Spillover Report for the 2011 Article IV Consultation and Selected Issues

Japan’s position is one of the largest and richest economies in the world. Tokyo as a financial marketplace is not a major intermediator of global capital flows. The current macroeconomic environment is conducive to spillovers being larger than captured by the empirical analysis. Apart from heading off tail risks, fiscal consolidation in Japan would have medium to long-term benefits for its partner countries. Exchange rate-related spillovers on foreign financial markets are found to be small and depend partly on policy developments abroad.


Japan’s position is one of the largest and richest economies in the world. Tokyo as a financial marketplace is not a major intermediator of global capital flows. The current macroeconomic environment is conducive to spillovers being larger than captured by the empirical analysis. Apart from heading off tail risks, fiscal consolidation in Japan would have medium to long-term benefits for its partner countries. Exchange rate-related spillovers on foreign financial markets are found to be small and depend partly on policy developments abroad.

Japan’s Role in the World Economy

1. Japan’s position as one of the largest and richest economies in the world owes much to its rise as an export powerhouse in the second half of the 20th century. With its sophisticated manufacturing base, Japan has enjoyed current account surpluses since the 1970s, helping the country to become the world’s largest net creditor. The yen has become a key international currency, and several Japanese banks were at one time among the world’s largest financial institutions. However, Japan’s “lost decade” of the 1990s, the subsequent deleveraging of bank and corporate balance sheets, and adverse demographics have since contributed to a more modest pace of economic expansion.

Japanese Trade: High Value Added

2. Japan is a global supplier of high-end consumer goods and sophisticated intermediate products (Spillover Issues: Chapter I). With the United States and China as its largest trading partners, it accounts for about 5 percent of world trade. Japanese consumers have long ranked among the most important buyers of finished products from Asia. In this regard, imports from the region rank third in size behind China and the United States, although Japan’s contribution to regional growth has slowed as domestic demand has stagnated in recent years.2

3. Japanese technology plays a key role in facilitating exports of neighboring countries. Japanese exports have the lowest share of foreign value added in the region, underscoring Japan’s “upstream” position in the regional production chain.3 As Japan has increased the sophistication of its export basket, it maintains a lead in specialized core components.4 This has enabled Japan to maintain a bilateral trade surplus with most countries in the region, including China, and capture a significant share of value added in other Asian countries’ exports (Box 1). For example, Japanese companies account for about 10 percent of value added in Chinese exports of electrical equipment.

4. The destruction caused by the March 11, 2011 earthquake has revealed Japan’s importance in the global supply chain. Earthquake damage and subsequent power outages led to a halt in the production of key ingredients for car computers, integrated circuit chips, and printed electronics boards. The resulting supply disruptions, albeit temporary, were felt in factories in many countries, including Europe, the United States, and Asia (Box 2). According to market analysts, the number of cars manufactured worldwide was expected to drop by up to 30 percent in the two months following the quake, and to shave as much as ⅓ to ½ a percentage point off annualized U.S. GDP growth in the second quarter. But any loss in this regard is expected to be offset in subsequent quarters, resulting in little net impact for the year.

Figure 1.
Figure 1.

Japan and the World Economy

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

Sources: DOTS, IIP, WEO and Fund staff calculations.

A Byte of the Apple: The Distribution of Value from iPod to iPad

As an example of regional supply chains, Dedrick, and others (2010)1 suggest that, whereas the greatest value added from the production of the iPod accrues to the U.S. company (Apple), the second largest share of value added is captured by Japanese firms, which produce the high-value components of the product.

This research estimated that $163 of the iPod’s $299 retail value in the United States was captured by American companies and workers, breaking it down to $75 for distribution and retail costs, $80 to Apple, and $8 to various domestic component makers. Japan contributed about $26 to the value added (mostly via the Toshiba disk drive), while Korea contributed less than $1. The unaccounted-for parts and labor costs involved in making the iPod came to about $110, of which China earned around $4.

A similar breakdown of the iPhone 3G by the research from iSuppli confirms this analysis. The phone is made in China, but Japanese components account for about $60 of production costs (flash memory, touch screen), whereas Chinese assembly adds about $6 of total costs.

A breakdown of the iPad, on the other hand, highlights the growing competitive strength of Korea. In the particular device they examined, the flash memory was provided by Samsung and the touch screen was made by LG—although iSuppli noted that, for some iPads, Apple still sources these components from Japan.

1 Who Profits from Innovation in Global Value Chains? A Study of the iPod and Notebook PCs,” Industrial and Corporate Change 19(1), pp. 81-116.

5. Reacting to competition from low-cost producers, as well as increasing local demand, many Japanese companies have shifted production to the region. Japan accounts for almost one-quarter of total advanced-economy FDI in Asia, second only to the United States. Traditionally, factor price differentials were the key drivers for outward FDI, as labor-intensive production, such as final assembly, was moved to countries with lower costs. More recently, countries’ market size has also become a significant determinant of FDI, with an increasing share of FDI aimed at servicing the growing consumer markets of Asia (Spillover Issues: Chapter III). Key FDI recipients include Thailand, Korea, and Taiwan POC, as Japan’s output share in East Asia dropped from two-thirds in 1995 to one-quarter in 2008.

Financial Markets: Largely Domestic

6. Owing to its large external surpluses, Japan has accumulated the world’s largest net foreign asset position. Japan’s $3 trillion net international investment position reflects both official reserves (mostly held in the form of U.S. Treasuries), and a large net private position in bonds.5 The private position (about $1½ trillion) primarily consists of the outward investments of banks, life insurers, and corporate pension funds in U.S. Treasuries and both U.S. dollar and yen-denominated corporate bonds.

