Japan: Staff Report for the 2017 Article IV Consultation

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Japan


2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Japan

Abenomics Advancing but Key Goals Remain to be Achieved

1. Structural impediments underlie Japan’s struggle with stagnant growth and deflation. A rapidly aging population and shrinking labor force are hampering growth and productivity. 1 The low growth/low interest rate environment is constraining monetary easing and fostering macro-financial challenges manifest in sovereign-financial linkages, declining profitability of financial institutions, and emerging risks associated with intensified search for yield. While there is room in the short-term for fiscal support under certain conditions, the scope for fiscal stimulus in the medium term is constrained, as gradual consolidation will be needed to address an unsustainable level of public debt. Structural bottlenecks in the labor market undermine productivity growth and limit the pass-through of demand stimulus to higher wages. Weak domestic demand and increased overseas investment have strengthened the underlying external balance by constraining imports and boosting income from abroad.

2. Abenomics has improved economic conditions and engendered structural reform, but key policy targets remain out of reach under current policies. Abenomics—with its “three arrows” of monetary easing, flexible fiscal policy, and structural reform—has helped ease financial conditions, increase corporate profits, and boost employment and female labor force participation. Structural reforms have advanced in energy and agriculture, trade and investment promotion, and corporate governance. Revised national accounts indicate more robust GDP growth during 2013-15 than originally estimated, reflecting stronger private investment and consumption (Box 1). Nevertheless, inflation is well below target, public debt remains unsustainable under current policies, and progress in removing bottlenecks to private consumption and investment has been uneven. Ensuring adequate coordination and pace of the three arrows has been a main challenge. While monetary policy has taken the lead through balance sheet expansion, fiscal policy has been characterized by a stop-go approach and structural reforms have lagged.

Economy Gaining Momentum

A. Recent Developments

3. Recent growth has been driven mainly by external demand and temporary fiscal stimulus. The economy is growing above potential, narrowing the negative output gap. The expansion is now broader and more balanced than in 2015, with private consumption growth turning positive and private investment strengthening on the back of residential investment. Net exports picked up in the second half of 2016 as global demand rebounded and imports fell, driven by lower energy costs. The current account balance, while dominated by the income account, strengthened accordingly. Exports, private consumption and investment maintained momentum in the first quarter of 2017, with imports starting to pick up in late 2016.


Contributions to QoQ Real Growth (SA)

(In percent)

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Source: Haver Analytics.

4. Labor shortages are evident, but wage growth remains weak (Figure 6). Unemployment has fallen to a 25-year low and the job-to-applicant ratio is at an all-time high. Wage pressure is mounting in the lower-paid non-regular work segment but overall wage growth is lackluster—manifest in the outcome of the 2017 spring wage negotiation. The reasons for the low responsiveness of wages include limited labor mobility, preference for job security, and base pay negotiations guided by current inflation. Female labor force participation has increased, but the gap between male and female employment rates remains high.

Figure 1.
Figure 1.

Japan: Recent Economic Developments

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Figure 2.
Figure 2.

Japan: Inflation Developments

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Figure 3.
Figure 3.
Figure 3.

Japan: Monetary Policy Transmission

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Figure 4.
Figure 4.

Japan: Financial Markets Developments

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Figure 5.
Figure 5.

Japan: JGB Market Liquidity

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Figure 6.
Figure 6.
Figure 6.

Japan: Labor Market and Wage Developments

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

5. Inflation is stubbornly low. After falling during the first three quarters of 2016 due to lower energy prices and a stronger yen, headline inflation began to rise in the last quarter on the back of stabilizing energy prices and higher fresh food prices. Meanwhile, inflation excluding fresh food and energy declined throughout 2016. Medium- and long-term inflation expectations were depressed in 2016 and remain low, although market based indicators suggest that they may be approaching an inflection point (Figure 3).


Inflation Indicators

(YoY; in percent)

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Sources: Haver Analytics; IMF staff estimates.

6. Monetary policy has settled in to a more sustainable accommodative stance and fiscal policy has been marked by a delay in the planned increase in the consumption tax and implementation of supplemental spending.

  • ➢ Following adoption of its negative interest rate policy (NIRP) in February 2016, the Bank of Japan (BoJ) introduced “QQE with yield curve control” (YCC) in September, including a long-term interest rate target and a commitment to overshoot the 2 percent inflation target. The framework upgrade was aimed at raising inflation expectations and strengthening the commitment to sustained monetary easing (Box 2). Communication about the timing of achieving the inflation target was deemphasized, providing more flexibility to monetary policy.

  • ➢ In June 2016, the government postponed the planned 2 percentage point increase in the consumption tax rate from April 2017 to October 2019, and followed up in August 2016 with a 1.5 percent of GDP supplementary fiscal package, raising spending primarily in 2017.2

7. Structural reform remains the lagging element of Abenomics. That said, the Work Style Reform (WSR) agenda unveiled in March 2017 seeks to address wage gaps between regular and non-regular workers, envisages a cap on overtime that is expected to boost productivity and labor force participation, and provides an expansion in childcare facilities to support further integration of women in the labor market (Annex I). Moreover, the government strengthened income policies by raising the minimum wage by 3 percent in FY2017 and enhancing tax incentives for wage increases. However, WSR implementation will be slow and reforms to remove labor market duality and eliminate disincentives to regular work embedded in the tax and social security system have fallen short (Annex I). Corporate tax rate cuts and governance reforms have yet to mobilize corporates’ large cash reserves (at almost 50 percent of GDP) for private investment and wage increases. New trade agreements, including with the remaining eleven Trans-Pacific Partnership (TPP) countries and the EU, could encourage restructuring in the services and agriculture sectors.


