy horizon (i.e., three years) thereafter.

These policy shifts should take a gradual and well-communicated approach to anchor market expectations.This approach will continue to keep monetary policy and financial conditions accommodative, while giving the BoJ time to confirm the strength of the incoming data. To mitigate risks:

The BoJ may also need to make state-contingent purchases of JGBs and implement other targeted and temporary measures to ensure sufficient liquidity support for relevant financial markets.

A clear and effective communication strategy by the BoJ that underscores factors that support a gradual and cautious pace/timing of policy rate increases (e.g., confirming that wage growth is sufficiently robust to support private consumption and sustain inflation at target) will be key for a smooth transition. This strategy would also minimize disruption from outward spillovers to other sovereign debt markets, where Japanese investors hold large positions.

Japan’s longstanding commitment to a flexible exchange rate regime will help absorb economic shocks and support monetary policy’s focus on price stability.At the same time, it will also help maintain an external position in line with fundamentals.

Safeguarding Financial Stability

The Japanese financial system has withstood a series of recent shocks including the COVID-19 pandemic, aided by strong capital and liquidity buffers and extensive policy support. Credit provision to the private sector has remained robust since the pandemic, supporting a steady economic recovery. Key risks to macro-financial stability stem from an abrupt slowdown in global growth and a surge in inflationary pressures that could lead to an increase in foreign and domestic interest rates and financial market volatility. A materialization of these risks could potentially interact with three key sources of vulnerabilities in the financial system: the sizable holdings by financial institutions of securities under mark-to-market accounting, some banks’ notable foreign currency exposures, and signs of overheating in part of the real estate markets.

The systemic risk analysis, conducted as part of the ongoing IMF’s Financial Stability Assessment Program (FSAP), suggests the financial system is broadly resilient, but some areas merit attention and close monitoring.Japanese banks and insurers are, in the aggregate, well able to withstand an adverse scenario with low global growth and high inflation but some institutions may be vulnerable. Liquidity risks for banks appear contained at the system level, though there could be pressure on some banks under a stress scenario due, in particular, to their sizable foreign currency exposures. Climate risk analysis, while uncertain, suggests that banks have notable exposures to emission intensive sectors but at a system level may be resilient to a transition to net zero emissions by 2050.

The financial oversight and crisis preparedness frameworks need to be strengthened further to manage the challenging and evolving risk environment. The risk-based approach to the supervision of banks should be developed further. Appropriate minimum liquidity requirements should be set for all banks, while capital requirements need to be tailored to individual bank risk profiles. A framework of comprehensive risk-based and proactive supervision should be established for insurers. The macroprudential framework could be further strengthened by clarifying the mandate of the Council for Cooperation on Financial Stability and expanding the macroprudential toolkit. Against the backdrop of growing global cybersecurity risks, the regulatory and supervisory frameworks of cybersecurity need to be enhanced. More banks should be subjected to recovery and resolution planning requirements. The authorities should continue to ensure an effective recovery and resolution (planning) regime for insurers and central clearing counterparties (CCPs) that is consistent with pertinent international standards and guidance. As a priority, staffing resources need to be increased significantly to enhance the supervision and resolution of financial institutions.

Structural Policies

Further structural reforms are needed to support fertility, promote female leaders, advance a more equal society, accelerate startups and innovation, and transition to a green economy, with labor market reforms at the forefront of the reform agenda.

Supporting Japan’s Fertility and Promoting Female Leaders

Amidst a declining labor force due to an ageing population, supporting fertility, increased female economic participation, and effective use of women’s skills can help boost Japan’s growth potential. Advancing reforms in the following areas are key to improve career prospects for women, which in turn would also support Japan’s fertility rate.

Expanding childcare facilities and resources and facilitating fathers’ contribution to home/child-care. A further expansion of childcare facilities, particularly for children below the age of two, is crucial to support fertility. Attracting foreign workers to address labor shortages (e.g., nursery teachers) could complement the support provided by childcare facilities. At the same time, offering stronger incentives for the use of paternity leave– which while growing, remains low–can alleviate the burden of childcare on mothers.

