Japan: Staff Report for the 2003 Article IV Consultation

Japan has made progress in addressing major economic challenges. Executive Directors emphasized for a comprehensive program designed to resolve financial and corporate sector weaknesses, end deflation, and rein in fiscal imbalances. They stressed the need to maintain strong fiscal and monetary policies and also accelerate structural reforms. They welcomed the program for financial revival and commended Japan's continued commitment to overseas development assistance. They stressed the need to improve the legal framework for antimoney laundering and countering the financing of terrorism.


Japan has made progress in addressing major economic challenges. Executive Directors emphasized for a comprehensive program designed to resolve financial and corporate sector weaknesses, end deflation, and rein in fiscal imbalances. They stressed the need to maintain strong fiscal and monetary policies and also accelerate structural reforms. They welcomed the program for financial revival and commended Japan's continued commitment to overseas development assistance. They stressed the need to improve the legal framework for antimoney laundering and countering the financing of terrorism.

I. Recent Economic and Policy Developments

1. At the time of the 2002 Article IV consultation (concluded in July), the Japanese economy was recovering from its deepest recession in four decades. By that time, Japan had already experienced ten years of sluggish growth and several years of deflation. Executive Directors welcomed the economy’s improvement but noted that there were still considerable downside risks to economic activity. Directors also commended the government’s commitment to press ahead with structural reforms and build on the progress achieved in its first year in office.

2. The cyclical recovery in 2002 included a strong pickup in activity in the second quarter followed by a gradual slowdown during the rest of the year. For 2002 as a whole, real GDP grew by only 0.1 percent, owing to the low base for the recovery that resulted from the sharp fall in output during the previous year (Figure 1; Table 1).

Figure 1.
Figure 1.

Japan: Selected Economic Indicators, 1997-2003

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Sources: Global Insight, Nomura Database; and CEIC Database.1/ “Favorable” minus “unfavorable”.2/ Higher number implies greater degree of consumer anxiety about future prospects.
Table 1.

Japan: Selected Economic Indicators, 1995-2004

Nominal GDP: US$3,998 billion (2002)

Population: 127.4 million (2002)

GDP per capita: US$31,394 (2002)

Quota: SDR 13,312.8 million

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Sources: Global Insight, Nomura database; and staff estimates and projections as of July 16, 2003.

Annual growth rates and contributions are calculated from seasonally adjusted data.

Contribution to GDP growth.

Annual growth rates are calculated from annual averages of monthly data.

Including social security, excluding bank support.

From April 1998 onward, data reflect the inclusion of foreign banks, foreign trust banks and Shinkin banks in the monetary survey.

Based on normalized unit labor costs; 1990=100.

June 2003.

May 2003.

July 16, 2003.

3. The recovery appears to have stalled in 2003. GDP grew by only 0.1 percent in the first quarter, and monthly indicators point to continued sluggish activity in the second quarter. Exports and the external balance, past sources of strength, have declined as partner-country growth has slowed. Industrial production has leveled off, household expenditure and retail sales have been broadly flat, and the cyclical rebound in business fixed investment and profitability seems to have lost momentum (Figure 2).

Figure 2.
Figure 2.

Japan: Monthly Indicators of Real Activity, 1997-2003 1/

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: Global Insight, Nomura Database.1/ Seasonally adjusted data.2/ Excluding ships and public utilities.

4. Labor market weaknesses persist (Figure 3). The unemployment rate remains near its record-high 5.5 percent. Moreover, employment, the labor force, and monthly earnings (real and nominal) have all been on downward trends since around mid-2001.

Figure 3.
Figure 3.

Japan: Price and Labor Market Indicators, 1997-2003 1/

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: Global Insight, Nomura Database.1/ Seasonally adjusted data except for land prices, household income, and monthly earnings.

5. Amid persistent economic slack, deflation continues. The staff’s production-function-based output gap widened from 1.9 percent to 2.8 percent of potential GDP in 2002, reflecting below-potential growth. The GDP deflator fell in 2002 for a fifth consecutive year, by 1.7 percent. In the first quarter of 2003, the deflator declined by 3.2 percent (y/y), partly reflecting a steep fall in civil servant bonuses (which subtracted an estimated 0.6 percent from the deflator). The core CPI (excluding fresh food) has also decreased (y/y) virtually every month for the past four years. The rate of decline bottomed out in early 2002 and stood at 0.4 percent in June 2003, with the easing in deflation partly reflecting the effects of a one-time increase in medical insurance co-payments. Meanwhile, expectations of deflation remain entrenched, with the July consensus forecast predicting CPI deflation of 0.5 percent in 2003 and 0.6 percent in 2004.


Japan: Inflation. 1998-2003 1/

Four-quarter percent change

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: Global insight, Nomura database.1/ Seasonally adjusted.

6. Monetary policy has remained focused on maintaining financial stability, primarily by providing liquidity to ensure that banks could meet their funding needs without difficulties. Over the past 12 months the Bank of Japan (BoJ) raised the target for current account balances on several occasions, periodically injected liquidity (pushing current account balances well above the target ahead of the end-March 2003 book-closing), expanded the range of collateral eligible for operations, and removed the restriction on the maximum number of days for the use of Lombard loans, beyond which the penalty rate was applied. The BoJ has also helped banks reduce their equity risk with its program to buy banks’ shareholdings for up to ¥3 trillion through September 2003 (with a possible one-year extension). A program of outright purchases of asset-backed securities, up to ¥1 trillion through March 2006, is set to commence at end-July 2003.


Japan: Money, 2000-2003

Twelve-month percent change

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: Global insight, Nomura database.

General Government Revenue and Expenditure

(In percent of fiscal year GDP)

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: Cabinet office and staff estimation.

7. Growth in base money has not fed into broad monetary aggregates or arrested the continuous decline in bank lending, although short-term interest rates have been kept at virtually zero (Figures 4 and 5; Table 2). With persistent economic weaknesses and bank balance sheet problems limiting loan demand and banks’ willingness to lend, bank loans continued declining by about 5 percent a year (including loan write-offs), while y/y growth in M2+CDs slowed to about 1½ percent.

Figure 4.
Figure 4.