The Supply-Chain Spillovers of the March 11, 2011 Earthquake

Japan is a globally important source of essential components and capital goods—representing, for example, one-fifth of the world’s semiconductor production. In particular, Japan is a critical upstream supplier for many countries across the globe. In the machinery and reactors sector, for example, Japan accounts for more than a third of global exports of machinery and wafers (ISIC code 8486), providing more than 50 and 35 percent of U.S. and Chinese imports, respectively. Lengthy disruptions to exports of these components could have important spillover effects for production worldwide.

Table 1

Japan’s Share in Global Export Markets and Partner Imports, 2010

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Notes:8486: Boilers and reactors: mach & appl for mnf semiconductors8408: Boilers and reactors: compression-Ignition for combustion engines8541: electrical machinery: semiconductor devices8703: vehicles excl railways: autosSource: Global Trade Atlas.

The earthquake has highlighted the fragility of tightly integrated global-production networks. The main issue is the specialization and concentration of upstream manufacturers—as you go further up the supply chain, volumes are lower, reducing the need for multiple factories or firms. Often one small company with a single factory can have an 80 percent global market share. It therefore takes much less damage to throw the whole supply chain into disarray.

  • In addition to producing one-fifth of the world’s semiconductor supply, Japan also controls 90 percent of the world’s production of bismaleimide-triazine (BT) resin, which is used to manufacture substrates, the basic raw material for the production of integrated circuit chips and printed electronics boards. Production was suspended for two months at Mitsubishi Gas and Chemical, which accounts for 50 percent of the world’s supply.

  • In the auto sector, a particular source of concern has been the supply of microcontroller units (MCU), which are small, single-chip computers that are used in a variety of automotive applications, including engine control and safety electronics. A critical producer (Renesas), which provides MCUs for Japanese production worldwide, was hard hit by the disaster, and is operating at reduced capacity

With few immediate alternatives, and with long lead times in the construction of new supply facilities, most firms in Japan and abroad have had to simply absorb added losses until Japanese production recovers, either by drawing down their inventories or by temporarily scaling back production.

Recent equity-price developments can help assess the worldwide significance of earthquake-related disruption. Cumulative abnormal equity returns since the earthquake captures the market’s assessment of firms’ ability to cope with key supply-chain bottlenecks (see table below).

These data suggest that the global impact of the earthquake will be short lived. In the high-technology sectors, initial market concerns seem to have eased, and international equity prices are recovering. Market analysts generally expect worldwide semiconductor production to pick up in July-September, and to have largely normalized by the end of the year.

Similarly, the immediate impact on automobile production has been notable both in Japan and abroad. But looking forward, most analysts expect a normalization of supply

toward the end of 2011, so that the net impact will be to shift production from 2Q11 to subsequent quarters.

Table 2

Firms in the Silicon Wafer Supply Chain 1/

article image
Sources: Bloomberg, various news services, and IMF staff calculations.

Firms in red are those directly impacted by the earthquake.

Nonetheless, downside risks remain. A key concern in this regard is the speed of Japanese reconstruction and the reinstallation of key infrastructure. Semiconductor production, in particular, requires a stable supply of electricity and clean water. Prolonged power shortages or unexpected blackouts would continue to constrain activity—even beyond the disaster zone—and would significantly hamper the normalization of production, both in Japan and abroad.

The longer-term implications for other countries are mixed. In contrast to the short-term costs of reduced output and exports, the disaster may offer Japan’s neighbors some longer-term opportunities. Most obviously, it presents regional firms with a window to step up their production of intermediate products. The medium-term impact of the crisis, therefore, may be to provide an added impetus for countries climbing up the value-added chain, especially for those with a more-advanced industrial base.

7. Japanese debt and equity markets are among the top 5 international markets in size, but are primarily geared toward domestic investors. Only 5 percent of Japanese government bonds (JGBs) are held by foreign investors, of which about one-fifth are located in Asia (Spillover Issues: Chapter IV). By comparison, more than 30 percent of U.S. Treasuries and around 55 percent of German bunds are held abroad. However, officials indicated that foreign investors account for about 15 percent of the cash turnover in JGB bonds, and 65 percent of futures markets transactions. Participation in the equity market is larger, with one quarter of market capitalization held abroad, but less than one-half of a percent accounted for by Asian investors.6

8. Given its domestic focus, Tokyo as a financial market place is not a major intermediator of global capital flows. Foreign issuance of equity and debt in Japan has been negligible in recent years, and bonds placed by Japanese issuers abroad amount to only 1½ percent of global outstanding cross-border debt securities. At 14 percent of GDP, the sum of gross capital inflows and outflows in the Japanese BOP—a crude measure for financial market turnover—is considerably smaller than in other systemic economies.

