The Japanese economy is vulnerable to external and domestic shocks. The new government has made a commitment to turn the fiscal situation around. The new policy framework provides the Bank of Japan with the scope to ease the policy stance. A deteriorating macroeconomic environment has exposed underlying structural problems in the banking sector. Over the past year, Japan maintained its traditional emphasis on pursuing further trade liberalization through the World Trade Organization (WTO) framework, while at the same time initiating talks on bilateral free trade agreements.


The Japanese economy is vulnerable to external and domestic shocks. The new government has made a commitment to turn the fiscal situation around. The new policy framework provides the Bank of Japan with the scope to ease the policy stance. A deteriorating macroeconomic environment has exposed underlying structural problems in the banking sector. Over the past year, Japan maintained its traditional emphasis on pursuing further trade liberalization through the World Trade Organization (WTO) framework, while at the same time initiating talks on bilateral free trade agreements.

II. Fiscal Policy Developments1

1. Public finances in Japan are under serious strain. A decade of expansionary fiscal policy has resulted in a high fiscal deficit relative to GDP and a level of government debt that, on some measures, is the highest among the G-7 countries. This situation has generated concerns about the sustainability of fiscal policy. Rising debt service obligations, weak revenues owing to the continued stagnation in economic activity, and rigidities in expenditure management have sharply reduced the room for maneuver in the central and local government budgets. In addition, together with sluggish income growth, adverse demographics have erased much of the earlier surpluses of the social security system, and the situation is projected to deteriorate as population ageing intensifies.

2. The new government has made a commitment to turn the fiscal situation around. Following the large stimulus in FY1999, the fiscal stance—as measured by the structural balance of the general government—was broadly unchanged in FY2000, and for FY2001, a modest degree of consolidation is expected.2 For FY2002, a political commitment has been made to cap net JGB issues to ¥30 trillion, which may significantly increase the withdrawal of fiscal stimulus relative to the current year. The bond issuance target is the first step of a fiscal reform program outlined recently by the Council on Economic and Fiscal Policy (CEFP). The Council’s program also states that the goal of fiscal policy over the medium term is to achieve a primary surplus.

3. The Council’s reform blueprint outlines a range of other fiscal reforms. The seven-point plan covers issues related to the privatization of public corporations and the postal savings system; a review of public works projects; shoring up the finances of the pension and health care systems; reorganization of relations between the central and local governments to increase the latter’s revenue base while increasing accountability; and improvements in budget preparation and spending allocation procedures to enhance expenditure management and fiscal transparency. Taken together, these elements would imply a major overhaul of fiscal management in Japan. However, the details are yet to be fully worked out and a specific timetable for their implementation has not been presented.

4. This chapter is organized as follows. Section A provides a discussion of the budget policies of the central and local governments, and their implications for general government balances. Section B is devoted to the Fiscal Investment and Loan Program (FILP). Section C focuses on recent fiscal reform measures and the remaining agenda. Section D discusses the implications of budget policies for public debt and the adjustment required to stabilize the level of debt over the medium-term.

A. Budget Policies

5. The central government’s general account budget is considered to be the key lever of control over the fiscal system, although the fiscal stance depends also on the position of the special accounts and the local governments.3 The government’s bond issuance is determined by the general account budget which—together with the budgets for 38 special accounts that are controlled by government ministries—is approved by the Diet. The Diet also approves the budgets for government financial institutions and the FILP. It also reviews the Local Government Finance Program (LGFP) which provides a framework for the financing of local governments. The various accounts, agencies, and programs are interlinked. The consolidation of general government operations from these accounts is undertaken as part of the preparation of national income accounts by the Economic and Social Research Institute of the Cabinet Office. To assess the implications of these, and other government operations, the Fund staff uses the broader concept of general government (based on national income accounts-based data) to obtain a comprehensive indicator of the fiscal position. The annual national accounts data are, however, available with a lag of eight months after the end of the fiscal year, thus requiring the staff to estimate the general government’s fiscal position for FY2000 on the basis of available quarterly data.