Reforming current employment practices. Facilitating a cultural shift at the workplace by expanding the use of telework and flexible working schedules could support women’s ability to participate in the labor force (particularly for those with young children) while also allowing men to share more home-care burden.

Labor market reforms. While the government has been successful in increasing female labor force participation over the last decade, a substantial gender gap remains. A large share of female workers are non-regular and non-career track workers with lower wages and limited skill development and career advancement opportunities. Reducing labor-market dualism, encouraging merit-based promotions, and facilitating more job mobility can expand career prospects for women.

Advancing a More Equal Society

Market income inequality in Japan has increased and is now close to the OECD average. The redistributive effects of social transfers have helped lower income inequality. However, with high public debt limiting the scope for greater broad-based social spending, social transfers should be better targeted to protect the most vulnerable population. Moreover, reforms to reduce labor market dualism and removing the disincentives in the social security system that limit working hours are more sustainable ways to achieve a more equal society.

Accelerating Startups and Innovation

Japan’s startup ecosystem has grown in recent years, but with scope for further expansion. Startups in Japan tend to be smaller than those in other countries, with relatively low venture capital equity funding as a share of GDP. Better access to equity funding is crucial for startups to grow, innovate, and exit successfully. Dynamic firm entry and exit can help encourage entrepreneurship, innovation, and more efficient allocation of resources. A more flexible labor market and a shift away from the lifelong employment system could encourage talented individuals to consider setting up startups and to have a second chance in case they fail.

Transitioning to a Green Economy

Additional policies would be needed to reach Japan’s climate targets. While expanding carbon pricing and introducing carbon credits trading are broadly in line with previous staff advice, further clarifications on the planned measures are needed. Given the potentially adverse distributional effects of carbon pricing, it is crucial to protect the vulnerable population in the transition to a green economy. The phasing out of untargeted subsidies for gas, electricity, and fuel would support the transition.

Continuing Other Reforms

Reform efforts in digitalization and corporate governance should continue. The Digital Agency should continue to coordinate and implement policies to digitalize the public sector. Better data sharing between central and local governments and standardizing local government IT system can help improve the targeting of transfers to the most vulnerable households. Ensuring effective corporate governance practices and improved disclosure standards are needed.

Japan should continue to work actively with international partners to strengthen the rules-based multilateral trading system. It is important that trade agreements are used for further integration among members.

Industrial policies (IP) should be pursued cautiously and remain narrowly targeted to specific objectives where externalities or market failures prevent effective market solutions and aim to minimize trade and investment distortions. Pursuit of and competition among advanced economies over IP could lead to further strains in the global supply chain, technological fragmentation, rising input costs, increased trade tensions, and reduced international cooperation—outcomes that could undermine Japan’s broad support of the strong multilateral trading system. Furthermore, IP should avoid favoring domestic producers over imports or creating incentives that lead to a fragmentation of the global system for trade and investment.

The IMF team would like to thank the authorities and other interlocutors in Japan for the frank and open discussions. On behalf of the IMF, we would also like to convey our heartfelt condolences to those affected by the Noto Peninsula Earthquake.

Table 1. Japan: Selected Economic Indicators, 2020-25

Nominal GDP: US$ 4,256 Billion (2022)		GDP per capita: US$ 34,005 (2022)
Population: 125 Million (2022)		Quota: SDR 30.8 billion (2022)

	2020	2021	2022	2023	2024		2025
				Proj.

	(In percent change)
Growth
Real GDP	-4.1	2.6	1.0	1.9	1.0		0.8
Domestic demand	-3.3	1.5	1.5	1.0	1.0		0.9
Private consumption	-4.4	0.8	2.2	0.9	0.8		0.7
Gross Private Fixed Investment	-5.4	0.3	0.9	1.5	1.6		1.8
Business investment	-4.9	0.5	1.9	1.5	1.9		2.1
Residential investment	-7.7	-0.3	-3.5	1.4	0.4		0.1
Government consumption	2.4	3.4	1.7	0.9	1.1		0.2
Public investment	3.5	-1.8	-9.6	1.9	-0.7		-0.8
Stockbuilding	-0.5	0.2	0.4	0.0	0.0		0.1
Net exports	-0.8	1.0	-0.5	0.7	0.1		-0.1
Exports of goods and services	-11.6	11.9	5.3	2.3	3.2		2.5
Imports of goods and services	-6.8	5.1	7.9	-1.2	2.8		3.2
Output Gap	-2.9	-1.6	-0.9	0.2	0.3		0.2