Japan: Financial indicators, 1997–2003

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Sources: Global Insight, Nomura Database; CEIC Database; Bloomberg, LP; and staff calculations.1/ Deflated by CPI adjusted for changes in indirect taxes and administered prices.2/ Premium paid by Japanese banks to borrow dollars in London interbank market (average rate for Bank of Tokyo-Mitsubishi and Norinchukin Bank compared to London fixing rate from 3/18/02; previously, Fuji Bank was included in the average).3/ Five-year corporate bonds minus five-year government bond yields.4/ Five-year bank bonds minus five-year government bond yields.
Figure 5.
Figure 5.

Japan: Monetary and Fiscal Indicators, 1990-2003

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Sources: Ministry of Finance; Cabinet Office; Global Insight, Nomura Database; and staff estimates and projections.1/ The monetary conditions index Is the weighted sum of the short-term real interest rate and the real effective exchange rate, where the weights reflect the estimated impact of those variables on aggregate demand. Specifically, a 100 basis point change in the overnight call rate (in real terms) receives the same weight as a 10 percent change in the real effective exchange rate.2/ In percent of fiscal year basis GDP; the fiscal year is from April to March.
Table 2.

Japan: Monetary Survey, 1998–2003 1/

(Percentage change over corresponding period of previous year, end-period)

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Source: Bank of Japan, Financial and Economic Statistics Monthly.

From April 1998 onward, data reflect the inclusion of foreign banks, foreign trust banks and Shinkin banks in the monetary survey.

8. Fiscal policy was expansionary in FY2002. On a cyclically-adjusted (structural) basis, the estimated general government deficit widened by about 1 percent of GDP to 6.5 percent of GDP (Table 3). Unadjusted, the deficit rose to 7.5 percent of GDP, mainly reflecting a fall in revenue. Continued fiscal deficits have fed rapidly growing government debt, with end-2002 gross and net debt estimated at 158 and 72 percent of GDP respectively.1

Table 3.

Japan: General Government Operations, 1998–2003 1/

(In percent of GDP)

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Source: Staff estimates, based on the following assumptions: Stimulus Packages: The projections include the FY2002 supplementary budget, with public works spending of ¥1.5 trillion. A net tax cut of ¥1.8 trillion is assumed for FY2003 based on the budget. Tax revenue in FY2000 and FY2001 has been boosted by one-off increase in interest tax revenue from maturing postal saving deposits (estimated at ¥2.5 trillion for each year).

Estimated from the National Income Accounts data. The fiscal year is April through March.

The levels of gross and net debt were revised in the National Income Accounts data released in April 2003.

9. In the external sector, the favorable trade performance in 2002 raised the current account surplus by about ¾ percent of GDP to 2.8 percent of GDP (Table 4 and Figure 6). Export volume rose strongly in 2002 reflecting a sharp pickup in demand from Asian partner countries (notably China) and the United States, although volume growth slowed in the second half of the year. Imports, particularly from China, picked up during the year. As in recent years, the main financial counterparts of the current account surplus included net portfolio outflows, outward foreign direct investment, and acquisition of reserve assets. As of end-2002, Japan’s net foreign assets amounted to US$1.4 trillion (35 percent of GDP) and international reserves were US$461 billion (excluding gold; Table 5).

Table 4.

Japan: Balance of Payments Summary, 1996–2003

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Sources: Global Insight, Nomura database; and staff estimates.
Table 5.

Japan: Indicators of External and Financial Vulnerability, 1995–2003

(In percent of GDP, unless otherwise indicated)

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Sources: Global Insight, Nomura Database; IMF, International Financial Statistics; Fitch IBCA; and staff estimates.

Public sector debt securities and other loan liabilities.

Other investment income, debit.

Year on year percent change for the latest figure.

Major banks. Capital ratio is on a non-consolidated basis.

Figure 6.
Figure 6.

Japan: External Sector Developments, 1997-2003

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: Global Insight, Nomura Database.1/ Increase implies appreciation.

10. Compared to June 2002, the yen is broadly unchanged against the U.S. dollar but is modestly weaker in nominal and real effective terms (see Figure 6). In the second half of 2002, the yen/dollar rate ranged between ¥116 and ¥125 amid heightened geopolitical uncertainty and concerns about the pace and sustainability of recovery in the major economies. In the first half of 2003, the yen came under pressure to strengthen against the dollar, as the dollar weakened against the euro. This pressure prompted the authorities to intervene in foreign exchange markets on a number of occasions over this period, in the total amount of some ¥7 trillion. In the event, for most of 2003 to date the yen/dollar rate has moved in a range of ±¥2 around ¥119. The yen has weakened significantly against the euro, however, contributing to depreciation in real and nominal effective terms.

11. Long-term government bond yields hit record lows but subsequently rebounded sharply. The decline in yields in the face of high and rising government debt partly reflected heavy buying of Japanese Government Bonds (JGBs) by financial institutions owing to ample liquidity, weak loan demand, increased risk aversion, and banks’ efforts to cut risk-weighted assets. The BoJ has also made outright purchases of JGBs, amounting to ¥1.2 trillion per month since October 2002. Starting in June 2003, long-term yields more than doubled over a few weeks to slightly below the levels attained a year earlier. The rebound in JGB yields, which occurred in the context of a less pronounced global pickup in long-term interest rates, may have reflected financial market considerations such as portfolio rebalancing from bonds to equities, profit-taking, and investor concerns that yields had fallen too far. It may also have reflected an improvement in the economic outlook, although data continued to imply an outlook of broadly flat growth and persistent deflation.


Stock Market and Government Bond Yield

(In percent)

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: Bloomberg.

12. Stock prices have also recently recovered from long-term lows. Stock prices have fallen during most of the past 12 months, partly reflecting concerns about selling pressures from banks and pension funds. In early 2003, the Nikkei index declined broadly in line with other mature markets, but from already low levels, and in April bottomed out at 21-year lows. On the heels of rallies in overseas markets, the Nikkei subsequently rebounded largely driven by foreign buying. As of mid-July 2003, the Nikkei was up about 14 percent for the year but was still about 5 percent lower than a year earlier. Japan’s long-term market slide has had significant negative repercussions for the corporate and banking sectors and aggregate wealth. Between May 2002 and May 2003, Japan’s market capitalization declined by about 25 percent, to about 40 percent of its 1989 peak.