Central government operations

Fiscal Year 2000

6. The FY2000 initial budget did not contain significant reform measures. In keeping with past practice, the initial general account budget was formulated in relation to the initial budget of the previous year (Table II.1). Central government general expenditure—total general account expenditure excluding debt service payments and local allocation tax transfers—was slated to increase by 2½ percent, largely on account of higher transfers to the social security special account. The level of public works spending was kept unchanged. Reflecting higher tax revenue projections, and to shore up the weak financial position of the local governments, grants to local governments were increased by around ¥1½ trillion. At the same time, the higher public debt level generated an increase in projected debt service payments of over ¥2 trillion. The budget also included a substantial allocation for the Deposit Insurance Corporation (¥4½ trillion) following heavy losses related to bank failures. On the revenue side, the projected increase of ¥4 trillion (0.8 percent of GDP) in tax revenues came largely from the interest tax windfall from a high volume of maturing postal savings deposits (Table II.2). The budget provided for net JGB issues of ¥32½ trillion, about ¥1½ trillion more than in the previous year.

Table II.1.

Japan: Central Government General Account Budget, FY1996–2001

(In billions of yen)

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Source: Data provided by the Japanese authorities.

Includes repayments of principal and running costs.

Total expenditure excluding debt service and local allocation tax transfers.

Table II.2.

Japan: Tax Receipts of the Central Government General Account, FY1996–2001

(In billions of yen)

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Source: Data provided by the Japanese authorities.

Compared to latest available data of the previous year.

7. A supplementary budget was passed in November 2000 to help sustain economic recovery. The budget contained expenditure measures of about ¥5 trillion (1 percent of GDP), of which half was on public works. The supplementary budget followed the announcement of a stimulus package with a headline figure of ¥11 trillion (2¼ percent of GDP). In addition to the real water spending, the package contained additional measures, including to support small and medium-sized enterprises and to stimulate housing investment and employment, mainly through an extension of loan guarantees and increased lending by government financial institutions (Table II.3). This brought the total bond issuance to ¥34½ trillion for FY2000, about ¥3 trillion less than in FY1999 when the mid-year stimulus package had been substantially larger.

Table II.3.

Japan: Summary of Economic Stimulus Packages, 1993–2000

(In trillions of yen)

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Source: Data provided by the Japanese authorities; and staff estimates.

Temporary measures.

Later increased to ¥9.3 trillion (1.9 percent of GDP).

Public investment comprises general public works (including land purchases), disaster reconstruction, buildings and equipment, and independent public works projects by local government.

Excludes land acquisition for public works projects, which is included in public spending.

Includes loans by the Pension Welfare Service Public Corporation.

Includes ¥1.3 trillion in lending by the Japan Corporation for small business.

Include the expenditures for employment measures.

Fiscal Year 2001

8. The FY2001 general account budget aimed to underpin growth prospects while increasing financing for priority programs. General spending by the central government was budgeted to rise by about 1 percent, although overall general account expenditures was reduced by nearly 3 percent, reflecting mainly lower allocations for bank restructuring. The allocation for public works spending was unchanged relative to the FY2000 initial budget. The budget also reflected substantially lower debt service payments (1 percent of GDP), including on account of declining average JGB yields. The local government tax allocation grant rose by about ¥2 trillion. The general account deficit was to be financed by a net bond issue of ¥28.3 trillion, raising the outstanding central government bonds to about ¥390 trillion (73 percent of GDP) by the end of FY2001 (Table II.4).

Table II.4.

Japan—Central Government Bond Issues, FY1999–2001

(In trillions of yen)

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Source: Bank of Japan, Economic Statistics Monthly; and staff calculations.

Including subsidy, subscription, and DIC bonds, and bonds converted from JNRSC bonds.

Budget projection.

9. The main revenue measures in the budget related to mortgage interest relief, the gift tax, and treatment of corporate mergers and spin-offs. In total, the tax relief offered by the budget was small (¥190 billion, less than 0.1 percent of GDP). On mortgage interest, the eligibility time limit for new homebuyers for income tax reimbursement was extended from end-June 2001 to end-December 2003, and the applicable period was shortened from 15 to 10 years. The deduction was also capped at ¥5 million (from ¥5.9 million). On the gift tax, the exemption limit was raised from ¥600,000 to ¥1.1 million. For gifts received for acquiring a home, the exemption limit was raised to ¥5½ million (from ¥3 million). In addition, to facilitate corporate restructuring, the budget included measures to reduce the tax burden in the event of corporate spin-offs and mergers. Specifically, the capital gains tax on assets transferred among corporations as part of the restructuring was deferred until such gains are realized. The tax treatment for shareholders receiving shares in the new entity was similarly revised, and the recognition of capital gains for tax purposes deferred until such gains are realized.