9. The yen remains an important global currency, although its share in global reserve holdings has declined in the past decade. Yen holdings currently account for 2 percent of reported foreign exchange reserves, and measured by turnover, the foreign exchange market in Tokyo remains the third largest in the world—albeit well behind London and New York. In recent years, the yen has been a funding currency in foreign exchange carry trades, as well as becoming a preferred investment destination during bouts of global turmoil. This has contributed at times to relatively abrupt currency movements, in response to shifts in sentiment.7

Banks: Expanding Abroad Again

10. Banking links have also become less important since the 1990s, but Japanese banks are again expanding abroad. Traditionally, Japanese banks have expanded abroad to support the global expansion of Japanese corporates. This trend has recently picked up again, following the slowly improving health of Japanese banks’ balance sheets, and slim margins at home. Japan’s cross-border bank claims have more than doubled since 2002, from $1 trillion to more than $2½ trillion, most of which are claims on the United States and other advanced economies. The total international exposure of Japanese banks, measured relative to GDP, nevertheless remains low compared with that of European banks.

11. There is still substantial room for banks to grow their cross-border links with Asia. Claims by Japanese banks on Asia account for only 10 percent of their total foreign claims, and are concentrated in Australia and Korea. Lending to the region is rising slowly, and a considerable portion of this expansion appears to reflect, as before, loans to large Japanese firms and intra-firm transfers of Japanese conglomerates, largely in support of regional FDI and trade. Market participants have suggested that some of this expansion is driven by limited lending opportunities at home; but they have also stressed that Japanese banks tend to face stiff competition from global competitors as they expand beyond their core Japanese corporate clientele.

Figure 2.
Figure 2.

Japan and Global Financial Markets

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

Sources: World Federation of Exchanges, Bank of Japan, BIS, Lipper/Thomson Reuters, Fund staff calculations.1/ Includes: Money-market funds; Mutual funds; Hedge funds; Pension funds; and Exchnage Traded Funds.

Spillover Analysis

12. This section expands on the stylized facts presented above. It reports the results of empirical analysis obtained by applying exogenous “shocks” to different models of Japan’s global economic and financial market relationships. These shocks are hypothetical, but provide an important yardstick for discussing the effects of policy changes in the next section.

Growth Spillovers: A Regional Story

13. In line with findings for other countries, with the exception of the United States, growth spillovers from Japan on the global economy are likely to be limited:

  • A simple VAR model analyzing interactions between the United States, Europe, Japan, and the U.K. finds that the impact of a growth shock in Japan is marginally positive on the Euro area, but other effects are small and statistically insignificant.8 This result is similar for the euro area and the United Kingdom. Indeed, only U.S. growth shocks tend to be large and persistent (Figure 3).

  • Input-output analysis suggests that, for example, a 10 percent increase in Japanese import demand would generate at most a ¼ percentage point export increase from its largest non-Asian trade partners.9

Figure 3.
Figure 3.

Japan and Global Spillovers

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

Source: Fund staff calculations.1/ Negative spillovers from Japan are not significant.

14. However, there is sufficient evidence to suggest that Japanese growth has a noticeable impact on its key regional trading partners:

  • Staff’s macroeconomic model calibrated for the G-20 economies indicates that a one percent growth shock to Japan would have a noticeable impact on Chinese output (of the order of 18 basis points) and vice versa.10 A similar regional relationship is observed between the Euro Area and the United Kingdom, whereas other spillover coefficients are comparable to the results described in the previous paragraph. The model also indicates a tenuous growth impact from Japan on Indonesia and Korea.

  • The results are similar when the analysis is refined to focus on Japan’s regional links. A Global Vector Autoregressive Model (GVAR)—which includes growth, inflation, and other macro variables—also finds modest regional spillovers, including for Japan’s impact on equity prices and interest rates (Spillover Issues: Chapter V).


Peak Impulse response to a 1% Growth Shock

(percent of output)

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

15. These findings are consistent with the projected impact of the recent earthquake. Taking into account the authorities’ likely reconstruction efforts, projected domestic output growth for 2011 has been downgraded substantially by around 2 percentage points. However, the impact on the United States and Euro area is expected to be minimal, and model simulations indicate that, ceteris paribus, the corresponding effect in Asia (including China) is unlikely to exceed 0.1-0.3 percentage points of growth.11

The Financial Channel: Generally Quiet

16. While Japanese growth spillovers are comparable in size to most other large economies, the impact of financial market shocks appears to be smaller. For example, staff estimates suggest that a “shock” to U.S. bond yields and stock prices would be noticeable in all global financial markets, and an impulse from Euro area equity markets would still be felt in the United Kingdom and Japan. In contrast, Japanese financial variables are not found to trigger major spillovers, consistent with the absence of strong external financial sector links.12 Other findings point in a similar direction:

  • Japanese banks score low in “market distress models”. Japanese banks are more likely to be affected by distress in foreign financial institutions than the other way around. When ranked according to their estimated ability to generate distress in others, no Japanese bank scored among the global top 10.13

  • BIS cross-border inter-bank exposures indicate that global financial institutions are fairly impervious to Japanese credit risk (Spillover Issues: Chapter VI). Furthermore, Japan is found to be among the most resilient countries to cross-border credit shocks, suggesting that it would mitigate rather than amplify the transmission of global shocks. The impact of a hypothetical credit event in a Japanese bank would be comparable, by order of magnitude, to that of an average medium-sized European economy with low interest rate spreads.

17. With a few exceptions, these results also hold within Asia:

  • Network analysis tools can also help simulate the regional impact of hypothetical credit events in Japan. Under a scenario that includes a credit event and subsequent deleveraging, some Asian banking systems could experience moderate but not systemic losses (Spillover Issues: Chapter VI).

