Japan: Selected Issues

Abstract

Japan: Selected Issues

Executive Summary

Staff’s analytical work since around the launch of Abenomics has focused on how to reflate the economy and achieve fiscal sustainability. It covered the areas of potential growth, labor market duality’s implications for wage-price dynamics and productivity, drivers of private investment, the effectiveness of and limits to quantitative easing, aging and deflationary pressures, government revenue and expenditure priorities to restore public debt sustainability, financial sector reforms to rekindle risk-taking, and spillover effects of Japan’s new policy framework (Summary of staff research since 2010). Complementary research completed for the 2016 Article IV consultation supports the staff’s view that Abenomics needs to be reloaded along most dimensions to meet the authorities’ ambitious targets:

Labor market reform and incomes policies. Together with income policies, reforming structural features of the labor market, in particular addressing labor market-duality, will be essential to generate strong enough wage pressures to coordinate wage-price adjustment and help achieve the BoJs inflation target (Labor market and wage developments). Lifting minimum wage growth as decided by the authorities is a good starting point as it will partially pass through the wage structure and support reflation efforts (Minimum wages as a policy tool).

Headwinds from demographics. Ongoing aging and the recently started decline in population size are found to adversely affect productivity and inflation (Impact of demographics on growth and inflation). This finding puts a premium on policies to raise participation rates of females and older workers, make more use of foreign labor, and raise productivity through deregulation and support for innovation.

Monetary policy effectiveness. There are some concerns that easy monetary conditions do not fully get transmitted to credit-constrained SMEs, suggesting the need to phase out SME guarantees and improve risk-management capacity in the financial system (QQEs’ impact on financing conditions of listed firms). And structural features of banks appear to affect the pass through of the negative policy rate onto deposit rates (Negative interest rate policy and bank deposit rates).

Fiscal policy and frameworks. Strong home bias has allowed the public sector to finance high debt and deficits without adverse effects on funding costs, but it should not be taken for granted or expected to last forever, especially when the BoJ exits from its unconventional policies (Is home bias weakening?). At the same time, households have become less Ricardian, with the decline in average remaining life expectancy and the rising share of cash constrained households key factors (Fading Ricardian equivalence in ageing Japan). Hence, fiscal consolidation should start soon and be gradual. More broadly, economic policy uncertainty—measured using novel methods—appears to have a large and statistically significant adverse effect on output, employment and investment (Economic policy uncertainty). This suggests that steady, transparent, and credible policy frameworks could have large benefits, making the establishment of an independent fiscal council particularly beneficial (An independent fiscal institution for Japan).

Unorthodox policies? While many observers advocate further unorthodox policies (e.g., helicopter money), simulations suggest that a comprehensive Abenomics-reload package remains preferable to such alternatives from a risk-return perspective (Reflating Japan: time to get unconventional?).

Summary Of Staff Reseach Since 20101

Since the bursting of the asset-price bubble in early 1990s, Japan has faced the formidable challenge of raising growth, ending deflation, securing fiscal sustainability and maintaining financial stability. Japan’s rapidly aging society, entrenched deflationary expectations, and sluggish global growth hampered policy transmission. Against this backdrop, in late 2012, the Japanese authorities launched a comprehensive approach to revive the economy, composed of three complementary elements: aggressive monetary easing, flexible fiscal policy, and structural reforms to raise potential growth. Recent IMF research has focused on structural impediments to growth and wage-price dynamics, including from aging and labor market frictions. Other research areas covered the implications of the authorities’ new policy framework and the key policy challenges and points to the need for a comprehensive and coordinated set of reforms to transition to a self-sustained recovery.

A. Potential Growth

Over the last two decades, Japan’s growth has lagged that of many advanced economies, but Japan’s weak growth performance has been mainly driven by the decline in its labor force, while productivity growth has been comparable to other countries (Danninger and Steinberg, 2012). Potential growth declined from about 4 percent in the 1980s to 1 percent in the 2000s, initially reflecting deceleration in capital formation and total factor productivity growth after the bursting of the asset bubble, but more recently declining labor input has played an important role. Headwinds from Japan’s aging society are expected to play an important role in shaping not only potential growth, but also inflation dynamics, and fiscal sustainability. Anderson, Botman and Hunt (2014) find that a declining labor-force participation rate, falling land prices, and currency appreciation following the repatriation of foreign savings by the elderly could all create deflationary pressures amid a declining natural rate of interest and the zero-lower bound on monetary policy rates. These effects are magnified by the large and sustained fiscal consolidation need.