13. Banks’ end-FY2002 results revealed some progress in dealing with their problems. Major banks’ average ratio of NPLs to credit declined from 8.4 percent to 7.2 percent during the fiscal year, in an environment of more stringent regulation and in line with the authorities’ target to halve the ratio by end-FY2004. Major banks also cut equity market exposure. The ten largest regional banks managed to pare credit costs and increase return on equity to positive (but still low) levels, and also cut back equity exposures and slightly reduced the share of problem loans in total loans. Also, the fiscal year end passed without evident funding difficulties among major or regional banks.2

14. However, banks’ financial difficulties persisted. In FY2002, major banks’ losses from equity holdings together with credit costs (including ¥4.9 trillion in costs resulting from NPL disposal) resulted in net losses of ¥4.4 trillion (0.9 percent of GDP). The major banks’ average capital ratio declined—extending the ongoing fall since 1999—while the quality of banks’ capital remained poor, with deferred tax assets (DTAs) accounting for a large share of Tier-1 capital.3 In May, auditors for Resona—the fifth largest banking group—required the bank to significantly reduce its DTAs based on the auditors’ reduced estimate of its future profitability. With this adjustment, Resona’s capital fell short of regulatory requirements, and the government subsequently announced that it would purchase ¥2 trillion in shares in the bank. Capital adequacy ratios for other major banks remained above regulatory minimums, partly because some banks raised capital in the market. However, this capital was seen as overly expensive by the market, and this, along with the dilution effect, led to a fall in bank equity prices when the deals were announced.

15. Meanwhile, life insurers faced continued pressures from their equity exposures and high guaranteed rates on existing policies. In FY2002, the ten major life insurers posted current profits of just ¥350 billion, as their base profits were mostly offset by capital losses on securities. Solvency margins declined somewhat on average, although each company’s margin remained above the regulatory minimum. Legislation to allow insurers to reduce guaranteed yields on existing policies (to no lower than a minimum level to be determined later), subject to government and shareholder approval, and policyholder consent was passed by the Diet in July.

16. Corporate profits rebounded in FY2002, although some of the recovery momentum waned by early 2003. Current corporate profits rose for five consecutive quarters through the fourth quarter of 2002, reflecting cost-cutting among larger companies (SME profits remained weak). However, in the first quarter of 2003 profits fell by 3.1 percent (q/q, seasonally adjusted) as manufacturers’ profits contracted owing to weaknesses in export dependent segments such as transport equipment and machinery.

II. Short-Term Economic Outlook and Risks

17. The staff projects growth of 1.1 percent in 2003 and 0.8 percent in 2004, broadly in line with the July private consensus forecast. The projection for 2003 reflects carry over effects from strong growth in 2002. Output is projected to be broadly flat during 2003 (roughly in line with official views about the near term outlook), reflecting the staffs judgment that declining household incomes will dampen private consumption, uncertain sales prospects will restrain investment, and that slower growth in partner-country demand will limit the contribution from net exports.4 In 2004, growth is expected to recover gradually, led by net exports spurred by a modest uptick in partner country demand, with feed-through effects to profits, incomes, investment and consumption. Deflation is expected to persist, reflecting the continued sizeable output gap and entrenched deflationary expectations.

Projected Growth of Real GDP by Component (at 1995 prices)

(Percent change from the previous period)

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Sources: Global Insight, Nomura database; and staff projections.

Growth rates and contributions are calculated from seasonally adjusted data.

18. The outturn could be better than projected, but the risks are mainly weighted to the downside. Upside risks include stronger than expected private domestic demand, for example, if households reduced their savings rates even further, or if there is an end to the adjustment of inventories, which have been on a declining trend since mid-2001 and are now at an historical low. Regarding downside risks, partner country growth could be lower than anticipated; households might cut spending in light of the weak labor markets and uncertain outlook; and finally, turbulence in domestic financial markets could occur and aggravate corporate and financial sector fragilities, triggering a rapid cutback in bank lending and dampening investment.

III. Policy Discussions

19. The staff and the authorities broadly agreed on the nature and magnitude of the challenges facing Japan’s economy, but there were differences of view about the need for more decisive actions to address these problems. In recent Article IV consultations, the staff has emphasized the need to revitalize the corporate and financial sectors, tackle deflation, put the fiscal balance on a sustainable medium-term footing, and undertake regulatory reforms to facilitate the reallocation of resources. The authorities have shared this view and increasingly have taken steps toward addressing these issues: they have fashioned a framework for corporate restructuring, strengthened bank supervision and regulation, adopted more aggressive monetary policies, moved to reduce and allocate more efficiently public works spending, and started to deregulate important sectors. But mainly because of concerns that bold actions might harm the economy in the short term, many reforms have been watered down, delayed, or only partially implemented. In the staffs view, while progress had been made, stronger actions in several areas were needed for Japan to tackle successfully the serious economic difficulties it still faced.

20. The mission acknowledged that accelerated reforms could entail significant short-term economic costs, possibly including a sharp rise in bankruptcies and a further increase in unemployment, but viewed these risks as outweighed by the medium-term benefits of reduced vulnerability and higher potential growth (Box 1).5 The 1990s illustrated the costs of a continued go-slow approach: unsteady growth, punctuated by bouts of financial instability and recessions; fiscal imbalances leading to a buildup of debt toward unsustainable levels; and an economic performance that substantially trailed that of other major countries. The alternative would be to more decisively address financial and corporate sector fragilities, deflation, and fiscal imbalances to attain a stronger and more resilient medium-term growth path. In view of Japan’s economic importance, both regionally and globally, stronger economic performance in Japan would benefit other countries as well.

21. Against this backdrop, staff continued to recommend a strategy based on four interlinked pillars:

  • In line with the FSAP’s recommendations, broadening and bringing forward financial sector reforms, building on the authorities’ recent program;

  • Accelerating corporate restructuring, and implementing complementary reforms to create new investment and job opportunities and improve the business environment;

  • Launching a more aggressive, coordinated attack on deflation with quantitative easing through purchases of a wider array of assets paired with a clear communication strategy;

  • Developing and implementing a framework for medium-term fiscal consolidation, with a significant start toward that goal in FY2004 to signal commitment to medium-term fiscal sustainability.