  • Using another approach, staff constructed financial stress indices—statistical indicators flagging abnormal movements a country’s key financial markets—for Japan and a range of emerging Asian economies to analyze their reaction to changes in stress indices in other advanced economies. The results suggest that financial stress in Japan could indeed spill over into regional markets, but the impact would be smaller than from other advanced economies, and there do not appear to be any spillovers from Japan to non-Asian emerging markets (Spillover Issues: Chapter VII).

Authorities’ Views

18. The authorities broadly agreed with the staff’s findings, albeit with a caveat that model-based findings would have to be interpreted carefully. They emphasized that Japan remained an important source of demand for its Asian trading partners. Officials generally felt that empirical models provided a useful guide to growth and trade-based spillovers, and suggested that spillovers into Japan were somewhat more pronounced than spillovers out of Japan. However they were generally skeptical about the capacity of current models to capture financial market spillovers, particularly concerning cross-border confidence effects. There was agreement that the absence of empirical findings on financial spillovers should not be interpreted that economic and financial developments in Japan could not have a more significant impact on global markets, in particular during times of global economic and financial uncertainty.

19. The staff noted that the current macroeconomic environment was conducive to spillovers being larger than captured by the empirical analysis. During Japan’s “lost decade”, buoyant economic growth in advanced economies may have helped shield the rest of the world from a sustained negative output shock in Japan. Today, the world economy is in a very different position. The growth outlook for advanced economies is more fragile, suggesting that negative developments in Japan could have a substantially stronger effect on global growth. Although this result has not been borne out by the experience of the recent earthquake, fiscal strains and near-zero policy rates in many advanced economies imply that there may be less scope for policy makers to respond to future demand shocks.

Policy Issues

Views Held by Other Authorities

20. Japan-related discussions with other authorities (held pre-earthquake) focused on the dynamics of public debt. There was general agreement that growth and financial spillovers from Japan were limited, but also concerns about the fiscal imbalance. Although a fiscal crisis was not viewed as imminent, other authorities regarded the current path as ultimately unsustainable, and they noted that the transmission of a shock would be primarily through global financial markets rather than the standard growth channels. On the exchange rate, it was noted that the carry trade from Japan had subsided, replaced to some extent by funding out of the United States. These issues are examined further below, along with other topics discussed in the Article IV Staff Report.

The Baseline: Fiscal Consolidation and Structural Reforms

21. Following a large reconstruction effort to repair the damage caused by the recent earthquake, fiscal policy is set to embark on a sustained consolidation effort. For the purposes of this report, the baseline case mirrors staff’s policy-adjustment scenario, where a medium-term fiscal consolidation effort will start in 2012 with a moderate tax increase to finance earthquake-related expenditures. Staff estimates that stabilizing the net debt ratio by 2016, and reducing it to around 135 percent of GDP by 2020, requires a 10 percent of GDP structural primary adjustment over the next ten years. Given the limited scope for spending cuts, fiscal adjustment would need to rely mainly on new revenue sources and limits on spending growth. Moreover, structural reforms are assumed to raise the potential growth rate to 2 percent over the next decade.

22. Policy simulations are based on the IMF’s GIMF model (Spillover Issues: Chapter VIII). In the short run, fiscal adjustment will reduce domestic demand. Over the longer run, lower public dissaving will help reduce interest rates, spur investment, and boost permanent income. At the same time, the growth-strategy reforms will help spur investment and boost aggregate demand. Although productivity rises only gradually, it ultimately results in a substantial increase in future income, which increases the confidence of forward-looking households and supports current consumption.

23. Spillovers to other economies would be modest relative to the impact in Japan. The main impact of fiscal consolidation would be to release a pool of savings for other countries to borrow. For Japan, increased savings translate into a larger trade surplus and real depreciation. For other countries, Japan’s trade surplus corresponds to lower net exports and reduced output. This would be offset to varying degrees by (i) accommodative monetary policies, and (ii) an increase in local permanent income owing to falling global interest rates. The average impact on other economies is a ¼ percentage-point drop in their current account balance.


Global Impact of Japanese Fiscal Consolidation

(GDP, percent difference)

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001


Impact of Consolidation on Emerging Asia

(percent difference)

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

  • For Asian countries with pegged exchange rates, fiscal consolidation generates additional short-term costs as yen depreciation translates into a real appreciation, lowering inflation, pushing up real interest rates, and suppressing output.

  • Over the long run, once fiscal consolidation is complete, all regions benefit from higher consumption and investment, owing to lower world interest rates.

Policy Simulations: Consumption

(percent difference)

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24. Japan’s growth strategy could help offset the decline in demand from fiscal consolidation, and so will reduce negative spillovers in the short- to medium term. By supporting Japanese consumption and investment; growth-enhancing reforms help scale back Japan’s trade surplus and depreciation. Even so, Asian economies with rigid exchange rates may still face short-term output costs, albeit less than in the case of a pure fiscal consolidation.

25. Strengthening the credibility of the fiscal program can limit the demand-side costs of adjustment. The model’s results suggest that the short-term costs of adjustment depend strongly on expectations of future productivity and income, and so will be shaped by the credibility of the authorities’ strategy. Uncertainty over the government’s long-term commitment would add to the short-term drop in demand, and hence would exacerbate the short-term negative spillovers to Japan’s trading partners.

