KEY ISSUES Abenomics has lifted Japan out of the doldrums and needs to be reinforced to accomplish the desired “once in a lifetime” economic regime shift. Building on initial positive results, policies now need to embark on a sustained effort to meet the unprecedented challenges Japan is facing: ending an entrenched deflationary mindset, raising growth, restoring fiscal and debt sustainability, and maintaining financial stability in the face of adverse demographics. Japan should be at the vanguard of structural reform. More vigorous efforts to raise labor supply and deregulate domestic markets, backed by further endeavors to raise wages and investment and designed to boost confidence and raise domestic demand, will be essential to lift growth, facilitate fiscal consolidation, and unburden monetary policy. A credible medium-term fiscal consolidation plan is needed to remove uncertainty about the direction of policies that may be holding back domestic demand. The overarching goal should be to put debt on a downward path, through gradual but steady consolidation that does not derail growth and inflation momentum. It should be based on prudent economic assumptions and on concrete structural revenue and expenditure measures identified upfront. More explicit monetary guidance would enhance inflation dynamics. Actual and expected inflation remain well below the Bank of Japan’s (BoJ’s) inflation target and monetary policy transmission remains weak. The BoJ needs to stand ready to undertake further easing and should provide stronger guidance to markets through enhanced communication. Absent deeper structural reforms, even with further easing, reaching two- percent inflation in a stable manner is likely to take longer than envisaged, suggesting that the BoJ should put greater emphasis on achieving the inflation target in a stable manner rather than within a specific time frame. The financial sector should be a greater catalyst for growth, and guard against risks from unconventional policies. The soundness of the financial system allows more risk taking and consolidation, while remaining resilient to the likely higher volatility of asset prices, exchange rates and interest rates, and lower liquidity in the JGB market as quantitative easing proceeds. While the 2014 external position was assessed to be broadly aligned with fundamentals, subsequent developments and incomplete policies raise the risk of negative spillovers. With the depreciation of the yen relative to its mid-2014 level, further monetary easing without bolder structural reforms and a credible medium-term fiscal consolidation plan could lead to sluggish domestic demand and overreliance on yen depreciation to pursue domestic policy objectives.

Abstract

KEY ISSUES Abenomics has lifted Japan out of the doldrums and needs to be reinforced to accomplish the desired “once in a lifetime” economic regime shift. Building on initial positive results, policies now need to embark on a sustained effort to meet the unprecedented challenges Japan is facing: ending an entrenched deflationary mindset, raising growth, restoring fiscal and debt sustainability, and maintaining financial stability in the face of adverse demographics. Japan should be at the vanguard of structural reform. More vigorous efforts to raise labor supply and deregulate domestic markets, backed by further endeavors to raise wages and investment and designed to boost confidence and raise domestic demand, will be essential to lift growth, facilitate fiscal consolidation, and unburden monetary policy. A credible medium-term fiscal consolidation plan is needed to remove uncertainty about the direction of policies that may be holding back domestic demand. The overarching goal should be to put debt on a downward path, through gradual but steady consolidation that does not derail growth and inflation momentum. It should be based on prudent economic assumptions and on concrete structural revenue and expenditure measures identified upfront. More explicit monetary guidance would enhance inflation dynamics. Actual and expected inflation remain well below the Bank of Japan’s (BoJ’s) inflation target and monetary policy transmission remains weak. The BoJ needs to stand ready to undertake further easing and should provide stronger guidance to markets through enhanced communication. Absent deeper structural reforms, even with further easing, reaching two- percent inflation in a stable manner is likely to take longer than envisaged, suggesting that the BoJ should put greater emphasis on achieving the inflation target in a stable manner rather than within a specific time frame. The financial sector should be a greater catalyst for growth, and guard against risks from unconventional policies. The soundness of the financial system allows more risk taking and consolidation, while remaining resilient to the likely higher volatility of asset prices, exchange rates and interest rates, and lower liquidity in the JGB market as quantitative easing proceeds. While the 2014 external position was assessed to be broadly aligned with fundamentals, subsequent developments and incomplete policies raise the risk of negative spillovers. With the depreciation of the yen relative to its mid-2014 level, further monetary easing without bolder structural reforms and a credible medium-term fiscal consolidation plan could lead to sluggish domestic demand and overreliance on yen depreciation to pursue domestic policy objectives.

On July 17, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Japan.

A modest economic recovery is underway. GDP is expected to grow at an above-potential pace this year (0.8 percent) buoyed by gradually strengthening private consumption on higher real wages and a gradual recovery of external demand. Inflation remains well below the Bank of Japan’s 2 percent target partly due to commodity price developments, but will start to pick up toward the end of this year with the dissipation of the negative effects of falling oil prices and higher wage growth.