22. The mission emphasized that these policies complemented one another and would therefore be most effective if implemented together. While each of the policies above would lead to some improvement over the present situation, it is their simultaneous adoption that would likely result in a sustainable revitalization of the economy. For instance, monetary policy would be more effective in ending deflation if banks’ balance-sheet problems were resolved. In turn, a durable strengthening of the banking system could only be achieved if viable but heavily-indebted corporations were restructured. Also, ensuring fiscal sustainability would be critical for the ultimate goal of putting Japan on a path of strong and sustained growth over the medium-term.

Macro–Effects of Corporate Restructuring

Restructuring—the reallocation of capital and labor across firms—entails both short-term costs and medium-term benefits. Costs arise in part because firm- or industry-specific capital and skills are lost. For instance, researchers have estimated these costs to be equivalent to about 72 percent of value for capital and 13 percent of income for workers. Costs also occur because output is lost during the time it takes to reallocate resources. A year typically passes between the time a firm shuts down and the time it sells its capital, while around 30 percent of laid-off Japanese workers remain unemployed for at least a year. Benefits from restructuring arise because capital and labor are reallocated to more productive uses.

An illustrative scenario, based on supply side simulations, suggests that for Japan the medium-term benefits from restructuring may significantly outweigh the short-term costs. The simulation had four steps, (i) Estimate total factor productivity Ai for each of 1,555 Japanese firms, based on Cobb Douglas production functions yi=Ai1i1αkiα, with industry-specific capital and labor coefficients (α); (ii) Identify the least-productive firms, defined as those with the lowest value of A;, starting with the least productive and adding firms until those representing five percent of debt outstanding are cumulated; (iii) Calculate the gross drop in the level of output from closing the least productive firms; (iv) Calculate the increase in the level of output from reallocating capital and labor released by these firms across all the remaining firms in proportion to their existing capital and labor. The reallocation occurs gradually over time—after the first year, one-half of the stock of “unemployed” capital and labor is assumed to be reemployed each year. The simulation assumes that 72 percent of restructured capital is permanently lost, that 30 percent of restructured workers’ human capital is permanently lost, and that 25 percent of restructured workers become permanently unemployed.

Adding up the costs and payoffs in the simulation, restructuring reduces the level of output by 0.8 percent in the first year and about 0.1 percent in the second year. The initial effect reflects the fact that the least-productive firms contribute about 0.8 percent to output. From the third year on, the level of output exceeds its initial level, converging to a level 1.5 percent above its initial level. This payoff reflects the fact that the average restructured firm is substantially less productive than the other firms. Sensitivity analysis indicates that the overall conclusions remain valid under a range of alternative assumptions.


Effect of Restructuring on the Level of GDP: Benchmark Case

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Two additional factors need to be considered in interpreting these results. First, the analysis focuses on the supply side, and thus implicitly assumes that demand for the additional output would be forthcoming. This underscores the importance of aggressive monetary policy aimed at eliminating deflation and fostering demand. Second, although the simulation uses conservative assumptions, the actual short-run costs of restructuring could be higher than these simulations suggest. For example, the restructuring simulation implies a sharp increase in unemployment, which could have social or economic costs that are not measured in this exercise. Accordingly, to limit the costs of restructuring it is important that an adequate social safety net is in place.

A. Financial Sector Issues

23. Financial sector restructuring has progressed under the Program for Financial Revival (PFR). Unveiled in October 2002, the PFR incorporated regulatory changes to accelerate bank restructuring, special facilities to support banks and thus ensure financial stability, and steps to revitalize the corporate sector.6 The PFR had prompted banks to increase provisioning, reduce NPLs, and raise new capital (although the capital had been costly, and in some cases was provided by customers and by other financial institutions, increasing cross-shareholding). In addition, the Resona rescue had proceeded smoothly, without any disruption in financial markets, showing the effectiveness of the safety net in dealing with weak banks; also, needed improvements to Resona’s management and governance were in train.

24. Notwithstanding this progress, the financial system has significant remaining problems (Box 2). The mission observed that low profitability made it difficult for banks to provision sufficiently against their still-high problem loans. Low profits were mainly due to the weak economy, but also reflected competition from government financial institutions and problems in bank management that could be traced to shortcomings in corporate governance. Also, bank capital had limited capacity to absorb losses, with Tier-1 capital relying heavily on deferred tax assets (DTAs). In addition, financial institutions remained vulnerable to a further decline in equity prices, an economic downturn, or a rise in long-term interest rates.

25. The authorities explained that their strategy for dealing with banking system weaknesses involved measures to encourage prompt disposal of NPLs and financial system strengthening. These measures included enhanced supervision (notably through the use of discounted cash flow methodology for provisioning on some loans and the latest round of special inspections); the introduction of new guidelines for the conversion of publicly held preferred shares into common shares; and targets for the major banks to halve the NPL ratio to about 4 percent by March 2005 and to reduce equity exposures to the level of Tier-1 capital. Major banks’ FY2002 results indicated that they were on track to achieve the NPL target, and that their equity holdings had declined from 150 percent to 100 percent of Tier-1 capital on average.

26. The mission welcomed these efforts, but considered that a more comprehensive and accelerated approach was needed to avoid the risk of a prolonged period of pressure on banks in which an ongoing cutback in credit would restrain economic growth. Such an approach would combine strengthened regulation with targeted use of public funds as needed to recapitalize weak but systemically important banks, in line with FSAP advice. A stronger capital base would allow banks to take the losses involved in restructuring weak borrowers, thereby improving the prospects for achieving the urgently-needed revitalization of the financial and corporate sectors and the restoration of economic growth.

Summary of the Financial Sector Stability Assessment Report

The FSSA notes that, notwithstanding important steps to address financial sector problems taken in recent years years, Japan’s financial system remains weak and vulnerable. The banks’ capital positions and earnings are weak; nonperforming loans, although declining, remain high; the system is exposed to sizable market and credit risks; and, looking ahead, losses are expected to continue in the absence of reform. Accordingly, financial sector weaknesses, if not squarely resolved, would persist and continue to restrain economic growth.