Fiscal Year 2002

10. Achieving the FY2002 target for JGB issues will require substantial budgetary measures. The MOF’s projection for net JGB issues in FY2002 contained in the FY2001 budget documents is ¥33.3 trillion. The government has proposed a reduction in general account spending focused on lower public works spending and transfers to local governments to achieve the ¥3.3 trillion in measures to realize the bond issue target. The CEFP has called for a review and scaling down of public works expenditures, and proposed the elimination of earmarking of gasoline and other tax revenues presently reserved for road construction—a means to reduce the allocations for public works projects besides improving public expenditure management. Also, the government has proposed that a part of the reduction in the general account deficit for FY2002 be accomplished through a review of transfers to local governments.4 The total scale of the measures—under a current services basis—required to achieve the target may be somewhat higher than the 2001 budget documents suggest, given that the MOF projections were made on more optimistic assumptions about growth in FY2001 and stronger prospects for recovery in FY2002. Moreover, there may be additional pressures on the general account to finance spending by special accounts, such as the national pension special account, which have not been accounted for in the MOF projections (Okue, 2001).

Local Government Operations

11. Fiscal conditions in the local governments have deteriorated. Over the course of the 1990s, the central government’s stimulus programs affected local governments through both the expenditure and revenue channels. On the expenditure side, the local governments bore their share of the large public works component of most stimulus programs, which they financed and implemented either independently or jointly with the central government. On the revenue side, the tax cuts granted by the central government affected local budgets through losses in shared taxes. The depressed state of the local economies further exacerbated these budgetary pressures. The cumulative effect has been to raise the debt service burden substantially. At the same time, the own-revenue collections of the local governments dropped significantly, with corporate tax revenues witnessing an especially sharp decline as enterprises continued to report losses. Reflecting these trends, the total outstanding local government debt is estimated to have more than doubled to over 38 percent of GDP at the end of FY2000 (Table II.5).

Table II.5.

Japan: Local Government Operations

(In percent of GDP)

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Source: Ministry of Home Affairs; Ministry of Finance; and staff calculations.

Using data provided by the authorities, the staff has reclassified financing items which are treated as revenues in the official statistics.

Including classification errors and omissions.

12. The deteriorating fiscal position of the local governments has prompted substantial consolidation efforts.5 The measures adopted have fallen mainly on investment projects financed entirely by the local governments. These cuts have resulted in a substantial decline in the share of public works projects financed and implemented by the local governments. With these cuts, the share of locally financed public works projects fell from around 75 percent in 1991 to around 60 percent in 1999 even as total public works expenditures rose during the 1990s (Table II.6). These cuts were at variance with the LGFPs which aimed at broadly stable investment-to-GDP ratios.

Table II.6.

Japan: General Government Public Works Projects

(In billions of yen)

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Source: Ministry of Finance; Local Government White Paper, various issues; and staff calculations.

Calculated as total central government expenditure on public works minus central share of joint public works.

Joint projects are implemented by local governments.

13. The local governments have supplemented expenditure measures with a search for additional revenue sources. Some prefectural governments have made use of the April 2000 decentralization law whereby some specific levies (e.g., on waste disposal, gambling, hazardous goods storage) could be imposed in consultation with the Ministry of General Affairs and without formal approval by the central government. In other cases, prefectures have exploited a loophole in the existing tax legislation which allows local authorities to raise business taxes on a base other than profits (so-called “external” taxes) if a business activity is unique to their jurisdiction. Using these provisions, for example, the Tokyo and Osaka governments have passed legislation to tax the gross profit (as opposed to net income) of major banks conducting business in their prefectures.

General Government Balances

14. The budget policies for FY2001 imply some reduction in the general government’s budget deficit and a withdrawal of fiscal stimulus. The staff projects that, on a national accounts basis, the general government deficit would fall by about 1¼ percent of GDP to 6½ percent (Table II.7). This projection incorporates the November 2000 supplementary budget—which was smaller than in November 1999 and would affect public investment in the following fiscal year—and continued constraints at the local level. The projection assumes that local governments will continue to cut back on locally financed public works projects and that a small (¥1 trillion) supplementary budget will be passed in the autumn. The structural deficit (including social security, but excluding bank support)—which reflects more closely the impact on aggregate demand—is projected to decrease by a little over ½ percentage point of GDP.


General Government Deficit

(in percent of GDP)

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A002

Table II.7.

Japan—General Government Operations, 1998–2002

(In percent of GDP)

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Source: Staff estimates.

