IMF Survey:Are the decisive election results and the seemingly more upbeat mood in Japan indications that the country has indeed turned the corner now?
Citrin: Japan had turned the corner before the election. Over the past couple of years, growth had been picking up and has been quite robust. Exports drove this growth initially, but increasingly the forward momentum has been based on domestic demand. In fact, the pattern of growth has been broadening throughout the economy. Since late 2003, there has been a surge in private investment, and this is now gradually translating into stronger consumer sentiment; improved employment, both actual and prospective; and much stronger underpinnings for the household sector and consumer demand. This strengthening is, in part, attributable to steady reforms in labor and product markets as well as success in bank-balance-sheet restructuring and also corporate efforts to eliminate excess capacity and debt, all of which have been going on over the past five or six years. The September election results—which by many accounts amounted to a ringing endorsement of the government’s plans—confirm the success of this strategy and take it to the next stage.
IMF Survey:But even with the added reform momentum, is this enough to truly banish the ghosts of the past?
Citrin: A lot of people ask, “Is this the real thing this time?” There’ve been two or three false starts over the past 15 years. Growth would pick up initially but soon lose steam, and the economy would slip back into recession. The difference this time is that, finally, the excesses from the bubble period— excess labor, capital, and debt—have worked themselves out. Corporate profitability is back at levels that prevailed in the mid-1980s, and indebtedness is back down to pre-bubble levels. The big banks have completed balance-sheet restructuring, with levels of nonperforming loans now well below the authorities’ target.
This year, there has also been progress on the employment front. During the long recessionary period, companies turned away from traditional lifetime employment and resorted to part-time workers—or workers on short-term contracts— to cut labor costs. This had a direct deflationary impact, because wages are about 40 percent lower for these types of workers. Labor income languished. Early this year, however, Japan reversed that trend. Large corporations are now increasing their hiring of full-time workers, and part-time employment—which peaked at some 30 percent of the total—is starting to decline. This is the final phase of the correction after the bubble, and it is why we, along with most other observers, are pretty confident that this time the recovery is for real.
IMF Survey:To what extent is Japan vulnerable to rising oil costs?
Citrin: In the short term, this is the biggest risk. Rising oil prices are a problem mainly through the effects on the United States and other major trading partners. Japan itself has improved its energy efficiency tremendously over the past two decades, so the direct effects of rising oil prices on its economy are quite modest. On balance, though, Japan’s stronger domestic economy bodes well for growth prospects in the near term, and we’re pretty confident that growth will be sustained at around 2 percent a year over the next couple of years.
On the mend
A rebound in Japan’s domestic demand suggests improved prospects for durable growth.
Contribution to real GDP growth.
Data: Global Insight, Nomura database.
IMF Survey:What does the IMF see as the key policy challenges going forward?
Citrin: First of all, on the macro side, despite the recovery, mild deflation does persist, so in the immediate future, it’s still important for the authorities to have a supportive monetary stance that allows Japan to escape once and for all from its deflationary period. Monetary policy needs to remain extra-loose for a while, until deflation and deflation expectations are defeated. That time is clearly approaching, with CPI inflation widely expected to turn positive sometime next year.
IMF Survey:How should monetary policymakers manage this transition?
Citrin: There has been much speculation in recent months about the timing and nature of the BoJ’s [Bank of Japan’s] exit from its quantitative easing framework, with some worrying that the central bank will tighten policy prematurely. The exit will, of course, involve a shift to a more conventional one in which the BoJ will target a short-term interest rate—the way most central banks operate around the world. And I am confident that BoJ officials are well aware of the need to be flexible, taking into consideration both price developments and the general well-being of the economy. Thus, one can expect that the BoJ will aim to accomplish the transition in a gradual and transparent fashion, ensuring that market expectations and longer-term interest rates—which are critical for investment and consumption decisions—are not destabilized. In doing this, clear communication will be important, so that market participants are kept well informed of the BoJ’s decision making. I believe the record thus far is encouraging in that regard.
IMF Survey:Are there challenges for fiscal policymakers too?
Citrin: Clearly the time has come for serious steps to address the budget deficit. The authorities have made efforts over the past couple of years, and these efforts need to continue to rein in an unsustainable pace of national debt accumulation. One big issue is tax reform. The government has to decide the right timing, but the problem has been recognized. The size of the budget deficit means that steps will need to be taken on both the spending and the tax sides.
On the spending side, there is still scope to eliminate wasteful public works. In terms of revenues, corporate tax rates are rather high already, but the income tax base is quite narrow, and there are lots of exemptions and special incentives. The main issue, though, is Japan’s consumption tax, which is very low in comparison with other countries. Policymakers recognize that if the country is going to be able to support a reasonable level of social welfare as its society ages, there will need to be significant increases in the consumption tax—but the exact pace and timing for such increases are still to be decided.
