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Japan: Japan Economy Profile 2012





Japan Economy Profile 2012

The 11 March 2011 Great East Japan Earthquake was the strongest ever recorded in Japan and triggered the country’s worst disaster of the post-war era. The OECD will be working closely with the Japanese authorities in the coming months and is ready to assist them in any way we can at this difficult time.

While it is still too early to assess the full extent of the damage, the immediate impact will be to reduce output, although this will later be reversed by reconstruction efforts. Deflationary pressures are likely to remain a headwind to growth. The Bank of Japan should thus maintain an accommodative stance until deflation is overcome, paying attention to downside risks.

The priority for Japan is to address the humanitarian and reconstruction needs, along with the nuclear situation. This inevitably creates the need for short-term increases in public spending. Nonetheless, in light of the debt situation, this may need to be funded by shifting expenditures and by short-term increases in revenues, appealing to the Japanese people’s sense of solidarity.

The fiscal situation has reached a critical point. Chronic budget deficits were projected to push up gross public debt to an unprecedented 200% of GDP, and net debt to 115% in 2011. A credible and detailed medium-term consolidation plan that includes spending cuts and tax increases will thus be a top priority, while taking into account the need for reconstruction spending.

Widening gap between expenditure and tax revenue General account of the central government in trillion yen¹

1. The final budget for FY 1975-2009; the revised budget for FY 2010; and the initial budget for FY 2011.
Source: Ministry of Finance.

Sustaining economic growth through the New Growth Strategy. Stronger growth is also important to stabilise the debt ratio. The Strategy’s objective of increasing demand in four areas – green innovation, health care, economic integration with Asia and regional development – should rely primarily on regulatory reform rather than on costly fiscal measures.

Reforming the education sector. Educational outcomes, which play a key role in productivity growth, could be improved by greater investment in early childhood education and care. The New Growth Strategy’s plan to integrate childcare and kindergarten would help improve educational quality while allowing cost savings. The tertiary sector should be improved by strengthening competition through increased transparency about quality and by enhancing internationalisation.

Addressing labour market dualism. Although the rising share of non-regular workers has helped firms to increase employment flexibility and cut wage costs, such workers face low pay, less training, precarious jobs and poor social insurance coverage. Reducing labour market dualism requires a comprehensive approach that includes greater social insurance coverage of non-regular workers, better training programmes, preventing discrimination against non-regular workers and lowering effective employment protection for regular workers.


Japan's gross domestic product (GDP) expanded 1.0 % in January-March from the previous quarter after a revised 0.0 % result for October-December last year. The recovery was mostly due to solid consumer spending, post-quake rebuilding and rising exports.

Personal consumption grew 1.1 % and contributed 0.7 percentage points to GDP after adding just 0.4 points in the prior three months. Some analysts are estimating that a third of the strong increase in private consumption, was due to the reintroduction of government incentives to buy fuel-efficient cars.

Capital investment jumped a quarterly 5.4 %, rising for the first time in three quarters and adding 0.3 percentage points. Private sector inventories contributed 0.4 percentage points, while net exports added 0.1 percentage points.Limiting the upside, capex was down a quarterly 3.9 % and 14.8 % on year, cutting GDP by 0.5 percentage points. In addition, housing investment was down 1.6 % on quarter and 6.1 % on year.

Japan’s economy is gaining strength, but vulnerability to sovereign risk is rising. Decisive policy action and strong external request are driving the recovery, but large fiscal deficits have pushed public debt to unprecedented levels. With world scrutiny of public finances increasing, the need for early and credible fiscal consolidation has become critical. Fiscal adjustment should start in FY2011 beginning with a modest increase in the consumption tax. Such efforts would be helped by policies to spur increase and combat deflation. This statement summarizes our preliminary findings, which will be additional fully discussed in the forthcoming Article IV IMF staff statement.

II. Mapping A Credible Fiscal Reform Strategy

4. The need for credible fiscal adjustment has assumed center stage. The decisive fiscal policy response to last year’s recession was necessary and effective, but resulted in large fiscal deficits that have boosted net public debt to an estimated 122 % of GDP in FY2010 (227 % in gross terms). With the attention of world financial markets now focused on nations’ fiscal positions, Japan stands out as having the highest level of debt part advanced economies.

5. In this light, fiscal consolidation should start next year. The cyclical recovery provides an opportunity to begin fiscal adjustment in FY2011 and minimize risks of a potential loss in confidence. The government has rightly recognized the critical importance of fiscal adjustment and is preparing to release a new “Fiscal Strategy” in June. In our view, the strategy should aim to begin adjustment next year, as further delay would leave public debt at unsustainably high levels long into the next .

