IMF Country Analysis: Japan’s Economy Slows, But Soft Landing Expected

International Monetary Fund. External Relations Dept.
Published Date:
August 2008
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Japan’s economy has shown resilience to recent external shocks but is nonetheless slowing, the IMF says in its latest annual economic review of the country. In its yearly Article IV consultation with Japan, the IMF says that the banking sector has withstood the worst of the global financial market wildfires that have swept across the globe in the past 12 months, and the economy has shown some resilience to surging commodity prices. Although consumer and business confidence declined, activity remained robust through the first quarter of 2008, aided by strong exports to emerging markets.

Timely liquidity provisions by the Bank of Japan (BoJ) and the financial sector’s limited subprime exposure also helped cushion the effects of global financial pressures.

Most recently, however, activity has slowed in line with decelerating global growth and the deteriorating terms of trade. In the Article IV report, the IMF projects GDP growth to moderate to about 1½ percent in 2008-09, reflecting weaker business investment and private consumption. However, these projections are likely to be revised down in light of weak second quarter data.

Headline inflation has climbed in recent months to 2 percent, but underlying inflation (stripped of food and fuel prices) is still about zero and wages remain sluggish.

Soft landing

Although a soft landing is foreseen, the growth outlook remains subject to considerable uncertainty, particularly surrounding the depth of the U.S. slowdown. Highly volatile commodity prices also make inflation difficult to project. Nonetheless, with the downturn expected to be modest, and inflation still contained, the IMF’s view is that current policy settings are broadly appropriate.

In particular, monetary policy should remain accommodative, fiscal policy should remain focused on medium-term challenges, and continued efforts should be made to strengthen the financial sector. There is also a need to reinvigorate structural reforms.

Given current uncertainties, monetary policy is understandably in a “wait and see” mode, with the BoJ keeping policy rates on hold pending a better sense of whether downside risks to growth activity or upside risks to inflation will prevail. The process of normalizing interest rates that began in 2006 could then resume once downside risks to growth recede. Meanwhile, the BoJ has enhanced its communication regarding the outlook, which should help guide inflation expectations.

Longer-term horizon

Fiscal policy should consider a longer-term horizon in light of the need to bring down high public debt and make room for aging-related spending. Strong tax collections and cuts in public works have enabled the primary deficit (excluding social security) to be reduced sharply in recent years (see Chart 1.).

Moreover, the authorities plan to eliminate the primary deficit altogether by FY2011. However, a more ambitious adjustment may be required to put the public debt ratio firmly on a downward path. This will not be easy, given that much of the room for expenditure reductions has already been utilized. Further fiscal consolidation will surely require revenue measures, including raising the consumption tax.

The government’s intention to increase its contribution to the basic pension during FY2009 provides an opportunity to raise taxes. The public may be more receptive to a higher consumption tax rate if it is linked to the need to fund social security. The government’s plan to end earmarking of gasoline tax revenue for road-related spending from next year is also welcome.

Chart 1.Sharp reduction

Strong tax collections and cuts in public works have enabled Japan to sharply reduce its primary budget deficit.

Citation: 37, 8; 10.5089/9781451967906.023.A010

(percent of GDP)

Source: IMF staff estimates.

Yen appreciation

Financial developments over the past year have been accompanied by an appreciation of the yen—by about 10 percent in real effective terms. Staff analysis suggests that the yen can be expected to strengthen further over the long run, particularly if structural reforms are implemented that yield widespread productivity gains. Nevertheless, the yen could remain weak in the short term owing to capital outflows driven by the declining home bias of Japanese investors.

Over the past year, the Japanese Financial Services Agency has taken important steps to monitor and disclose the exposure of the subprime losses. These measures have enhanced the transparency of Japanese financial institutions, thereby supporting market confidence (see Chart 2.).

But further steps to improve risk management and bolster capital cushions are necessary to strengthen the financial system and enhance financial intermediation. In this context, the privatization of Japan Post Bank last year was a landmark reform.

Chart 2.Mirror image

Japanese banks have been lending to foreign banks at a premium—the opposite of the situation in the 1990s.

Citation: 37, 8; 10.5089/9781451967906.023.A010


Source: CEIC; and IMF staff calculations.

1London Interbank Offered Rate.

2Tokyo Interbank Offered Rate.

Priorities to lift growth

The pace of structural reforms in Japan has slowed of late, in part reflecting concerns over widening inequalities. In recent years, dualities have become more pronounced across sectors, income groups, and regions.

Nonetheless, it is difficult to see Japan meeting its medium-term challenges without more vigorous structural reforms—as outlined in the Multilateral Consultation on Global Imbalances, and incorporated in the authorities’ recently released FY2008 Basic Policies program.

Increasing labor market flexibility, enhancing product market competition, and encouraging inward foreign direct investment remain priorities. Such reforms will lift medium-term growth prospects and contribute to the orderly resolution of global imbalances.

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