The main conclusions and recommendations from the FSSA include the following:

  • For the banking system, provisioning levels for certain loans should be strengthened including by requiring banks to use more forward looking expected loss estimates. Banks’ capital positions should be enhanced by introducing rules to limit the use of deferred tax assets for purposes of calculating capital adequacy. Those banks that are unable to raise sufficient capital in the market and whose failure would pose a significant threat to the financial system should be recapitalized to at least 8 percent while other nonviable banks should be wound down or merged to promote consolidation of the system. It would also be useful that banks adopt corporate governance guidelines consistent with the Basel Committee guidelines, and that the criteria for recognizing losses for tax purposes be aligned to those accepted under Japanese accounting standards. Also, the significant involvement of the public sector in financial intermediation has held back the profitability of the banking system, and thus it would be advisable for the government financial institutions and the Japan Post to downsize gradually their operations. In addition, public guarantees of bank lending distort the credit market and should be avoided.

  • Regarding nonbank financial institutions, shrinking profit margins and portfolio losses have weakened the capital bases of life insurers, which are of systemic importance given their large size and cross-shareholdings with other sectors of the economy. To ensure a more accurate assessment of their financial conditions, life insurers and their actuaries should establish appropriate policy reserves taking into account current investment returns, while supervisors should take steps to tighten their solvency standards. Pension liabilities are only partially funded, and the high level of premium nonpayment in the national system suggest the need for enhanced efforts to restore confidence in the system. The corporate sector’s high leverage and dependence upon bank financing means that its weaknesses have more serious potential implications for the health of the banking system than in other countries. Further improvements in corporate governance and strengthened banks could facilitate corporate restructuring.

  • In terms of supervision, the system has been strengthened with the creation of the Financial Services Agency (FSA) but more needs to be done. The FSA should continue to build and train an integrated and skilled modern staff and to recruit more skilled professionals, especially actuaries. Reforms are needed to give the FSA full operational autonomy and to facilitate routine exchange of information with the BoJ and other regulatory bodies. Safety net arrangements are broadly appropriate. Since 1998 a number of reforms have strengthened the efficiency and safety of the payment, clearing and settlement arrangements. Overall, the level of transparency of monetary and financial policies was in line with international good practices. Finally, a preliminary and partial assessment of the AML/CFT framework noted improvements in recent years and revealed no major issues.

27. The recommended strategy built on the existing framework of the PFR along four main lines. First, to improve recognition and resolution of problem loans, apply forward-looking assessments for all distressed loans, and extend these reforms to regional and smaller banks. Second, to facilitate provisioning, allow specific provisions required by the Financial Services Agency (FSA) to be recognized as a cost for tax purposes. Third, to ensure that the banking system was adequately capitalized, continue to apply rigorously the prompt corrective action framework to banks whose capital ratios fell below the regulatory limit; and provide public funds to systemically important banks (if needed) and convert any publicly-owned preferred shares into common shares. In addition, so that capital would better reflect resources available to meet losses, introduce rules to limit the use of DTAs in regulatory capital. Fourth, to improve prospects for bank profitability, enhance banks’ corporate governance, remove the requirement that banks receiving public funds commit to additional SME lending, and reduce the extent to which government financial institutions compete with private banks.

28. The authorities considered that the approach recommended by staff involved excessive risks and costs. In particular, accelerated reforms could adversely affect the economy. Also, allowing banks’ specific loan-loss provisions to be recognized as a cost for tax purposes may not be appropriate in all circumstances because tax and financial accounting serve different purposes (and could be seen as favoring banks over other types of firms). The mission acknowledged that bolder actions could involve near-term risks and costs, but saw them as outweighed by the medium-term benefits of reduced vulnerability and stronger growth.

29. In addition, officials so far had addressed the issue of DTAs through the auditing process rather than through regulatory means. The Japanese Institute of Certified Public Accountants (JICPA) had issued guidance requiring auditors to ensure that any DTA appearing in the balance sheet was based on a reasonable and conservative estimate of future profitability. Rather than limit the extent to which audited DTAs could be used to satisfy regulatory capital requirements, the FSA had instead formally requested auditors of financial institutions to observe the JICPA guidelines rigorously (this was the basis for the action of Resona’s auditors). Officials viewed this approach as in line with their efforts to promote more accurate assessments of banks’ balance sheets. In the context of discussing the FSAP, however, staff noted that in other countries regulators often allow audited DTAs to be used to meet only a small part of regulatory capital requirements. Such policies reflected a view that regulatory capital requirements—which aim to ensure that banks are financially sound—warranted a stricter treatment of DTAs than accounting requirements.

30. The authorities also raised concerns that the strategy recommended by the mission could make the government the largest shareholder in a number of banks, resulting in excessive government involvement in financial intermediation. In this connection, the mission noted that a transitional period of government ownership could be used to foster strengthened bank governance. As part of this approach, it would be crucial for the government to use its leverage to put in place an effective and transparent governance structure to give bank management a clear mandate to restructure the bank’s operations in preparation for its reprivatization, to protect managers from outside interference, and to hold them accountable for their performances. The mission viewed the Resona case as providing an opportunity for the authorities to demonstrate their resolve to implement such an approach.7 Regarding the government’s aim to limit its role in financial intermediation, the authorities noted that they intended to scale back the activities of public financial institutions in areas where they competed with private institutions, although they did not consider that such activities had a major impact on bank profitability.

31. The mission also urged the authorities to take further steps to address problems in life insurance companies, which continued to experience pressure on their solvency margins from negative spreads on investment returns and equity market losses. Moreover, they remained vulnerable to a further deterioration in financial markets. The mission recommended that regulation be strengthened, in particular by improving the basis for calculating solvency requirements, and introducing limits on single exposures and on outright positions in derivative markets. FSA officials, however, considered that the present solvency calculations adequately reflected life insurers’ financial conditions. Regarding position limits, they preferred to rely instead on supervisory assessments of risk management systems.