15. Further fiscal consolidation is likely in FY2002. The overall impact of the reduced expenditures—through lower public works allocation and transfers to local governments in the general account budget—required to meet the ¥30 trillion JGB issue target is somewhat difficult to assess since the composition of the expenditure cuts is yet to be firmed up. Also, it is difficult to foretell the likely impact of the cuts in general account transfers on local governments’ expenditure plans. Moreover, the initial point in the projections is subject to some margin of error given the lack of consolidated data for FY2000. Subject to these uncertainties, the staff’s current estimate is that the impact of these measures would be to reduce the structural general government deficit by about 1 percent of GDP in FY2002.

B. Fiscal Investment and Loan Program

FILP Operations

16. As a tool for fiscal management, the FILP plays an important role in Japan. By financing government activities and extending loans to government financial institutions (GFIs) and public enterprises, it has helped to build Japan’s infrastructure and, more recently, provided fiscal stimulus to sustain the pace of economic activity. Although the FILP is not formally a part of the general government sector, its annual plan is formulated in coordination with the budget process, and is submitted to the Diet together with the regular government budget. Indeed, owing to its size, the FILP is often referred to as the “second budget”. During the expansionary phase of fiscal policy, substantial additional FILP loans were announced as part of the 1998 and 1999 stimulus packages, mainly to improve credit conditions in the economy and extend financial support to local governments. However, the decline in the flow of funds into the postal savings and pension systems in FY1999, largely in response to weak income growth, prompted a sharp reduction in investments in government bonds.

17. During FY2000, the withdrawal of funds from the postal savings system—related to the maturation of postal savings deposits—further constrained the room for FILP investment. In the course of the fiscal year, the postal savings system registered a fall in deposits of about ¥9½ trillion, compared to the Postal Savings Bureau’s initially projected outflow of ¥16 trillion yen.6 Excluding withholding taxes on interest and amounts above the ¥10 million deposit limit, the postal savings system recorded a redeposit rate of about 72 percent on more than ¥50 trillion in maturing deposits. However, the surpluses of the pension system have also been declining as income growth has been sluggish, payment morale has been low, and payouts continue to mount. In response, amounts allocated for portfolio investments were again reduced sharply (Table II.8).


Japan: Liabilities of the Trust Fund Bureau Special Account

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A002

Sources: WEFA, Nomura Database.
Table II.8.

Japan: Fiscal Investment and Loan Program (FILP), FY1996–2001

(In trillions of yen)

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Source: Ministry of Finance.

Reflects the funding of the “lend-back” system under which the postal savings system, public pension funds, and the postal life insurance fund receive funds for portfolio management on their own account.

Compared to latest available data of the previous year.

As part of the FILP reform, effective April 1, 2001, the Trust Fund Bureau Special Account was replaced by the Fiscal Loan Fund Special Account.

18. In FY2001, continued reduction in inflows required broader cuts in FILP spending, as the general FILP budget was trimmed substantially, reflecting reductions in housing loan programs, support for SMEs, and programs of the other government financial and non-financial institutions. By contrast, financing for the local governments was increased by a small amount.

FILP Reform

19. A comprehensive reform of the FILP was initiated in April 2001. The aim of the reform program is to progressively align the activities of the program with market principles. The key elements of the reform bill approved by the Diet were the following:

  • Increasing role of market financing. Until FY2000 the primary source for FILP funds was Japanese savings held by public institutions, including the postal savings and public pension systems, which were invested by the Ministry of Finance’s Trust Fund Bureau (TFB). Starting FY2001, the compulsory transfer of deposits from the postal savings and pension systems to the TFB was abolished. Henceforth, the government will need to raise funds by issuing additional bonds (zaito bonds) and financing bills, to be transferred to a newly created Fiscal Loan Fund Special Account (FLFSA).7

  • FILP-agency bonds. Individual FILP agencies are encouraged to issue their own bonds. While the government may guarantee such bond issues in limited circumstances, the bulk of agency bonds is expected to be issued without guarantees. In FY2001, twenty FILP agencies—including the Housing Loan Corporation, the Japan Highway Corporation, the Finance Corporation for Municipal Enterprises, the Development Bank of Japan, the Japan Bank for International Cooperation, and the Shoko Chukin Bank—are slated to tap the markets directly for financing, with the total bond issuance expected to amount to ¥1.1 trillion (around 3½ percent of the general FILP spending). These agencies have sought bond ratings and the initial market response appears to have been favorable, which may reflect the general perception that these bonds implicitly carry government guarantees and that the agencies willing to enter the market may be the most financially sound among the FILP agencies.

  • Cost analysis. To assess their prospective financial implications and to improve their efficiency, subsidy cost analyses of FILP agencies and projects will be undertaken. These analyses are intended to assess the long-term viability of agency activities, including by identifying future government subsidies required to maintain financial balance.

