Abstract
KEY ISSUESAbenomics is gaining traction, but progress across the three arrows has been uneven andmedium-term risks remain substantial. Inflation has risen, a consumption tax increase has been implemented, and there are signs of a transition to private-led growth. However, structural reforms have progressed slowly and a medium-term fiscal plan beyond 2015 is still to be articulated. Uncertainty is therefore high whether the recovery and exit from deflation will become self sustained under current policies.More forceful growth reforms are needed to overcome structural headwinds to raising growth and ending deflation The next round of structural reforms should lift labor supply, reduce labor market duality, enhance risk capital provision, and accelerate agricultural and services sector deregulation. Corporate governance reforms already underway could help reduce firms’ preference for large cash holdings.A concrete medium-term fiscal reform plan is urgently needed. Given very high levels of public debt, implementation of the second consumption tax increase is critical to establish a track record of fiscal discipline. Adoption of a concrete medium-term fiscal consolidation planbeyond 2015 would build confidence in the sustainability of public finances and allow more flexibility to respond to downside risks. Plans to lower the corporate tax rate have growth benefits, but should proceed in combination with measures to offset revenue losses and be consistent with plans to restore fiscal sustainability.Monetary policy is appropriately accommodative. With inflation and inflation expectations increasing, no further easing is needed at this point. In case downside risks to the inflation outlook materialize, the Bank of Japan (BoJ) should act swiftly through further and/or longer- dated asset purchases. Communication should focus on achieving 2 percent inflation in a stable manner aided by a more transparent presentation of the BoJ’s forecast and underlying assumptions.The financial sector remains stable. Portfolio rebalancing by financial institutions and investors is desirable but also raises new risks, including from greater overseas engagement. In regional banks, limited growth opportunities and low net interest margins could further undermine core profitability and weaken capital buffers. Supervisors should continue to be proactive in monitoring these risks.Japan’s external position is assessed as broadly in balance—compared to moderately undervalued last year—because of structural changes in the external sector, including from the offshoring of production and sustained high energy imports, which have become more apparent.Launching all three arrows will create benefits for the region and the global economy. Spillovers via the trade channel and capital flows are expected to increase in coming years with uncertain net effects—higher exports and capital outflows—in the short term. As long as Japan continues to proceed with its reforms, incomes will rise and fiscal risks decline, which will bepositive for the global economy.
1. This statement contains information that has become available since the Staff Report was circulated to the Executive Board on July 8, 2014. This information does not alter the staffs broad assessment of policy issues and recommendations contained in the staff report.
2. Recent data releases paint a mixed picture but are broadly consistent with staff’s view that the economic contraction following the consumption tax increase will be short-lived, with the economy returning to a moderate pace of recovery from the third quarter. In terms of the details:
Private consumption rebounded in May, with the real synthetic consumption index up by 1.3 percent (m/m), and consumer confidence continued to edge up in June (41.1 from 39.3 in May).
Private machinery orders (excluding volatile items) fell sharply in May (19.5 percent m/m). In contrast, industrial production rebounded in May (0.7 percent m/m) and large firms have upgraded their capital spending plan for this fiscal year (7.4 percent annual, compared to 0.1 percent three month ago), according to the Tankan survey.
In line with staff’s baseline, the effects of the latest fiscal stimulus are beginning to be felt, with contract values of public works orders and public machinery orders rising sharply in May (14.0 percent and 22.4 percent m/m, respectively).
The current account surplus widened in May (about 0.9 percent of GDP), in line with staffs expectation of delayed J-curve effects.
Headline and core (excluding food and energy) inflation without the effect of the consumption tax increase declined to 1.6 and 0.5 percent (y/y) in May, in line with staffs projection.
3. The Bank of Japan kept its policy unchanged during its July 15 monetary policy meeting, noting that Japan’s economy is recovering moderately as a trend.
4. Financial market indicators remain stable. The benchmark 10-year JGB yield has declined slightly to 54 basis points and equities have risen by about 1.4 percent thus far in July, while the yen has fluctuated in a narrow range around ¥101 per U.S. dollar.