B. Corporate Restructuring and Structural Reform

32. Corporate restructuring has made headway, albeit limited and uneven. In recent years, debt/equity ratios for nonfinancial corporations had come down, while profitability had risen, especially for large companies. Also, some banks had recently created subsidiaries to handle nonperforming loans, and the local distressed debt market had continued to develop, both of which would facilitate restructuring. Nevertheless, many companies continued to suffer from high leverage, low profitability, and excess capacity.8 Also, progress in restructuring had not been uniform across sectors, and seemed to have been particularly slow among SMEs and in the construction and retail sectors.

33. Two main factors appeared to be responsible for the limited progress to date.9 First, and as the mission emphasized in the discussion of financial sector issues, banks lacked the provisions and capital needed to be able to take the losses involved in restructuring weak borrowers. Thus, more rapid progress to strengthen the banking system was key to faster corporate restructuring. Second, it seems to be difficult to coordinate creditors on debt restructuring plans under Japan’s main bank system, partly reflecting information asymmetries between main banks and other creditors.

34. The authorities indicated that the newly-created Industrial Revitalization Corporation of Japan (IRC J) would play a key role in facilitating corporate restructuring, mainly by helping to address the coordination problem.10 The IRCJ, by purchasing and bundling bank claims on troubled firms, would facilitate implementation of a restructuring plan in cooperation with the main bank, and sometimes with an outside sponsor. Also, banks and corporations involved in IRCJ-led restructurings could benefit from tax incentives—easing of conditions for restructuring-related tax deductions—designed to encourage them to cooperate. To limit the risk of direct political interference, the IRCJ had strict compliance requirements to promptly disclose contacts by politicians.

35. The mission agreed that the IRCJ could play an effective role, but stressed that it would need to operate free from political interference with decisions governed strictly on the basis of firms’ economic viability. The requirements that the IRCJ consult with ministries on individual restructuring plans and pay attention to employment stability could potentially be used to keep nonviable firms afloat. To mitigate this risk, the mission recommended that the period between the purchase and sale of loans should be kept as short as possible. The IRCJ’s accountability would also be enhanced by strict rules to make transparent its operations and progress in recovering public funds.

36. The mission suggested that corporate restructuring could be complemented by reforms to create new investment and job opportunities and improve the business environment. For example, stronger efforts were needed to improve competition in the markets for medical services, social welfare services, education and agriculture. The mission welcomed the special structural reforms zones initiative as an initial step that could show the benefits of regulatory reform and pave the way for its application at a national level. Nevertheless, reforms to clarify conditions for dismissing workers and deregulate labor contracts would be useful to help facilitate reallocation of labor.11 Finally, the mission considered that progress in adopting internationally recognized accounting standards should continue, and any pressure to undo prior improvements in the accounting framework should be staunchly resisted.

C. Monetary Policy

37. The BoJ’s quantitative easing policy had helped preserve financial stability and may have prevented deflation from worsening. By accommodating periodic increases in the demand for liquidity following shocks and maintaining short term rates at zero, the policy had kept funding difficulties from emerging in the banking system despite domestic and external disturbances (Box 3). Moreover, the deflation rate had been broadly stable in the face of a large and persistent output gap, implying that quantitative easing may have had some effect on the price level.

The Bank of Japan’s Quantitative Easing Framework

On March 19, 2001, the Bank of Japan (BoJ) adopted quantitative easing as a new framework for monetary policy. This framework has three main components:

  • A target for current account balances held by financial institutions at the BoJ: This target is adjusted by the BoJ in response to developments that are perceived to affect demand for liquidity. When facing a surge in demand, the BoJ would be ready to inject liquidity above the target if needed to preserve financial market stability. An objective of this policy is to prevent the emergence of liquidity shortages that could have systemic adverse consequences on the financial system and thus reinforce deflationary pressures. Another objective would be to potentially stimulate economic activity through the long-term interest-rate channel.

  • Increased outright purchases of long-term Japanese Government Bonds (JGBs): The BoJ would increase its outright purchases of JGBs when deemed necessary for the smooth provision of funds to meet die target for current account balances. (The BoJ however also has a self-imposed limit on JGB holdings, which is equal to the outstanding stock of banknotes issued. The limit has been set up to make clear that the BoJ’s purchases of JGBs are aimed at providing liquidity, rather than supporting government bond prices or monetizing fiscal deficits.)

  • Policy commitment based on the CPI: The BoJ commits to maintain the current framework for money market operations until the CPI (excluding fresh food, on a nationwide basis) records a year-on-year increase of zero percent or more on a sustainable basis. By providing assurances that an ample provision of liquidity will be maintained for a prolonged period, this commitment seeks to lower long-term interest rates by “borrowing” from the effects of future monetary easing.

Since quantitative easing was introduced, the target for current account balances has been raised several times, always in response to potentially adverse developments. From an initial level of ¥5 trillion, the target was increased in a number of steps to ¥27–30 trillion as of end-May 2003 (over this period monthly outright purchases of JGBs increased from ¥0.4 trillion to ¥1.2 trillion). Changes in the target responded to domestic developments (such as weakening of economic activity, steep decline in stock prices, and the Resona bank rescue) as well as external developments (such as global uncertainties following the events of September 11, 2001, and concerns about the impact of SARS). Sizeable provision of liquidity beyond the target was undertaken in March-April 2002 (in advance of end-FY2001 book-closing and the transition to partial deposit insurance, and after computer trouble emerged at Mizuho Bank) and in March-April 2003 (amid a sharp decline in stock prices—particularly bank stocks—around end-FY2002, and with an adjustment to reflect the establishment of Japan Post).


Japan: Current Account Balances at the BOJ

(In trillions of yen)

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Quantitative easing has kept short-term interest rates at zero, and has led to high—though unsteady—growth in base money. From about 1 percent in March 2001, base money growth (year-on-year) increased substantially, to peak at 36 percent in April 2002; it subsequently declined and stood at 20 percent in June 2003. On a cumulative basis over the whole period, base money grew by 56 percent, but broader monetary aggregates did not respond to the liquidity injection, with M2+CDs growing by only 6.6 percent.

Quantitative easing has also increased the BoJ’s holdings of JGBs. These holdings grew from ¥46.7 trillion (81 percent of banknotes) in April 2001, to ¥60.4 trillion (86 percent of banknotes) in June 2003.