A Rise in Long-Term Interest Rates

26. As noted before, the main concerns of other country authorities focused primarily on the medium-term dynamics of public debt. The growing debt stock is making Japan’s fiscal position increasingly vulnerable to upward movements in interest rates (Spillover Issues: Chapter IX). The prospect of a shock still seems remote, however, given Japan’s projected current account surpluses, net creditor status, and large size of foreign exchange reserves. The authorities and staff agreed that delayed fiscal reform would increase the risk of a rise in yields, in part because private saving may decline with population aging. A protracted slump in growth resulting from disruption caused by the earthquake would exacerbate revenue shortfalls and further raise market concerns about fiscal sustainability.14 There is also a risk of unexpected shifts in the portfolio preferences of Japanese investors (Box 3).

27. A rise in JGB yields resulting from a spike in risk premia could induce capital losses on bond holders, and possibly trigger deleveraging by Japanese banks. The direct effect on foreign investors would likely be moderate, given their relatively small overall holdings.15 But a bond shock, particularly if accompanied by an equity price drop, could hurt balance sheets of Japanese banks, which hold over 40 percent of outstanding JGBs, accounting for one fifth of their total assets. Capital losses could raise counterparty risks and force banks to deleverage their balance sheets, including by withdrawing from their positions abroad. FSA officials recognize, in general, that a level rise in interest rates would also increase profit opportunities for banks, especially if it was the result of a strengthening economy, and that the authorities’ concern was more with discrete shifts in the shape of the yield curve rather than an upward shift

The Impact of Japanese Investors on Global Interest Rates

Staff has analyzed the potential impact of a portfolio shift by domestic savers, including large institutional investors. Japan has long displayed a relatively strong degree of home bias, but the trend toward greater international diversification and the demand for higher returns is slowly gathering momentum (See Japan: Selected Issues, Country Report 07/281). Following the portfolio-balance framework of Neely (2010)16, staff has therefore considered how a steady shift of investment toward foreign bonds might impact interest rates in Japan and elsewhere (see China, Spillover Issues, Annex X).

As a hypothetical example, suppose Japanese investors were to sell $500 billion of JGBs, and purchase instead $200 billion of both U.S. Treasury Bonds and German Bunds, together with another $100 billion of U.K. Gilts and other advanced-market bonds. This shift would roughly double the stock of JGBs held by foreigners, and the overall impact would be to raise Japanese interest rates by around 160 bps, while lowering yields elsewhere by around 40 bps. This is broadly comparable to the estimate by Warnock and Warnock (2009)1 which found that a $500 billion foreign purchase of U.S. Treasuries would lower U.S. yields by almost 70 bps.

1 “International Capital Flows and U.S. Interest Rates,” Journal of International Money and Finance, V. 28, pp. 903-19.

28. The results of a structural macroeconomic model suggest that significant deleveraging would only materialize in the event of a major shock (Spillover Issues: Chapter X). In a stress test, Japan’s top banks were found to be able to absorb a 300 bps hike in JGB yields without breaching an (aggregate) 8 percent core Tier I capital ratio. Beyond that, banks would need to scale back their foreign lending. For example, assuming that foreign loans would be cut first, a hypothetical shock raising long-term government bond yields to the level of other large advanced economies (an increase of about 450 bps) would lead to a reduction in outward loans by 45 percent.

29. Foreign banking systems would be expected to withstand such a deleveraging, given their relatively small exposure to Japanese banks. According to network analysis based on interbank flows, banks located in the United Kingdom and South Korea would be most exposed by a loss in funding (Spillover Issues: Chapter X). The authorities cautioned that, in an extreme scenario, the combination of higher JGB yields and counterparty risk could trigger a squeeze in foreign banks’ Japanese derivatives operations, possibly requiring them to sell assets in other business areas. The confidence effects of such a shock were hard to predict, but could add to tensions in other wholesale markets.


Impact of a withdrawal of 45 percent of interbank funding from Japan

(percent of pre-shock capital)

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

30. Finally, spillovers could also be caused purely by market sentiment, translating a rise in JGB yields into higher interest rates elsewhere. An extreme value theory (EVT) framework provides only weak evidence of large movements in Japanese long-term interest rates prompting large movements in bonds and equity markets elsewhere, possibly including the United States (Spillover Issues: Chapter XI). However, history provides a limited guide, as more advanced economies have accumulated large public debt burdens in recent years. Conditional distress indicators (Spillover Issues: Chapter XII) suggest that the risk of transmission of sovereign debt shocks have increased considerably since the 2008 crisis, including from Japan to other sovereigns. Although the authorities reiterated their reservations on the methodology of projecting cross-border financial spillovers, both sides agreed that higher JGB yields could lead to higher interest rates elsewhere, especially in economies where public debt is already high.


Conditional probability of distress, given distress in Japan

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

Comprehensive Monetary Easing and the Yen

31. In this scenario, the Bank of Japan is assumed to continue its comprehensive monetary easing (CME) policy for another 2 years to provide support to the economy. In the staff’s GIMF model, monetary easing is expected to raise inflationary expectations, and thus support demand by lowering real interest rates. This support would be sufficient to raise growth by an average ½ percentage point over three years in Japan; yet hardly any spillovers—either positive or negative—would be seen abroad.