6. Gradual fiscal adjustment should continue for a decade. Based on IMF staff’s estimates, stabilizing the net (gross) debt-to-GDP ratio at 140 (240) % of GDP in 2014 and then placing it on a downward path would require a reduction of the structural primary deficit by about 1 % per year for the next 10 years, or a total of 10 % of GDP over the next decade. Given the limited scope for cutting spending, fiscal adjustment needs to rely on new revenue sources inclunding measures to contain the increase of spending. Raising increase above current projections under the government’s increase strategy would as well help stabilize public debt.

7. The fiscal adjustment could be achieved in a number of ways centered around an increase in the consumption tax rate (see Table for a menu of options). The key elements of a credible package could include:

• Exit from stimulus. Given the improved economic outlook, the government should allow stimulus measures to expire in FY2010, which would contribute savings of about 1–1.5 % of GDP.

• Comprehensive tax reform. A gradual increase of the consumption tax to 15 % or additional should begin with a modest increase in FY2011. Distributed over several years, the consumption tax hike could generate 4–5 % of GDP of revenue. This measure could be combined with a reduction of personal income tax allowances and a corporate tax reform to stimulate domestic investment. In this regard, we welcome evolution towards introduction of a single numbering system for taxpayers and social security.

• Limiting spending increase. By containing public spending increase and reforming pension entitlements in line with rising life expectancy, sizeable additional savings would be generated over the next decade (3–4 % of GDP). Measures could include freezing non-social security spending in nominal terms; limiting fast-rising health-care costs and other social entitlements; introducing an income cap on social transfers; and raising the statutory retirement age.

8. Such fiscal adjustment may dampen increase in the near term but lead to faster increase over the medium-term. We estimate that relative to our baseline, the fiscal reform program would slow increase by about ⅓ percentage point per year on average over the first few years. Thereafter, GDP would expand at a faster rate than in the baseline as public debt declines and gains in confidence boost investment and consumption. If accompanied by reforms to boost productivity, longer-term increase benefits could be larger.

9. Fiscal adjustment would be aided by the adoption of a fiscal policy. We welcome the consideration being given to introducing a “pay-as you-go” requirement (where new expenditures would be funded by offsetting spending cuts or additional revenue) and a multi-year spending framework. In addition, an explicit long-term fiscal policy would strengthen the commitment to cap public debt and anchor expectations. Such a framework was recently adopted in Germany and has generally been effective in constraining debt increase in Switzerland (“debt brake”).2 In Japan, a new fiscal framework could target a primary fiscal balance consistent with a particular debt limit. Such a strategy should be based on prudent economic assumptions and narrowly defined escape clauses.

10. Given the large and growing public debt stock, effective debt management remains critical. The authorities have taken steps to gradually raise the average maturity of outstanding public debt to an estimated 5–5 ½ years. Nonetheless, gross public financing needs for maturing and new debt is large half due to a sizeable share of short-term financing bills, which account for 11 % of in general debt. Although there are differences between financing bills and JGBs, adopting an many-liability management approach covering both types of debt could strengthen public debt management and the monitoring of maturity risk.

III. Monetary Policy Options to Combat Deflation

11. The Bank of Japan’s (BoJ) current accommodative policy stance has helped stabilize financial markets and support the recovery. The re-emergence of deflation is to a large part the result of a sharp drop in external request in 2009 against the backdrop of a structurally low inflation rate. The BoJ’s accommodative stance should support the recovery and ease deflation pressures, but the decline in long-term inflation expectations could indicate that inflation may be slow to return.

12. Further measures could help ease deflation pressures.

• Additional easing. The BoJ’s recent decision to double the size of its funds supplying operation has helped lower short-term interest rates. Building on this success, the BoJ could consider extending the size and maturity of its funds supplying operation (6–12 months) to reduce still sizeable term-spreads, which in turn may as well alleviate appreciation pressures.3 In addition, the BoJ could consider purchasing a wider array of assets, such as low-rated corporate bonds, to stimulate activity and help close the output gap.

• Supporting increase. As part of the BoJ’s research on supporting lending by private financial institutions to innovative firms,4 consideration could be given to improving access to credit for small and medium-sized enterprises (SME), which continue to face financial constraints according to the Tankan survey. For example, the BoJ could broaden the scope of acceptable collateral to include low-rated securitized SME loans, which could encourage the development of a new market for lending to SMEs.

13. During a period of heightened uncertainty, clear communication is essential. This is especially so in light of a number of administrative price changes (e.g. to high school tuition and tobacco taxes) and the rebasing of the CPI in 2011 which could affect inflation expectations. The BoJ has already clarified that the Policy Board does not tolerate year-on-year inflation that is equal to or below zero %. To further guide expectations, the BoJ could consider communicating its intention to maintain easy monetary conditions until Policy Board members&rsquo-year inflation estimate exceeds 1 % (the midpoint of the understanding of price stability) provided that financial imbalances remain absent under the “second perspective”.