C. Fiscal Reforms

Social Security Reforms

20. Japan’s unfavorable demographic trends are also adding to fiscal pressures. Under current projections, Japan is likely to experience the most rapid increase among the G-7 countries in the share of the elderly in its total population, and, by 2020, the number of senior citizens is projected to be around 33 million (about 25 percent of the population). These trends imply sharply increasing pressures on health care and pension costs.8

21. A far-reaching bill for the reform of the public pension system was approved by the Diet in March 2000. The bill included cuts in lifetime pension benefits by around 20 percent for future retirees and an increase in the eligibility age for earnings-related pensions, considered sufficient to limit future increases in pension contribution rates in both the (basic) National Pension and (earnings-related) Employee Pension Insurance (EPI) schemes by a substantial margin. The Ministry of Labor, Health and Welfare estimated that, absent the reform, the required contribution rate to maintain the solvency of the EPI would have to rise to 34½ percent of monthly wages by 2025 (compared to the current level of 17.35 percent). Following the reforms, the required rate to ensure solvency is estimated at 25 percent in 2025. Of course, such estimates are subject to a wide margin of error; future contribution increases could be higher, for example, if the fertility rate does not recover as projected.

22. Despite the reform measures, the finances of the pension system remain under strain. Although the reforms are estimated to have reduced the projected net liabilities of the pension system by almost 30 percent of GDP to around 60 percent of GDP, these liabilities are still relatively large by industrial country standards. Moreover, this estimate is also based on the assumption that the amount of government transfers to the basic pension scheme would be raised, effective 2004, from one third to one half of the basic pension benefits.

23. The reform blueprint of the CEFP addresses the continued difficult finances of the public pension system. Once again, while the details are yet to be worked out, the blueprint states as one of the government’s goals the creation of a reliable and easily understood social insurance system. It proposes the introduction of individual social security account to help people track their payments and benefits. The blueprint also calls for a review of pension taxation to smooth the tax burden among generations.

24. Some progress has been made in health care reform, but key reforms are still under consideration:

  • A revised Health Insurance Law was enacted in December 2000. A key provision of the law was that patients aged 70 and above would pay a fixed proportion (10 percent) of their medical costs, replacing the flat rate system. The provision would help shore up the finances of health insurance societies that are running out of legally mandated reserves due to growing payments for medical care for the elderly. However, some of the relief may come from senior citizens abstaining from doctor visits. An amended Medical Service Law which eased advertising restrictions on medical institutions and enhanced the nurse-inpatient ratio was also passed.

  • However, further significant reform of the system is still required. Last year’s revisions will likely be insufficient to curb growing medical costs while maintaining a safe and high-quality medical system. Issues that need to be addressed include implementation of stricter examination of cost breakdowns on medical bills, resolution of the gap between official drug prices covered by insurance and the prices paid by hospitals, and improved information disclosure and the quality of services offered at hospitals and clinics. An extensive reform of the system is planned for FY2002.

  • A government panel is considering proposals which could form the basis of the reform of the national health insurance program. The panel’s stated goal is to restrict the growth of medical costs for the elderly (currently rising at an average rate of 4 percent a year) to no more than GDP growth. The panel’s proposals include provisions for senior citizens with sufficient assets and income to shoulder a greater share of costs; a revamping of the current system of reimbursing hospitals for medical costs and paying artificially high government-mandated prices for drugs; and reductions in public nursing care and health insurance coverage for high-income seniors.

Public works

25. Longstanding concerns about public works have become acute in recent years. Public criticism has been directed at the economic value of the projects—both at the central and local level—as well as at the contracting procedures. In a number of cases, project revenue has been substantially lower than projected, mostly on account of over-optimistic assumptions of the size of the economy. Costs have also frequently been higher than anticipated, including on account of restrictions placed on the number of bidders and bidding practices which favor well-connected local construction companies.

26. To address the efficiency issues, new guidelines for a review of public works projects were announced in early July. These guidelines apply to projects which are incomplete after ten years of being approved. The guidelines are more forward-looking than the current provisions and allow for scrapping of projects whose prospects for completion are uncertain. In addition, projects which have not begun five years after approval, will be reviewed. These steps follow action taken in the fall of 2000 when, after a review of projects by the ministries and a panel of the ruling coalition, 233 projects worth ¥2.8 trillion (½ percent of GDP) were recommended for cancellation.