IMF Survey:Isn’t raising the consumption tax a bit tricky given that Japan, presumably, is looking to boost domestic demand?
Citrin: Absolutely. But if you look at the past four to five years, domestic demand has been accelerating in the face of a fairly significant reduction in public sector demand. Experience suggests that countries that tackle their underlying fiscal imbalances through steadfast efforts are better able to sustain growth over longer periods, and, even in the short term, convincing steps to address structural deficits can be growth enhancing. The time has come for a firm, meaningful effort to put Japan’s public finances in order. It is up to the authorities to decide on the best strategy.
The public mood seems to be “before we start paying higher taxes, the government needs to demonstrate that it has done all that it can to cut wasteful spending”—measures that seem also to mean cutting fat within the bureaucracy. Mindful of the political winds, the Japanese government is already taking a hard look at civil service reforms, hoping for further savings in this area. Perhaps, the government will wait a bit before tackling the consumption tax, but it shouldn’t delay for too long.
IMF Survey:And beyond the fiscal issues, what policies are needed to ensure durable growth?
Citrin: The main challenge for Japan in the years ahead will be to sustain strong growth in the face of population aging. Its working-age population—those between 15 and 64 years old—has already been shrinking for a few years, and by 2007, its total population is going to start shrinking. Estimates vary, but Japan could see close to a 35 percent decline in its working-age population by 2050.
Policymakers can do two things. They can continue to address the fiscal imbalance, reduce the debt burden on the population, and make room for the increasing costs of health care, pensions, and social security expenditures that will necessarily rise over time as Japanese society grows older. They should also pursue a broad set of structural reforms to enhance productivity growth and ensure that growth is robust enough to continue not only improving living standards but also paying for all the increases in social expenditures that accompany population aging.
IMF Survey:Which reforms are you thinking of?
Citrin: The list is long. Japan will need to make its labor markets more flexible, encourage more foreign direct investment, improve domestic competition, and pursue agricultural reform and liberalization. Progress has been made on a whole host of reforms, but more needs to be done to improve long-term growth prospects. It’s a question of prioritizing and doing things steadily.
IMF Survey:Recently, an important step in this direction seems to have taken place with the approval of the plan to privatize Japan Post. How big a deal is this?
Citrin: It is a big deal. We are talking about funds that currently account for 30 percent of all household savings deposits in the country. The direct impact of the reform in the short term may not be that large, because Japan Post will be privatized over 10 years. But the large postal savings system has permitted fairly significant distortions. It provided a pool of savings that helped finance inefficient and wasteful public investment projects. And the postal savings system enjoyed cost advantages over private banks. It did not pay deposit-insurance premiums and enjoyed tax-free income. This has tilted the playing field against private financial institutions in an alarming way. Some of these cost advantages are now being eliminated. Clearly, a combination of a shrinking deposit base and a decline in public works spending will help reallocate financial resources to more productive uses.
IMF Survey:Do you see China’s rising economic clout posing medium- or longer-term problems for Japan?
Citrin: At present, Japan retains a comparative advantage in higher technology, but over time, it can expect to be in direct competition with China in more and more sectors. But China’s growth has created, and will continue to create, opportunities for Japan. There is a lot of Japanese foreign direct investment, and exports to China are growing faster than exports to any other destination—they now represent over 15 percent of total exports. Some of that represents inputs that are then used in manufacturing goods exported to the United States and elsewhere, but there is substantial exporting to meet China’s domestic demand.
Worrisome public finances
Japan must tackle its high government debt, which has risen sharply in contrast to that of other major economies.
Data: IMF, World Economic Outlook.
IMF Survey:On balance, isn’t it true that what’s good for Japan is good for the world, and vice versa?
Citrin: The more Japan can do on the structural reform front to boost growth, the better this will, on balance, support domestic demand and help reduce global current account imbalances—a continuous threat hanging over the global economy. Of course, the issue is how fast Japan should put its fiscal house in order, given that standard macro models suggest that fiscal contraction will lead to a larger current account surplus. But we see any policy mix that combines structural reforms and fiscal consolidation not only directly boosting productivity growth but also strengthening the resilience of private domestic demand. And this, in turn, leads to a healthier Japan and a reduction in global imbalances over time. So, yes, policies that are good for Japan are good for the world.
The full text of the IMF staff report on Japan (Country Report No. 273), Selected Issues (Country Report No. 272), and Public Information Notice (No. 05/105) issued at the conclusion of the IMF Executive Board’s discussion is available on the IMF’s website (http://www.imf.org).