Ongoing structural reforms have improved long-term prospects modestly. Growth is projected to stabilize at around 0.7 percent over the medium term with improvements in productivity and capital formation and higher labor force participation offsetting headwinds from the diminishing labor force. On the back of the closing of the output gap, a tight labor market and renewed favorable wage-price dynamics, inflation is expected to increase gradually to about 1.5percent over the medium term under current policies. However, risks to this outlook are tilted to the downside with the most important risks stemming from weak domestic demand and incomplete policies, particularly with regard to the fiscal consolidation and structural reforms.

Abenomics needs to be reloaded so that policy shortcomings do not become a drag on growth and inflation. In addition to swift implementation of already announced reforms, further high-impact structural reforms are urgently needed to lift growth, facilitate fiscal consolidation, and unburden monetary policy. The next round of reforms should lift labor supply, reduce labor market duality, continue agricultural and services sector deregulation and turn the financial sector into a driver of reforms.

A credible medium-term fiscal consolidation plan is needed to remove uncertainty about the direction of policies that may be holding back domestic demand. The medium-term fiscal reform plan should aim to put debt on a downward path, based on realistic economic assumptions, and specify structural revenue and expenditure measures upfront. The Bank of Japan needs to stand ready to ease further, provide stronger guidance to markets through enhanced communication, and put greater emphasis on achieving the 2 percent inflation target in a stable manner. However, further monetary easing without bolder structural reforms and a credible medium-term fiscal consolidation plan could lead to sluggish domestic demand and overreliance on yen depreciation to pursue domestic policy objectives, with possible adverse spillovers abroad.

Executive Board Assessment2

Executive Directors welcomed the improved medium-term outlook for growth and inflation. Directors commended the authorities for persistently pursuing the three-pronged economic strategy to lift growth, overcome entrenched deflation, and reduce public indebtedness. With risks tilted to the downside, Directors underscored that it would be essential to reinvigorate all elements of the government’s economic strategy, the success of which will also be beneficial for the global economy.

Directors emphasized the urgency of completing far-reaching structural reforms to address the challenge of population aging and achieve the ambitious growth objectives of the revitalization strategy. They welcomed the recent progress in improving corporate governance and raising female labor force participation. Directors encouraged further growth-enhancing reforms to increase labor supply, reduce labor market duality, and deregulate the agricultural and service sectors. Continued efforts are also needed to enhance the efficiency of resource allocation through the financial system.

Directors agreed that the fiscal consolidation strategy needs to strike a balance between making progress on deficit reduction and supporting growth and inflation momentum. They welcomed the recent announcement of a medium-term fiscal consolidation plan with specific primary deficit targets while acknowledging the need for flexibility to take account of economic and price developments. Directors noted that prudent economic assumptions, identification of concrete measures to put the debt-to-GDP ratio on a downward trajectory, and strong fiscal institutions would help impart credibility to the consolidation plan. Specifically, ongoing efforts to raise the consumption tax and reform expenditures are crucial to this strategy.

Directors stressed that raising inflation in a stable manner remains an important—albeit challenging—priority. They were reassured by the authorities’ readiness to take further monetary policy action as necessary, complemented with enhanced communication to guide markets. Directors encouraged the authorities to continue to improve monetary policy transmission, and to strengthen momentum for wage increases in the tripartite dialogue.

Directors agreed that the financial system remains sound and well capitalized. They supported initiatives to further enhance its resilience to risks, including from volatility in interest rates and liquidity in the government bond market. Directors saw scope for financial institutions to seek higher returns while improving their risk management tools. They emphasized the role of macroprudential policies in addressing financial stability risks in a low interest rate environment.

Directors took note of the staff’s assessment that Japan’s external position was broadly consistent with fundamentals in 2014 but that the yen has depreciated since then. Going forward, ambitious structural reforms to boost domestic demand and credible fiscal consolidation are critical to avoid overreliance on the depreciation of the yen. These efforts will ease the burden of monetary policy, as well as help avert negative spillovers from portfolio rebalancing by Japanese financial institutions.

Japan: Selected Economic Indicators, 2010–16

Nominal GDP: US$ 4,602 Billion (2014)

Population: 127 Million (2014)

GDP per capita: US$ 36,205 (2014)

Quota: SDR 15.6 Billion (2014)

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Sources: IMF, Competitiveness Indicators System; OECD, and IMF staff estimates and projections as of June 11, 2015.

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

Contribution to GDP growth.

For 2014 export and import growth rates are inflated because of changes in the compilation of BoP statistics (BPM6) implying a break in the series relative to previous years.

Including the effects of consumption tax increases in 2014 and 2015.

Based on normalized unit labor costs; 2005=100.

1

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

2

At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.