27. Contracting procedures have also been reformed. The government has started disclosing data on tenders and contracts for public works projects costing more than ¥2½ million. This cost limit is expected to cover more than 95 percent of all public works projects. The ministries and local authorities are also required to release their job performance evaluations of public works contractors. In the past, ministries and local governments have scored the performance of contractors after completion of a job, and the results were sent to the contractors but not made public. Moreover, the government is also considering proposals to exclude financially weak companies from bidding for public work contracts unless the bid would be covered by a bank guarantee. Starting October 2001, the government will accept bids online for public works projects and will make available via the Internet bidding results and information on plans to invite tenders for directly controlled public works projects. Electronic bidding will expand gradually in FY2002 and FY2003 and is expected to be used for all projects starting FY2004.

28. The CEFP blueprint suggests a need for further review of public works projects and related budget procedures. It emphasizes the need to reform the current practice of earmarking revenues for particular public works projects (e.g., road construction), to review existing budget allocation procedures which distinguish between public work and non-public work projects, to make allocations across regions more flexible, and to review long-term public works plans.

Tax Reform

29. The Tax Commission Report suggested wide-ranging reform measures for the tax system. As part of an extensive review of the tax system in FY2000, it recommended tax policy measures to improve government finances as well as steps that could be taken to improve tax administration. These recommendations included a review of the income tax exemptions and deductions; the introduction of consolidated corporate taxation; a larger role for the consumption tax in government revenues; rationalization of the inheritance tax structure; reorganization of central and local tax responsibilities; and the introduction of taxpayer identification numbers.

30. The government has begun to contemplate these recommendations. To broaden the income tax base, a reduction in personal income tax exemptions is being considered. The discussion on consolidated corporate taxation has also progressed. Issues related to the reorganization of taxation responsibilities between the national and local governments are expected to be a key element of the FY2002 budget discussions.

Fiscal Transparency

31. The recent Fund staff’s Report on the Observance of Standards and Codes identified areas for improving fiscal transparency in Japan. The report noted that while the Japanese fiscal system is complicated, the budget process meets a high standard of transparency, including a solid legal basis and clear administrative accountability, public availability of comprehensive budget documentation, and regular reporting on budget execution. Moreover, recent initiatives—the enactment of freedom of information legislation, steps towards administrative reform of the national government, opening up of the deliberations of policy councils for greater public input, the publication of a balance sheet,9 and the FILP reforms—have improved fiscal transparency. The key areas identified for further progress were:

  • Providing timely information on the overall stance of fiscal policy. This would require providing more comprehensive measures of the fiscal position, with a focus on the finances of the general government, regular reporting on fiscal developments, including the provision of a detailed mid-year budget report, and less reliance on supplementary budgets, in particular by formulating initial budgets to reflect the desired stance of fiscal policy.

  • Examination of fiscal policy in a longer-term context. This would require the development of a medium-term budget framework which would allow the annual budget to be formulated in a forward-looking manner, and projections of social security and health spending which are integrated with budget projections as a basis for assessing long-term fiscal sustainability.

  • Clarification of the role of public financial intermediation. This would require a review and restatement of the objectives of the FILP and provision of more information on its financial implications, and on that of the financial implications of any public policy obligations that are retained by other government ministries and agencies.

D. Medium-term Fiscal Sustainability

32. Japan’s fiscal deficit and gross debt are now the highest among major industrial countries. The fiscal position has worsened especially during the latter half of the 1990s, in part on account of the weak state of the economy. However, even after adjusting for the weak cyclical position of the economy, the fiscal deficit has been higher than other G-7 countries, and is in marked contrast to the earlier decades when conservative fiscal policies generated low deficits and debt levels.

Table II.9.

General Government Finances, 2000

(In percent of GDP)

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Source: IMF World Economic Outlook, April 2000; staff estimates.

Excluding social security.

33. A number of conceptual issues arise in assessing the size of Japan’s public debt burden.10 The gross concept is likely to overstate the level of government debt as the government holds substantial assets, primarily through the pension system. Netting out these assets also poses problems as the assets of the pension system are more than offset by its projected future liabilities, and the value of assets may be overstated by the book value of claims. Furthermore, compared to other countries, the government’s involvement in financial intermediation is substantial. A large portion of the loans extended by GFIs is to public corporations for social infrastructure projects, which exposes the government to future losses. In addition, the government has also guaranteed market debt issued by these corporations and other public agencies. The illiquid nature of the FILP assets, the troubled finances of the public corporations, and the substantial volume of government-guaranteed debt have generated concerns about the contingent liabilities attached to these loans and guarantees. These considerations need to be borne in mind when assessing the actual and potential public debt obligations in Japan.