Danninger and Steinberg (2012) propose that real GDP growth in Japan could be increased by 1 to 2 percentage points over the course of a decade through increased immigration, greater labor force participation of women and the aged and higher productivity, especially in protected sectors, as a result of deregulation, a more dynamic financial sector and greater international integration. Steinberg and Nakane (2012) argue that raising female labor force participation can indeed provide an important boost to growth and policies should target reducing the gender gap in career positions and providing better support for working mothers. Kinoshita and Guo (2015) explore the implications of non-regular employment among female workers, arguing that child cash allowances reduce the proportion of regular female employment. More public spending on childcare can help women continue to work. Ganelli and Miake (2015) find that increasing reliance on foreign labor could help ease labor shortages.

While rare, sustained trend growth increases of more than 1 percent have been achieved in several advanced economies, and have been driven mainly by contributions from labor input and total factor productivity. As highlighted by Danninger and Steinberg (2012), achieving a sustained increase in growth would only be feasible by concerted action on all fronts and a comprehensive reform package which delivers sustainable public finances, steady positive inflation and structural reforms. Staff research finds that full implementation of structural reforms is also critical to improve equality (Aoyagi et. al., 2015).

B. Labor Market Dynamics

Japan’s labor market has fared relatively well considering the substantial output losses that have occurred at time, with unemployment remaining low. Steinberg and Nakane (2011) find that while Japan’s employment responsiveness to the cyclical position has been relatively low, it has been rising over time reflecting the higher share of the non-regular workforce. The lower employment response to output compared to other countries during the Great Recession reflects the quick implementation of an employment subsidy program, a more flexible wage system and strong employment protection. Notwithstanding Japan’s relatively low unemployment rate, there are important skill mismatches in certain sectors and the occupational and employment type mismatch in Japan’s labor market has increased substantially since the global financial crisis (Shibata, 2013).

Japan stands out as having downward nominal wage flexibility, as a large share of remuneration consists of bonuses, while wages tend to be more rigid upwardly. In addition, real wage growth has lagged productivity over the last two decades. Aoyagi and Ganelli (2013) argue that increasing labor market duality, with a rising share of non-regular workers, has contributed to the sluggish real wage growth. It likely had a negative net effect on potential growth by reducing total factor productivity as non-regular workers have lower incentives to exert effort and firms have lower incentives to train them. Based on cross-country evidence, they propose reducing the difference in employment protection between regular and non-regular workers in an effort to reduce labor market duality. This could be achieved through the introduction of a Single Open Ended Contract for all newly hired workers, or by encouraging a wider use of the “limited regular” contracts which already exist in Japan. Porcellacchia (2016) finds that reducing labor-market duality can help generate favorable wage-price dynamics by raising the bargaining power of workers, in particular if it is implemented together with corporate governance reforms to provide managers an incentive to pass on higher input costs into prices. However, such reforms come with an unusual trade-off, whereby attaining higher inflation involves lower employment.

C. Drivers of Private Investment

One of the key policy objectives under Abenomics has been to boost private demand and achieve sustained growth momentum. Tokuoka (2010) argues that private consumption could be a critical driver of growth and finds that boosting household income through higher wages and property income can support consumption growth. Boosting private investment is also critical to increase potential growth and raise employment but it has remained subdued in recent years, despite favorable financing conditions, an aged capital stock, and improved profitability in the corporate sector. Kang (2014) finds that firms’ expectations of demand growth over the medium term are a key determinant of corporate investment, highlighting the importance of expediting structural reforms. Kang and Piao (2015) explore factors behind the weak investment response at the firm level distinguishing between firms expanding abroad and those operating mainly in domestic markets. They find that the former are less responsive to the Q ratio and more responsive to cash flow, suggesting that firms rely on internal financing for overseas expansion. Japanese firms’ aiming to have a footprint in markets where demand is growing could therefore explain the subdued investment performance despite increasing profitability, the weaker yen under Abenomics, and favorable financing conditions and balance sheets.

Syed and Lee (2010) find an important role for raising the return on investment (including through reforms to the tax code), improving SME access to finance through venture capital investment and more risk-based lending and supporting corporate sector restructuring to raise investment and spending on R&D. Subdued investment and low dividend payouts amid high profits have led to the accumulation of excessive cash holdings by Japanese corporates. Sher (2014) finds that cash accumulation has been due to financial imperfections combined with rising corporate profitability and uncertainty, while corporate governance has also played a role. Aoyagi and Ganelli (2014) highlight corporate governance as an important factor in understanding Japanese firms’ investment decisions. They propose policies to encourage the use of firms’ cash holdings, including ambitious requirements for the number of outside directors and measures to reduce cross shareholding.