32. The lack of spillovers from monetary policy also extend to the exchange rate. It is conceivable that continued monetary easing could weaken the yen by lowering longer-term interest rates and widening the interest differential vis-à-vis other currencies. Empirical estimates, however, do not provide support to this hypothesis:

  • An event-study analysis of the BoJ’s large-scale asset purchases (LSAP) confirms that LSAPs have had a modest impact on local bond yields (around 15-25 bps) but little effect on the term premium or the exchange rate. Financial markets in the United States and Europe have remained largely unmoved.17

  • Drawing from these results, staff have simulated the impact of further LSAP, assuming that purchases continue up to the authorities’ current allowable limit. Again, spillovers are modest, with the peak impact on other economies ranging below 0.1 percent of GDP.18


Impact of Monetary Accomodation on Real GDP

(ppt difference, 3-year average)

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001


Peak Impulse Response to Japanese LSAP

(percent of output)

Citation: IMF Staff Country Reports 2011, 183; 10.5089/9781462328451.002.A001

33. Any revival of the carry trade would depend on monetary policy abroad. Although cross-country interest differentials are at an historic low, many other economies are expected to recover somewhat faster than Japan, which implies that their monetary policies may begin to normalize somewhat earlier.

  • Forward-looking measures of risk-adjusted gains are significantly lower for the Australian, New Zealand, and U.S. dollar compared to the precrisis period, reflecting much narrower interest-rate differentials against the yen and a higher level of implied volatility priced into current markets owing to the crisis.

  • Position and leverage indicators also suggest lower appetite for carry trades. Prior to the crisis, noncommercial accounts held large short yen futures positions on the Chicago Mercantile Exchange. Since the last quarter of 2007, however, these accounts have mostly held net long positions.19

  • Market observers agreed that a sudden return of the carry trade was unlikely. Nonetheless, they concurred that, as rates increase in the United States and elsewhere, there might be a growing interest in using the yen as a funding currency, putting further downward pressure on the exchange rate. Staff simulations suggest, however, that the marginal impact on the currency is likely to be limited (Spillover Issues: Chapter XIII).20

34. The impact of any CME-related depreciation would mostly occur outside Asia. Simulating the impact of even a sizeable nominal effective depreciation on regional trading patterns—using a more detailed, partial-equilibrium framework—Asian trade responds relatively sluggishly, leaving Asia’s role as Japan’s dominant partner largely unchanged. This likely reflects the nature of Asia’s production chain, where the costs of severing a trading relationship may be higher than elsewhere, and where Japan retains significant market power. Trade with the United States and Europe, on the other hand, is more sensitive to exchange rate changes (Spillover Issues: Chapter I).

A Regional Trade Agreement

35. A key part of the authorities’ growth strategy includes efforts to build a regional FTA, possibly through the Trans-Pacific Partnership Agreement (TPP). Aside from any short-term dislocation costs, the macroeconomic impact of this policy will likely center around a sustained improvement in productivity and income—officials estimated that the net gain to Japan could amount to about percentage point of additional output growth. Also, the TPP could help entrench a rules-based framework for new trade areas: such as medical services, pharmaceuticals, and insurance.

Gains for TPP members from Japanese membership

(percent change)

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Source: GTAP and IMF staff calculations.

36. TPP would generate welfare gains for members and minimal losses for nonmembers. Staff has employed a computable general equilibrium (CGE) framework to assess the impact and benefits of the TPP to the region as a whole, and to isolate the marginal contribution of Japan’s membership.

37. On average, without Japanese membership, the TPP would generate efficiency benefits equivalent to a one-time boost of 0.1 percent of GDP for regional members. If Japan joins the partnership, these benefits increase to 0.2 percent (Spillover Issues: Chapter XIV). These estimates only reflect static effects in the CGE model, however; the gains could be considerably larger if increased competition as well as the expansion of rules-based frameworks in TPP member countries led to additional investment and further productivity gains.


38. Notwithstanding its position among the world’s largest economies, there has been little evidence of significant policy spillovers from Japan. To be sure, the recent earthquake has revealed the importance of Japanese intermediate inputs in the global supply chain, with Japanese technology a key input for industrial production in many of its trading partners. Japan also remains an important and steady source of final demand for its Asian neighbors, but neither economic nor financial policies appear to have had a significant growth impact on partner countries in recent years.

39. Nevertheless, developments in Japan matter. For one, many other advanced economies have become more vulnerable than they were during Japan’s “lost decade,” suggesting that the impact of Japanese outcomes may be larger than it was in the 1990s—both on the upside and the downside. Moreover, among foreign policy makers, the currently unsustainable fiscal trajectory has triggered concerns about the buildup of public debt, and there is broad agreement on the need for a credible medium-term adjustment strategy. In the staff’s view, insufficient fiscal adjustment could lead to a spike in JGB yields which, even if the effects were contained, could trigger financial volatility and prove highly disruptive.

40. Apart from heading off tail risks, fiscal consolidation in Japan would have medium to long-term benefits for its partner countries. The main impact of fiscal consolidation would be to release a pool of savings for other countries to borrow, while putting downward pressure on Japan’s real exchange rate. Over the short run, for Asian countries that peg their exchange rates to the dollar, this might initially translate into higher real interest rates and reduced output. Over the long run, however, all regions benefit from lower world interest rates; and speedy implementation of Japan’s growth strategy would help offset negative short-term spillovers.

41. Exchange rate-related spillovers on foreign financial markets are found to be small and depend partly on policy developments abroad. Going forward, as monetary policies in other countries are likely to normalize earlier than in Japan, there could be renewed downward pressure on the exchange rate. However, the regional impact of a yen depreciation on foreign financial markets and trade is likely to be modest. Spillovers from regional trade agreements would be slightly positive for countries that joined the initiative.


The report does not try to capture the full extent and historical significance of Japan’s influence on the world economy. Rather, it focuses on key policy-relevant issues raised by partners, and describes the reactions of the Japanese authorities. Technical chapters underlying the analysis can be found in the accompanying Spillover Issues Paper.