34. By whatever measure chosen, Japan’s public debt has risen sharply since the early 1990s. By end-2000, general government gross debt had reached 130 percent of GDP. However, the sizeable assets of the government have kept net debt (around 45 percent of GDP at end-1999) at a relatively low level by international standards. The assets of the pension system (valued at 55 percent of GDP) and financial assets held by the central and local governments (45 percent of GDP) account for the difference between gross and net debt. An alternative definition of net debt would treat the social security system as independent and exclude its assets—which for Japan are more than offset by the projected net future liabilities of the pension system—from public debt calculations. This concept of net debt excluding the social security system is used by the staff to assess Japan’s fiscal position. At nearly 95½ percent of GDP at the end of FY2000, net debt excluding the social security system was higher than in most other industrialized countries.


Public debt(in percent of GDP)

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A002

35. The general government’s true net obligations may be somewhat higher than suggested by the net debt figures. Specifically, it is difficult to estimate the true value of government assets, in part because some of them are illiquid. It is also possible that the government may need to bear some contingent liabilities arising from its loan programs. While the default rate on loans by government financial institutions has so far been low (bad loans account for about 1–2 percent of the total loan portfolio), many large public infrastructure investments appear to generate significantly less than budgeted returns, which may imply an inability to meet debt service obligations, and thus significant liabilities for the government (as happened in the case of the Japanese National Railway Settlement Corporation). For example, a recent study of the finances of the Japan Highway Corporation and the Honshu-Shikoku Bridge Authority by the Ministry of Land, Infrastructure, and Transport suggests that revenue shortfalls for these public corporations would lead to a large increase in their outstanding debt.11 In the event that these corporations are unable to service their debts, the government would need to step in to meet repayment obligations which could be substantial. The total amount of outstanding government-guaranteed debts amounted to ¥55¾ trillion (about 10 percent of GDP) at end-2000. The government may also be called on to cover losses related to ¥41½ trillion in guarantees extended by regional credit guarantee associations to cover bank loans to small and medium-sized enterprises (including ¥20 trillion in outstanding special loan guarantees that have been extended since 1998).

36. In part reflecting concerns about the mounting public debt burden, rating agencies have downgraded Japan’s sovereign rating over the past year. Citing rising debt levels and the government’s diminished fiscal flexibility, Standard and Poor’s downgraded Japan’s long-term local and foreign currency sovereign credit ratings from AAA to AA+ in February 2001. In March 2001, Fitch downgraded the outlook for Japan from “stable” to “negative” citing concerns over “the political uncertainty that have seen the structural reform agenda effectively grind to a halt since the last rating action in June 2000.” Earlier, in September 2000, Moody’s had downgraded the yen-denominated domestic securities issued or guaranteed by the government to Aa2 from Aa1, while maintaining a negative outlook.

Stabilizing public debt

37. To place public debt on a sustainable path, substantial fiscal adjustment will be required over the medium term. The extent of consolidation that may have to be undertaken to stabilize public debt can be derived from the accounting relationship between debt and budget deficits, the primary balance necessary to stabilize the debt-to-GDP ratio in the year t:


where bp is the target for the primary balance in percent of GDP, d is the debt-to-GDP ratio, and r and g are the values for the nominal interest rate paid on government debt and the nominal GDP growth rate, respectively. The amount of fiscal consolidation necessary to stabilize the debt-to-GDP ratio (the “required adjustment”) can then be calculated as the difference between the value of bp and the current cyclically adjusted primary balance of the general government (excluding social security), estimated at -3½ percent of GDP in FY2001.

38. Net debt and primary balance for the general government excluding social security, are used as proxies for d and bp, respectively. As regards r, an implicit measure can be derived from the interest paid on government debt which reflects past debt contracted at different maturities and interest rates. As interest rates on government bonds have generally been declining in recent years, the current value of r is higher (at roughly 3¼ percent) than the current yield on 10-year JGBs (1¼ percent). With an average debt maturity of about 4–5 years, the projected future changes in JGB yields affect the average interest rate only gradually.