D. Monetary Policy

An important element of Japan’s policy response to shore up growth and exit deflation involved monetary stimulus through the Bank of Japan’s (BoJ) zero interest rate and quantitative easing policies, first introduced in 2001. The BoJ exited its quantitative easing policy in 2006, amid signs that the economy was coming out of deflation (Botman, 2015). Looking at the BoJ’s experience with quantitative easing during this period, Berkmen (2012) finds that unconventional monetary easing has had a positive effect on output, which increased over time with the improvements in the banking and corporate sector, but it has been less effective in terms of raising inflation. After the financial crisis, the BoJ undertook several measures including a clearer commitment to the zero interest rate policy and a new asset purchase program under its Comprehensive Monetary Easing (CME) policy involving purchases of private sector financial assets in addition to government securities. Lam (2011) finds that the unconventional monetary easing measures introduced since 2009 under the Comprehensive Monetary Easing (CME) had a statistically significant impact on lowering bond yields and improving equity prices, but no notable impact on inflation expectations. Lam (2011) also found that the composition of asset purchases by the BoJ mattered, with private asset purchases critical in affecting asset prices.

With the launch of Abenomics, the BoJ adopted a new monetary policy framework consisting of a higher inflation target of 2 percent and an unprecedented asset-purchase program (QQE) which was further expanded in October 2014. Against this background, Arslanalp and Botman (2015) look at the scope for further portfolio rebalancing using realistic scenarios based on collateral needs of banks, asset-liability management constraints on insurers, and announced asset allocation targets of major pension funds. They find that the BoJ may face limits on its purchases of JGBs and need to taper its purchases in 2017 or 2018. However, the BoJ can continue to provide monetary stimulus by extending the maturity of its JGB purchases or by scaling up private asset purchases. The significant expansion of the BoJ’s balance sheet also poses important questions regarding its exit from unconventional monetary policies. Yamaoka and Syed (2010) analyzed the BoJ’s exit from its earlier quantitative easing policies in 2006, with a view to inform the exit strategies of other central banks.

E. Fiscal Policy

The weak, post-bubble, nominal economic growth rate, fiscal stimulus measures and aging led to a significant deterioration in Japan’s fiscal position. Public debt increased substantially and at 246 percent of GDP in 2014, it is the highest among advanced economies. The appropriate fiscal stance in the context of Japan’s weak growth and efforts to exit from deflation as well as the timing and composition of fiscal adjustment to put public debt on a sustainable path have been among the mostly debated policy challenges. Given the sizeable adjustment need and the relatively large scope for raising revenues, staff’s analysis has suggested that the consolidation strategy should include both spending and revenue measures. Tokuoka (2012) finds that combining social security spending reforms and revenue measures in a balanced manner is also desirable from an intergenerational equity perspective.

On the spending side, social security and health care spending are important areas of reform. Although Japan’s social security spending is relatively low, it is still an important component of total outlays. Against this background, Kashiwase, Nozaki and Tokuoka (2012) analyze different reform options for Japan’s public pension system. They argue that the most attractive option is to increase the pension eligibility age in line with the high and rising life expectancy. This would have a positive effect on long-run economic growth and would be relatively fair in sharing the burden of fiscal adjustment between younger and older generations. If implemented, together with other measures, the fiscal deficit can be reduced by up to 1¼ percent of GDP by 2020. Nozaki, Kashiwase and Saito (2014) find that health care spending would increase by about 5½-6½ percent of GDP during 2010-2030 on current policies. This increase is driven to a large extent by aging. The authors propose raising copayment rates and more efficient use of health resources to partially offset the projected increase in health care spending.

Japan has significant scope to raise revenues and improve its composition by relying more on consumption taxes. Keen et. al. (2011) argue that Japan’s relatively low consumption tax rate and the lower distortions associated with this tax makes it a more appealing measure than other taxes. They also highlight the need to raise the consumption tax rate sooner than later, in a pre-announced stepwise fashion, while maintaining the single rate structure. The relatively high level of statutory corporate tax rates in Japan suggests that reforming the corporate tax system can help boost investment and growth. De Mooij and Saito (2014) find that with every point of rate reduction, investment is expected to increase by around 0.4 percent. Although part of the revenue loss could be recovered in the long run through dynamic scoring, offsetting measures are necessary to minimize the impact on the fiscal balance.