38. Nevertheless, the mission considered that a more decisive and proactive monetary policy strategy to end deflation was warranted, given the costs of deflation and the risk that it might intensify. Entrenched deflation and deflationary expectations were imposing large economic costs by keeping real interest rates higher than desirable given the weak economy and by inhibiting financial and corporate sector restructuring.12 Moreover, the mission saw a significant risk that a shock could send the economy into a deflationary spiral.

39. While acknowledging the difficulties of conducting monetary policy with interest rates at zero and a weak banking system, the mission felt that a strategy comprising two main elements could be effective. The first element was more aggressive quantitative easing implemented by purchasing a wider array of assets, with the aim of allowing monetary policy to act through asset prices as well as through the now weak liquidity channel. In particular, continued sizeable purchases of JGBs could hold down or even reduce long-term interest rates (albeit from already low levels). Also, foreign asset purchases could bring the exchange rate channel into play, influencing the price level directly through import prices, by stimulating net exports, and through inflation expectations.13 Finally, purchases of equities through exchange traded funds (ETFs) could reinforce economic activity through wealth effects and by boosting the value of shares on corporate and financial institution balance sheets. The second element of the strategy was clear communication to the public of this bolder approach to enhance the effectiveness of monetary policy by influencing inflation expectations, with a commitment to end deflation within a limited time frame and establishment of a medium term inflation target.

40. The authorities considered that quantitative easing already involved adverse side effects, and thus preferred to work on improving the transmission mechanism rather than undertaking more aggressive easing. Zero interest rates already entailed negative side effects such as reduced market discipline, compressed credit spreads, and pressure on bank profits. Such costs were a necessary price to pay for maintaining financial stability and preventing deflation from worsening, but the situation nevertheless made the BoJ cautious about raising further the target for liquidity provision. Accordingly, the BoJ’s preferred approach was to make better use of the already ample liquidity in the financial system by working to strengthen the transmission mechanism. In this connection, the BoJ’s current plans for outright purchases of asset-backed securities (ABS) would eventually foster deepening of securities markets and reduce reliance on the weak banking system for financial intermediation, thereby improving the transmission channels for monetary policy.

41. Concerning the proposal to buy a wider set of assets, the authorities acknowledged that aggressive purchases could raise asset prices but emphasized the attendant risks. They stressed that asset prices would respond to such purchases only when market participants believed that the central bank was determined to purchase the assets without limit.14 Such purchases, however, would imply that the BoJ would be ready to incur significant costs, which would ultimately be borne by taxpayers. It was unclear to the BoJ whether it was appropriate for a central bank to engage in such quasi-fiscal operations. Moreover, large purchases of assets could distort the market mechanism, without necessarily improving the transmission channels of monetary policy.

42. As regards buying foreign assets, in particular, officials acknowledged that this could bring the exchange rate channel into play, and that depreciation could in principle help to reverse deflation, but expressed several reservations. First, given the relatively small share of trade in the Japanese economy, a sizeable depreciation would be needed to have a significant impact on deflation. Second, it was questionable, especially in light of recent experience with interventions, whether the injection of liquidity through purchases of foreign assets could result in a significant impact on the yen. Third, and crucially important, given the yen’s role in the global financial system, the possible international repercussions had to be taken into account; in this connection, it was stressed that agreement among major countries would be needed, particularly if a significant fall in the yen were involved.15

43. Regarding inflation targeting, BoJ officials viewed their current announced policy as embodying a stronger commitment to ending deflation than conventional inflation targeting. Under the BoJ’s current approach, the quantitative easing framework would remain in place until actual inflation became positive, whereas with conventional inflation targeting, policy would be tightened based on projected inflation—which could be too early. Furthermore, officials considered that setting an inflation target would accomplish little if the BoJ lacked measures that could effectively achieve the target. That said, the BoJ acknowledged that inflation targeting was potentially useful for increasing monetary policy transparency, and indicated that they would continue to consider the possibility of adopting it.

44. The mission viewed the possible negative side effects and distortions from more aggressive quantitative easing as outweighed by the benefits of decisively tackling deflation. Ending deflation would alleviate the aforementioned problems associated with the current zero rate environment by fostering a pickup in interest rates and spreads, and could also benefit the financial system through a stronger economy and a rebound in equity and land prices. In the meantime, while efforts to strengthen the monetary policy transmission mechanism through purchases of ABS were useful and welcome, they were unlikely to have a major near-term impact on deflation.16

45. The staff acknowledged that its recommended bolder approach might entail risks to the BoJ’s balance sheet, but saw these risks as manageable. In particular, they could be handled through institutional loss-sharing arrangements with the government. For instance, the BoJ could swap (with the government) its holdings of fixed-rate bonds for floating-rate bonds to limit the capital losses that could arise from a sizeable increase in long-term interest rates.17 At the same time, the risks were not entirely on the downside: an end to deflation could yield gains on some assets on the BoJ’s balance sheet through an attendant pickup in stock prices and a depreciation of the yen.

46. The mission recognized the difficulties with injecting liquidity through purchases of foreign assets, but, given the lack of effective alternatives, felt that this mechanism deserved consideration. While the mission emphasized that it was not advocating targeting the exchange rate, unsterilized intervention could activate the exchange rate channel for monetary policy.18 Normally part of the transmission mechanism, with interest rates at the zero bound and bank lending unresponsive to increased liquidity this channel was not working. The mission acknowledged that the implications for the global economy were very important and would need to be taken into account, particularly in light of Japan’s high current account surplus. However, the mission noted—and the authorities agreed—that the impact on partner-country growth could well be positive in the medium term as Japan began to escape from deflation and recover.19

47. As regards inflation targeting, the mission argued that its adoption could help anchor medium-term inflation expectations. While the BoJ had clearly stated its intention to maintain zero short-term interest rates until deflation ended, it was clear that deflationary expectations remained entrenched. An explicit inflation target would strengthen perceptions about the BoJ’s commitment to end deflation, guide inflation expectations and help to manage any risk that inflation would overshoot a desirable range. That said, it was agreed that merely announcing an inflation target would be unlikely to affect deflation or deflationary expectations. However, in the context of the more aggressive quantitative easing strategy outlined above, an inflation target could help to reverse deflationary expectations.