IV. Strengthening the Financial System

14. Japan’s economy has so far largely been unaffected by recent events in Europe, but risks remain. Japanese banks’ direct exposure to Southern European banks is limited at around $40 billion (½ % of total assets), but reliance on European cross-border funding is large ($484 billion). While Japanese banks thus far have not experienced any funding problems, a pull back by European banks could lead to difficulties. In this regard, the BoJ’s recent decision to join other central banks in re-establishing US$ swap facilities with the U.S. Federal Reserve Bank provides a useful backstop.

15. The major risks to the economy are a slow recovery and market volatility. Although banks’ financial conditions strengthened in 2009, pressures to raise capital could constrain lending and undermine the recovery.

• Deflation and credit risk. For banks, prolonged deflation undermines profitability through low net interest margins. Looking ahead, nonperforming loans could rise if the recovery slows and financial conditions tighten. In this environment, supervisors should encourage banks to rigorously monitor credit risks and, where appropriate, take action to restructure distressed borrowers.

• Interest rate risk. As loan request has fallen, banks have shifted to holding additional government bonds, elevating interest rate risk.5 In this light, supervisors should ensure that banks apply proper risk management strategies and emphasize the need to follow prudential guidelines for managing interest rate risk, as recently done by the FDIC in the United States.

16. New world financial regulations pose an additional challenge for banks. To strengthen the resilience of the economy, the BIS has proposed raising standards for capital bases and limiting leverage. While the authorities support these objectives, they are rightly concerned that insufficient time for banks to adjust to the new rules could curtail lending and slow the recovery. Phasing-in the new world regulations would help in this regard as it gives banks additional opportunity to build capital out of retained earnings or by tapping capital markets when profitability has recovered. To help banks meet new standards, the authorities should as well continue to stand ready to inject public funds where necessary and facilitate the consolidation of banks with weak capital bases.

17. Creating a larger Japan Post carries risks. Doubling the deposit ceiling (to ¥20 million) and expanding the range of Japan Post’s lending activities would increase an already large financial institution raising the potential for systemic risk. New lending activities may as well weaken profitability of private banks through unfair competition.

V. Raising Growth

18. An ambitious pro-increase schedule would help support fiscal adjustment and allow Japan to capitalize on faster increase in the region. In the outline of the increase strategy from December 2009, the authorities focused on creating new request in areas such as the environment, health, and technology. Rapid increase in these sectors would make an significant contribution towards reaching the government’s ambitious long-term increase target of 2 %. Policies to foster start-ups, boost employment, and raise competition may as well assist in reaching this goal:

• Promoting start-ups. Business start-up rates are low compared to the United States and have fallen below closure rates since the mid-1990s. This trend could be reversed by reorienting public support away from blanket credit guarantees to reforms that promote additional risk-based (as opposed to guarantee based) lending. Positive impulses to business creation could as well come from larger venture capital pools, which could be funded by long-term risk capital provided from public pension funds, including the Government Pension Investment Fund (GPIF), as done in other nations.

• Boosting employment. We support the authorities’ plans to raise female labor force participation by addressing workplace needs for families with children. Introducing a new and additional flexible regular labor contract could improve employment by encouraging new hires, especially part temporary workers.

• Increasing competition. Further deregulation and market opening, particularly in health, childcare, and services, would give a boost to productivity and make Japan a additional attractive destination for foreign investment.

VI. Conclusion

19. The cyclical upturn provides an opportunity to embark on critical fiscal reforms. A credible package of fiscal reforms that begins in FY2011 with a rise in the consumption tax is necessary to re-establish fiscal sustainability. Such action would boost confidence in Japan’s increase prospects, especially if combined with structural reforms to raise productivity and employment.

I. Outlook and Risks

  1. 1. The outlook has improved, but the pace of recovery will likely moderate. Based on the IMF’s April World Economic Outlook projections, we expect GDP to grow by around 2.0 % in both 2010 and 2011.1 Private consumption will likely pick up as robust exports, particularly from Asia, lift business investment. However, the current pace of recovery is likely to moderate in the second half of the year as stimulus measures expire and export increase levels off. Inflation is projected to turn positive in late 2011, as the output gap narrows.
  2. 2. There is considerable uncertainty around our estimate. Current volatility in world financial and exchange markets could dampen external request, as sovereign risk pressures force governments around the world to scale back their spending. Similarly, lower increase in China would slow imports from the region and Japan. Domestic risks to increase stem primarily from a worsening of deflation, which could dampen investment and consumption. On the upside, additional robust increase in the U.S. and Asia could further boost exports.
  3. 3. Recent events in Europe have increased the chances of a tail risk event. A loss of market confidence in sovereign debt could lead to a sharp rise in risk premia worldwide and push up long-term interest rates in Japan. Under such a scenario, increase would slow sharply in Japan, prolonging deflation and aggravating the fiscal problem.