Despite rising public debt levels, long-term interest rates in Japan have remained low. Arslanalp and Lam (2013) find that bond yields have been pushed down by higher demand for safe assets amid population aging and increased purchases by the BoJ. Similarly, Lam and Tokuoka (2011) and Tokuoka (2010) find that Japanese sovereign bond yields have remained low and stable supported by steady inflows from the household and corporate sector amid high domestic ownership of government bonds, while safe-haven flows have also contributed. They argue that over time, the market’s capacity to absorb new debt will likely shrink as population ages and risk appetite recovers. Fiscal reforms to reduce public debt more quickly and lengthen the maturity of government bonds will help limit these risks.

F. The Financial Sector

The financial sector plays a critical role in the effectiveness of the new policy framework. There has only been limited progress with portfolio rebalancing from safe assets towards higher-yielding capital provision, despite the substantial improvement in banks’ balance sheets (Arslanalp, Lam and Nabar, 2015). Limited risk capital reflects both supply and demand factors. Lack of securitization and venture capital, together with factors that impede the demand for risk capital, such as insufficient SME restructuring, entry, and exit have contributed to the reliance on low-yielding, safe assets (Lam and Shin, 2012). Public guarantees have compounded this problem by facilitating rollovers and delaying repayments. Lam and Shin (2012) propose measures to accelerate SME restructuring, deepen capital markets to enhance risk capital availability, and address regulatory barriers to starting a business.

New policies under Abenomics also have important implications for banks, in particular, their exposure to interest rate risk and from rising overseas lending. Arslanalp, Lam and Nabar (2015) consider how under different assumptions about policy implementation under Abenomics, the interest rate risks for banks evolve over time. They find that in the near-term interest rate risk of banks would decline substantially, but in the medium term, risks may emerge if structural and fiscal reforms disappoint. Their finding emphasizes the need for a complete reform package for reducing risks to the financial sector. Another implication of greater portfolio rebalancing under Abenomics is the overseas expansion of Japanese banks mainly in Asia, which has gathered further momentum in recent years. Lam (2013) finds that both global and regional factors explain a large part of the Japanese banks’ expansion abroad. Among domestic factors, the strong capital positions of major Japanese banks played the biggest role, while limited domestic opportunities contributed to a lesser extent. The overseas expansion of Japanese banks brings opportunities and risks. While a more diversified income base and increased profitability are desirable, a rapid expansion abroad could result in losses given the scope for underestimating risks in new markets and potential foreign exchange funding risks.

G. Spillovers

Japan’s economic performance and policies also have potential spillover effects on the rest of the world. In general, a stronger economic recovery in Japan would have positive spillovers for its trading partners. For example, Botman and Kang (2015) find that successful implementation of a comprehensive reform package would generate a small positive effect on the G-20 countries in the short-run (0-0.1 percent of GDP), but as the structural reforms gradually raise Japan’s potential growth rate in the medium-term, positive spillovers would also increase. They argue that an important positive spillover from reforms in Japan includes the reduction in medium-term tail risks, given Japan’s high level of public debt and large net foreign asset position.

Regarding the exchange rate, the process of production offshoring and the emergence of global supply chains put into perspective the transmission of economic policies and spillovers. Potential effects of the yen’s depreciation on Japan’s competitors and the impact of capital outflows from Japan have been relatively muted so far. The depreciation of the yen did not have a substantial impact on export volumes, in part reflecting reluctance by Japanese exporters to gain market share, instead opting to keep invoice prices broadly stable. The lack of an export response is also explained by the increasing trend of production outsourcing and Japan’s upward position in the Asian supply chain (Kang, 2015a, and IMF, 2011).

Ganelli and Tawk (2016) use a Global VAR model to study spillovers from the BoJ’s QQE on emerging Asia. Their main result is that, despite an appreciation of their currencies vis-à-vis the yen, the impact on emerging Asia’s GDP tended to be positive and significant. Their results suggest that the positive effect of QQE on expectations, by improving confidence, more than offset any negative exchange rate spillover due to expenditure switching from domestic demand to Japanese goods.

Finally, Japan’s safe-haven status is an important consideration when evaluating spillovers from the rest of the world onto Japan, as it can pose policy challenges. Botman, Carvalho Filho, and Lam (2013) find that neither capital inflows nor expectations of the future monetary policy stance can explain the yen’s safe haven behavior. In contrast, they find evidence that changes in market participants’ risk perceptions trigger derivatives trading, which in turn lead to changes in the spot exchange rate without capital flows. Specifically, the authors find that risk-off episodes coincide with forward hedging and reduced net short positions or a buildup of net long positions in yen. These empirical findings suggest that offshore and complex financial transactions should be part of spillover analyses and that the effectiveness of capital flow management measures or monetary policy coordination to address excessive exchange rate volatility might be limited in certain cases.

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Prepared by Elif Arbatli (APD). The research discussed in this chapter has been summarized in Botman et al. (2015).