The extent to which each country’s income depends on the final demand of others can be measured by the value-added in the home country induced by foreign trading partners (Spillover Issues: Chapter II).


Input-output tables for Asia show that the foreign component in most countries’ domestic output has been rising strongly, and that a significant portion of the final assembly of Asian-made products, which used to be assembled and finished throughout the region, has shifted to China (Spillover Issues: Chapter II).


Studies find that is not only how much, but also what you export that matters—countries with more ‘sophisticated’ export baskets enjoy faster subsequent growth. (Spillover Issues: Chapter I).


Japan still enjoys a current-account surplus of around 3 percent of GDP, and provides almost $200 billion of capital each year for other countries to borrow.


Foreigners account for 42 percent of equity trading volumes.


The sensitivity of the yen to exogenous shocks was revealed by the recent earthquake, when worries about a large-scale repatriation of capital initially resulted in a sharp currency appreciation. These concerns appeared to have been premature, however, and yen volatility quickly diminished after a coordinated one-off intervention by the G7.


The methodology follows Bayoumi and Bui (2010), “Deconstructing the International Business Cycle: Why Does A U.S. Sneeze Give The Rest Of The World A Cold?” IMF Working Paper 10/239, whose approach allows both the identification of causation of shocks and the decomposition into different spillover channels. China could not be included in the analysis because of data limitations. For Japan, a 1 percent of GDP shock is broadly equivalent to one standard deviation.


See U.S. Spillover Report. Spillover Issues: Chapter 6.


See Vitek, F., 2010, “Monetary Policy Analysis and Forecasting in the Group of Twenty: A Panel Unobserved Components Approach.” IMF Working Paper 10/152.


Analytically, the demand-side implications of the shock are complicated by a shift in expenditure toward infrastructure reconstruction, and additional import demand for energy and materials.


Based on the methodology in Bayoumi and Bui (2010), staff extended the VAR approach to include financial-market shocks. See the U.S. Spillover Report. Spillover Issues: Chapter 1.


See “Japan and the Global Financial System: Spillovers and Systemic Linkages,” IMF Staff Country Report 09/211, Ch.2.


Over the past decade, Japan has witnessed several episodes where 10-year JGB yields picked up by 100 bps or more (e.g., the VAR shock in 2003, the 1998 Fiscal Investment and Loan Program shock). Furthermore, events in Europe have demonstrated that once confidence in fiscal sustainability erodes, authorities can face an adverse feedback loop between rising yields, a deteriorating fiscal situation, and a contracting real economy.


Total foreign holdings of JGBs amount to $390 billion, which is equivalent to around 1 percent of the combined global market for sovereign bonds, and 4 percent of the U.S. market.


The Large-Scale Asset Purchases Had Large International Effects,” Federal Reserve Bank of St Louis, Working Paper 2010/18C.


See Spillover Issues: Chapter XIII, and Japan: 2011 Article IV Staff Report (Box 4).


This is likely to be an upper bound, as a large portion of the impact of LSAP is felt on announcement.


Similarly, the call-money liabilities of foreign banks suggest that hedge funds and other speculative investors have a much more challenging time building up leverage in the post-Lehman environment.


Regression analysis relating movements in the currency to U.S. market developments suggest that, since early 2007, the yen has been particularly responsive to movements in the U.S. 10-year bond yield (U.S. Spillover Report: Spillover Issues, Chapter 2). However, this result may reflect the abrupt carry-trade unwinding of 2008-09, and Japan’s safe-haven status during recent European turmoil, and so may not serve as a guide to the likely impact of higher U.S. yields going forward.


Prepared by Nagwa Riad (SPR) based on analysis in a Board paper on Changing Patterns in Global Trade (forthcoming).


The ESI measures the similarity of export patterns across pairs of countries, and takes a higher value for pairs with similar shares of each product category.


For each product category, the EXPY index notes the average income level of those countries producing the same product—capturing the fact that goods produced by industrialized countries will likely embody higher quality/value added. See Hausmann, and others (2007) -What You Export Matters” J. of Ec. Growth, Vol.12.


See Changing Patterns of Global Trade (forthcoming), for a detailed description of the methodology and additional results. Data on imports at the 6-digit level is used for the full set of 162 countries for data available in COMTRADE.


Prepared by Hitoshi Sasaki (SPR).


NIEs3 includes Korea, Taiwan, and Singapore, while ASEAN4 includes Indonesia, Malaysia, the Philippines, and Thailand.


Prepared by Hitoshi Sasaki (SPR).


Variables are transformed using a semi-log procedure of the form, x=sign(x)log(1+|x|), in order to include entries with recorded values of zero.


Prepared by Akira Otani (MCM) and Andrew Tiffin (SPR).


Prepared by Sergejs Saksonovs (SPR).


Not all variables are available for all countries and some missing data is interpolated from annual levels. Euro Area variables are defined as a GDP weighted aggregate of eight countries: Austria, Belgium, Finland, France, Germany, Italy, Netherlands and Spain.


See Pesaran, and others (2004), -Modeling Regional Interdependencies Using a Global Error-Correcting Macroeconometric Model”, J. of Bus. & Ec. Statistics 22(2) and Dees, and others, (2007) -Exploring the International Linkages of the Euro Area: A Global VAR Analysis”, J. of Applied Econometrics, 22.