D. Fiscal Policy

48. The authorities and the mission agreed that substantial medium-term fiscal consolidation was needed to stabilize the public debt. High fiscal deficits had led to rapid growth in both gross and net debt, with gross debt now above 150 percent of GDP, by far the highest level among advanced economies. In the absence of fiscal adjustment, with fiscal deficits currently above 7 percent of GDP and growing social security expenditure arising from an aging population, both gross and net debt were expected to continue growing rapidly relative to GDP over coming years. The mission expressed concerns that this trend would eventually precipitate an increase in real long-term interest rates, with adverse effects on growth. The authorities broadly agreed with this assessment, and thus the discussions focused on the desirable pace and form of medium-term adjustment.


General Government Balance and Gross Debt, 1990-2003

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Source: WEO.

49. The authorities viewed their medium-term framework as setting out the general direction for fiscal consolidation and as providing some specific measures. The framework comprised pension reform and a goal to achieve primary balance excluding social security by the early 2010s. They saw pension reform as a high priority, to be taken up in the context of the forthcoming review of the system to be finalized by end-2003. Nevertheless, they noted that concrete plans that ensured the medium term viability of the system could take time to develop given existing differences of view on the issue. To achieve the goal of primary balance excluding social security,20 they envisioned making spending cuts in the near term, followed by tax increases beginning in a few years. The authorities viewed their medium-term target as anchoring fiscal policy while remaining flexible (by not committing to specific measures) and avoiding being unduly ambitious in light of the weak economic environment. Also, they cautioned that it could be difficult to muster public support for bold measures given concerns over the weak economy.

50. The mission agreed that the fiscal deficit should not be reduced too abruptly, but stressed that a detailed and ambitious medium-term program was urgently needed. While recognizing the considerable difficulties in embarking on a medium-term adjustment program in present circumstances, further delays would only require a more painful and disruptive adjustment down the road. Also, defining specific measures up front would enhance the program’s credibility and reduce the risk that concerns about debt sustainability would result in sharp increases in real interest rates. Regarding the medium term, the mission considered that stabilizing the debt to GDP ratio (even at a level of around 100 percent of GDP on a net basis) would require: (i) a major reform of the social security system that eliminated net liabilities in present value terms; and (ii) a substantial adjustment in the accounts of the rest of the general government (that would likely need to go beyond the official goal of reaching primary balance by the early 2010s).21 It was important to address these two components together, as increased dependence by the social security system on transfers from the budget would imply the need for stronger adjustment in the rest of the general government.

51. A program to achieve these objectives would need to include the following elements:

  • Adjustment to social security benefits and contributions. Given the magnitude of the needed adjustment, both benefit reductions and revenue measures would likely be required. However, substantial reliance on revenue measures in the pension reform may result in too heavy a tax burden on future generations with negative effects on growth. The mission welcomed recent changes in the medical insurance system, but noted that additional efforts would be required to contain growing costs in this area.

  • Public expenditure reduction. With the level of public investment relative to GDP still twice the average level in other G-7 countries despite recent declines, current steps to cut inefficient public works and improve bidding practices were welcome and should continue. Further reduction in ear-marking of revenues would contribute to these efforts.

  • Tax reform. Tax revenue in relation to GDP remained low relative to other advanced economies. Room existed to broaden the personal income tax base and to increase the consumption tax rate. Introducing taxpayer identification numbers would improve tax administration.

Public Debt Sustainability

This box presents a standard analysis of public debt sustainability in Japan, including the results of stress-tests. The point of departure is end-2002, with gross debt at 158 percent of GDP and net debt at 72 percent of GDP. Table 6 contains the full sustainability template.

The baseline scenario is broadly based on the authorities’ announced fiscal policies. The main assumption is that the government attains its medium-term goal of eliminating by the early 2010s the primary deficit of the general government excluding social security (the cyclically-adjusted primary deficit was about 4.5 percent of GDP in 2002). The social security system is assumed to remain unchanged, with contribution rates at current levels and benefits (per person) changing in line with the latest reforms. The paths for real GDP, the GDP deflator, and real interest rates are consistent with the current WEO projections until 2008. After 2008, real GDP growth and GDP deflator growth are assumed to be 1 percent each, and the long-term real interest rate is assumed to be 3 percent.


Sensitivity of Net Public Debt

(in percent of GDP)

Citation: IMF Staff Country Reports 2003, 281; 10.5089/9781451820492.002.A001

Under the baseline scenario, the public debt-to-GDP ratios would increase by about 50 percentage points over the next ten years, and would continue increasing thereafter. Gross and net debt respectively would reach 207 and 121 percent of GDP by 2012 (assuming no change in government assets). The increase in debt is driven by both growing interest payments and rising pension and medical expenditures related to the rapid aging of the population. Debt may accumulate even more rapidly than projected in the baseline scenario if the government needs to meet any contingent liabilities, such as bank recapitalization or defaults on guaranteed loans. These are difficult to quantify with any precision, however; for example, the fiscal costs of bank recapitalization would depend on the extent to which private sector capital would be involved.

Various stress tests illustrate the sensitivity of the projection to different shocks. The figure shows the path for net public debt under alternative assumptions for the real interest rate, real growth, and the primary balance. The individual shocks—effective in 2003 and 2004—are equal to two standard deviations from the ten-year average for each variable (the interest-rate scenario does not include possible quasi-fiscal costs related to adverse effects on the banking system). Of course, under these adverse shocks net public debt grows even more rapidly than under the baseline scenario.

Stabilizing the debt-to-GDP ratio over the ten year horizon—even at very high levels—would require substantial consolidation beyond that included in the baseline. For instance, the figure shows an adjustment scenario that stabilizes net public debt at about 100 percent of GDP by the early 2010s. This scenario assumes: (i) a pension reform (a gradual doubling of pension contribution rates that would make the pension system actuarially solvent), which by the early 2010s would strengthen the social security primary balance by 2 percent of GDP with respect to the baseline; and (ii) an adjustment of 6.5 percent of G