39. The staff’s current baseline forecast corresponds to a scenario in which real growth converges to a medium term potential of about 2 percent, and real JGB yields rise to 214 percent by 2005.12 In this case, fiscal adjustment of 3¾ percent of GDP—sufficient to generate a structural primary balance by FY2006—would stabilize net debt (excluding social security assets) around 110 percent of GDP, compared to an estimated 100 percent of GDP in 2001 (Table II.10). The required fiscal adjustment would be smaller, however, were the potential growth rate to increase, and correspondingly higher if the growth rate were to fall. Variations in JGB yields also change the required fiscal adjustment. For example, if real interest rates fell to around 1 percent, the required adjustment would be ½ percent of GDP smaller than in the baseline scenario. A more gradual consolidation effort to stabilize net debt by 2010 scenario would require approximately the same cumulative shift in the structural balance, but spread out over a longer period. However, slower adjustment under this scenario would lead to higher debt accumulation in the interim and stabilization of debt at a higher level of about 120 percent of GDP.

Table II.10.

Japan: Baseline Scenario for Medium-Term Debt Consolidation

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Source: Staff calculations.


  • Bayoumi (1998), The Japanese Fiscal System and Fiscal Transparency, Aghevli, et. al., Structural Change in Japan: Macroeconomic Impact and Policy Challenges, IMF.

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  • Faruqee, H. Mühleisen, M. (2001), “Population Aging in Japan: Demographic Shock and Fiscal SustainabilityIMF Working Paper 01/40, Washington, DC.

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  • IMF (2001), Japan: Report on the Observance of Standards and Codes, Fiscal Transparency Module.

  • Okue, K. (2001), Japan’s Fiscal Status and Outlook: Rising Systemic Risk, Dresdner Kleinwort Wasserstein, Tokyo.


Prepared by Sanjay Kalra (ext. 36142)


The fiscal year starts on April 1.


These concepts, and linkages among them, are discussed in Bayoumi (1998) and IMF (2001).


Transfers to local governments are channeled through the Local Allocation Tax and Transfer Special Account (LATTSA). Until FY2000, LATTSA transfers to local governments exceeded those from the general account into the LATTSA which were determined on the basis of revenue sharing arrangements. The difference was financed by borrowings from the Trust Fund Bureau or from commercial banks. Starting in FY2002, however, the LATTSA will no longer have the authority to borrow; instead the general account and the local governments will be jointly responsible for repaying the outstanding debt. As an interim measure in FY2001, the LATTSA will receive ¥6 trillion from the successor of the Trust Fund Bureau (see below), while the general account and the local governments will each contribute ¥1.4 trillion.


The consolidation measures were encouraged by the statutory limitations on local government borrowing. Two fiscal indicators trigger intervention: (i) a local authority’s bond issues are restricted if its ratio of debt service to local tax revenues exceeds 20 percent; and (ii) a prefecture (municipality) is required to undertake fiscal restructuring under direct national (prefectural) control if its fiscal deficit exceeds 5 (20) percent of a standardized expenditure measure.


The postal savings system holds roughly ¥250 trillion (50 percent of GDP) in deposits, largely in 10-year fixed-term savings instruments (teigaku), which have been fully invested in the FILP. About 40 percent of these funds were deposited between April 1990 and March 1992, when teigaku interest rates were at their peak, and are now about to mature. The Postal Savings Bureau had estimated that about ¥50 trillion in funds would flow out of the postal savings system by March 2002.


For an interim time period of seven years (the maturity of the outstanding loans to the FILP), the postal savings and pension systems would continue to underwrite FILP bonds, but at successively lower levels, In FY2001, the postal savings system is slated to subscribe to ¥17.9 trillion out of a total issuance of ¥43.9 trillion in zaito bonds; the remainder would be absorbed by the pension reserves (¥11.9 trillion), the postal life insurance (¥3.6 trillion), and the bond market (¥10.5 trillion).


See H. Faruqee and M. Mühleisen (2001).


The balance sheet was published in October 2000. It reported assets and liabilities as of end-FY1998 and covered the general and special accounts, including the social security system. The reported net liabilities were in the range of ¥130-770 trillion, depending on the treatment of pension reserves and the present value of future government transfers and pension contributions.


For a discussion, see OECD, Gross and Net Debt Measures in Japan, 1998.


The study states, for example, that a 10 percent lower-than-projected traffic on the national expressways could increase the debt of the Highway Corporation—currently at ¥23 trillion—to ¥31 trillion over a 50 year period.


Inflation is assumed to be flat at 1 percent a year throughout. For simplicity, it is assumed that growth and interest rates on new debt converge in a linear fashion to their steady-state values by 2005, and the adjustment in the structural balance is also assumed to be linear over the adjustment period. Variations in the paths of interest rates and growth towards their endpoints have only small effects on the required adjustment.

Japan: Economic and Policy Developments
Author: International Monetary Fund