Regional countries are Australia, China, India, Indonesia, Korea, Malaysia, New Zealand, Singapore, Philippines and Thailand.


Prepared by Srobona Mitra (MCM).


The analysis is based on BIS locational statistics as of September 2009. This allows for a broad sectoral breakdown and rich set of Asian countries.


Countries included in the analysis are Australia, Austria, Belgium, Canada, France, Germany, Ireland, Italy, Japan, Netherlands, Portugal, Spain, Sweden, Switzerland, United Kingdom, United States, China, Taiwan, India, Indonesia, Malaysia, Philippines, South Korea, Thailand, and Vietnam. Note that global exposures of banks in China, Indonesia, Philippines, Thailand and Vietnam are extracted from data on liabilities of the countries’ counterparties.


Marco Espinosa-Vega and Juan Solé, 2010, -Cross-border Financial Surveillance: A Network Perspective,” IMF Working Paper 10/105.


Prepared by Stephan Danninger (APD).


Balakrishnan, and others, 2009, World Economic Outlook, Spring 2009, Chapter 4; Fall 2008, Chapter 3.


Following the literature, an episode of financial stress is identified as a period when the FSI exceeds 1.5 standard deviations above its mean.


Prepared by Pelin Berkmen (APD).


The model covers five regions: Japan, the United States, Euro area, emerging Asia, and remaining countries. The calibration is slightly different from the version used for Japan 2010 Article IV, with updated monetary policy parameters and steady state debt.


This scenario assumes that interest rates will stay low for the initial two years.


While the decline in demand creates downward pressure on inflation, depreciation of the yen and the increase in consumption taxes pull it up.


The improvement in emerging Asia’s current account stems from import suppression originating from the decline in demand prompted by to higher real interest rates. Similar to the fiscal consolidation scenario, with flexible exchange rates, import suppression is much less, dampening the impact on emerging Asia’s trade balance.


Prepared by Andrew Tiffin and Francis Vitek (SPR), and Kiichi Tokuoka (APD).


Vitek, F., 2010, -Monetary Policy Analysis and Forecasting in the Group of Twenty: A Panel Unobserved Components Approach,” IMF Working Paper 10/152.


Prepared by Akira Otani and Mitra Srobona (MCM).


Tomiyuki, Kitamura, and others, -Hybrid Japanese Economic Model: Quarterly Japanese Economic Model (Q-JEM)”, Bank of Japan Working Paper 09-J-06, Bank of Japan, 2009 (only in Japanese).


The Bank of Japan’s default rate function—outlined in Financial System Report, April, 2007—is used to estimate GDP-related losses in the loan portfolio. In addition, the three mega banks’ core operating profits are assumed to be the same as 2010.


Megabanks are assumed to aim at an 8 percent Tier I ratio.


We repeat the network analysis used in Chapter VI to simulate a funding shock restricted within the region.


Again, local banks will need to need sell some of their assets at fire-sale prices, and we assume a discount of 50 percent.


Prepared by Srobona Mitra (MCM).


See Annex 1 for the definition and methodology for calculation of exceedances.


Prepared by Tola Oni and Andrew Tiffin (SPR).


Segoviano, M., 2006, -The Consistent Information Multivariate Density Optimizing Methodology,” Financial Markets Group, London School of Economics, Discussion Paper No. 557; Segoviano, M., and C. Goodhart, 2009, -Banking Stability Measures”, IMF Working Paper 09/04.


Prepared by Phil de Imus, Andrew Tiffin and Francis Vitek (SPR).


See R, Lam (2011), -Bank of Japan’s Monetary Easing Measures; Are they Comprehensive and Powerful?,” Japan: Selected Issues Paper, forthcoming.


Vitek, F., 2010, -Monetary Policy Analysis and Forecasting in the Group of Twenty: A Panel Unobserved Components Approach,” IMF Working Paper 10/152.


This is likely an upper bound, as a larger part of the impact of LSAP tends to be on announcement.


A -carry trade” exploits opportunities presented by of low borrowing costs in one market combined with higher returns in another. Its success as strategy has long been a puzzle for economists, given that it violates the hypothesis of uncovered interest parity—the so called forward premium puzzle.


Prepared by Nagwa Riad (SPR).


Regulatory coherence is aimed at making the regulatory systems of the TPP countries operate more seamlessly and addressing so-called =behind-the-border’ issues that pose increasing barriers to U.S. business in trying to access foreign markets. The intent would be to establish oversight regulatory bodies such as the U.S. Office of Information and Regulatory Affairs (OIRA).


The next round (seventh) of negotiations on TPP will be held during the week of June 20, 2011, in Vietnam.


The latest version of GTAP is used (version 7); the base year is 2004.


Kawasaki, Kenichi (2010), -The Macro and Sectoral Significance of an FTAAP” ESRI Discussion Paper Series #244.


Wignaraja, Ganeshan (2011), ASEAN or TPP? Pathways Towards East Asian FTA Consolidation, presentation at the Fund in February 2011. His analysis assumes a TPP-11 which includes: Australia, Brunei, Chile, Korea, Malaysia, New Zealand, Peru, Singapore, the United States, and Vietnam. GTAP however does not cover Brunei, and is therefore not included in our analysis.


See Goldman Sachs Global Economics, 2011, -TPP and Its Positive Impact” Japan Economics Analyst, Commodities and Strategy Research, Issue No.11/03.

Japan: Spillover Report for the 2011 Article IV Consultation and Selected Issues
Author: International Monetary Fund