	(In percent change, period average)
Inflation
Headline CPI	0.0	-0.2	2.5	3.3	2.2		2.1
GDP deflator	0.9	-0.2	0.3	4.0	3.0		2.3

	(In percent of GDP)
Government
Revenue	35.5	36.4	37.6	36.5	35.8		36.5
Expenditure	44.5	42.5	41.9	42.1	42.2		39.5
Overall Balance	-9.1	-6.1	-4.4	-5.6	-6.4		-3.0
Primary balance	-8.4	-5.5	-3.9	-5.5	-6.3		-2.8
Structural primary balance	-7.5	-4.8	-3.9	-5.6	-6.4		-2.8
Public debt, gross	258.3	253.9	248.7	251.7		251.6		250.2

	(In percent change, end-of-period)
Macro-financial
Base money	19.2	8.5	-5.6	6.4	2.9		2.2
Broad money	7.3	2.9	2.2	2.9	1.8		1.7
Credit to the private sector	6.1	1.9	4.2	4.1	2.7		2.1
Non-financial corporate debt in percent of GDP	151.8	155.0	159.4	154.3	153.5		153.8

	(In percent)
Interest rate
Overnight call rate, uncollateralized (end-of-period)	0.0	0.0	0.0	…	…		…
10-year JGB yield (end-of-period)	0.0	0.1	0.4	…	…		…

	(In billions of USD)
Balance of payments
Current account balance	149.9	196.4	84.5	148.4	159.4		160.1
Percent of GDP	3.0	3.9	2.0	3.5	3.7		3.6
Trade balance	26.6	16.4	-117.5	-50.7	-24.4		-30.4
Percent of GDP	0.5	0.3	-2.8	-1.2	-0.6		-0.7
Exports of goods, f.o.b.	630.6	749.2	751.8	708.0	733.9		768.7
Imports of goods, f.o.b.	604.0	732.7	869.4	758.7	758.3		799.1
Energy imports	89.1	127.8	195.5	162.2	155.1		146.1

	(In percent of GDP)
FDI, net	1.7	3.5	2.9	2.8	3.0		2.9
Portfolio Investment	0.8	-3.9	-3.4	-1.3	-1.3		-2.0

	(In billions of USD)
Change in reserves	10.9	62.8	-47.4	11.5	11.5		11.5
Total reserves minus gold (in billions of US$)	1348.2	1356.2	1178.3	…	…		…

	(In units, period average)
Exchange rates
Yen/dollar rate	106.8	109.8	131.5	…	…		…
Yen/euro rate	121.9	129.9	138.6	…	…		…
Real effective exchange rate (ULC-based, 2010=100)	75.3	73.5	62.0	…	…		…
Real effective exchange rate (CPI-based, 2010=100)	77.3	70.7	61.0	…	…		…

	(In percent)
Demographic Indicators
Population Growth	-0.3	-0.3	-0.3	-0.4	-0.5		-0.5
Old-age dependency	48.3	48.7	48.9	49.3	49.8		50.3

Sources: Haver Analytics; OECD; Japanese authorities; and IMF staff estimates and projections

[1] An IMF mission, led by Ranil Salgado and including Kohei Asao, Yan Carriere-Swallow, Salih Fendoglu, Purva Khera, Chris Redl, Haruki Seitani, and TengTeng Xu, conducted meetings in Japan during January 25-February 7, 2024. The mission met with senior officials at the Ministry of Finance, Bank of Japan, and other ministries and government agencies, along with representatives of labor unions, the business community, financial sector, and academics.

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Japan: Staff Concluding Statement of the 2024 Article IV Mission

Continuing Other Reforms

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