Non-Financial Sectors: Currency and Deposits

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Source: Haver Analytics.

Cash Holdings by Sector

(In percent of total cash, 2014)

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Source: Orbis firm-level data.

8. Macro-financial challenges persist. The new monetary policy framework has brought stability to markets in the short run. However, financial firms face a challenging environment from the structural impact of demographic headwinds combined with low interest rates—reducing profitability and leading to a search for higher yields. Meanwhile, sovereign-financial linkages remain high and claims on overseas assets have increased.3

  • Sovereign debt market. Following implementation of the YCC framework, the shorter end of the yield curve stabilized, and the 10-year yield has hovered close to the zero percent target. Super-long yields rose amid higher global interest rates, recovering some ground lost in the wake of NIRP introduction. With BoJ’s JGB purchases continuing to outpace government issuance, financial institutions’ JGB holdings fell in 2016. However, the pace of purchases has slowed recently and some aspects of market liquidity have improved (Box 2, Figure 5).


    Japan: Financial Condition Index and Credit Cycle

    Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

    Sources: Bank of Japan; Ministry of Finance; Haver Analytics; and IMF staff estimates.1/ Estimated as the first principal component of (standardized) 2-year/3-month JGB yield spread, 10-year/2-year JGB yield spread, 3-month TIBOR/3-month JGB yield spread, 1-year/1-month TIBOR spread, short-term prime lending rate/1-year JGB yield spread, long-term prime lending rate/10-year JGB yield spread, benchmark housing finance rate/10-year JGB yield spread, first difference of log stock price, and first difference of log nominal effective exchange rate.2/ Estimated as the average of the HP-filtered real total credit growth (deflated by CPI) and total credit-to-GDP ratio.

  • Financial intermediation. Financial institutions continued to increase their risk-taking in search of higher yields, by expanding real-estate and overseas lending. Investment in foreign securities has been on an upward trend but has weakened recently. Credit growth picked up in the last quarter of 2016 and reached 3 percent in Q1 2017—higher than the historical average of 2 percent during 2011–16—suggesting an expansionary credit cycle (Figure 3). Financial conditions remain broadly favorable.

  • FX and equity markets. Some of the sharp nominal yen appreciation in the first half of 2016 was reversed by end-year as U.S. interest rates rose. Together with a more favorable global outlook, this elevated equity prices. U.S. dollar funding costs increased in 2016, but have lessened somewhat in 2017 due to lower investment demand for foreign bonds and relatively higher dollar supply from sovereign wealth funds and EM foreign reserve managers.

  • Households. Housing loans grew about 2 percent in 2016. Household portfolio rebalancing toward risky assets remained slow. Direct household exposure to equity is low and indirect exposure through investment trusts and insurance products has increased only marginally.

  • Corporates. Retained earnings grew significantly, contributing to further build-up of large cash holdings. Corporates continued to show preference for loan financing—which grew by nearly 3 percent in 2016—while issuance of equity and debt securities remained relatively low.

Authorities’ Views

9. The authorities noted that growth momentum is strengthening and that labor shortages are starting to create wage pressures. They pointed to strong regional demand as a main driving force for exports and noted that underlying fundamentals, such as business confidence, corporate profits, and the income and employment situation, are improving, with imports showing a pick-up since end-2016. They acknowledged that inflation has been lower than expected given the improvement of output gap and tight labor market. However, wage increases for non-regular workers are beginning to spill over to regular workers while some firms are responding to labor shortages by investing in labor saving measures. The BoJ emphasized that the new monetary policy framework has been well received by market participants and helped enhance the sustainability of the accommodative monetary policy stance. The authorities noted that the supplementary budget measures are starting to kick in and that structural reforms are progressing, including the adoption of the action plan for Work Style Reform.

B. Outlook and Risks

10. The growth momentum will carry through 2017 but would weaken in 2018 if fiscal stimulus fades as currently scheduled. The fiscal stimulus package supports 2017 growth through higher consumption and investment. Monetary policy under YCC is expected to remain accommodative and facilitate a virtuous cycle between credit and economic growth. However, the possible expiration of the fiscal stimulus in 2018 (a contraction of 0.6 percent of GDP in the structural primary balance) together with a smaller expansion in foreign demand would reduce the rate of growth to less than half of that in 2017, despite an anticipated Olympics-related boost in private investment. While exports are expected to rise, the contribution to growth from net exports would narrow in 2017 and turn negative in 2018 as stronger investment and consumption boost imports.

11. Inflation is expected to rise only gradually despite the tight labor market. Average inflation would remain below one percent in 2017, notwithstanding a narrowing output gap and stabilizing energy prices. Wage-push inflation is unlikely to contribute significantly given modest wage increases. In 2018, average inflation is projected to decline slightly as growth slows. With only gradual reforms to reduce labor market duality and engender a stronger focus on nominal wage increases, tight labor market conditions would not generate meaningful wage-related price pressures.

12. Over the medium term, growth will stay close to potential and inflation below target. Without discretionary fiscal support, the fiscal stance would be contractionary in 2018–20 due to expiry of the 2017 stimulus measures and the scheduled consumption tax hike. Consumption is likely to rise prior to the tax hike but then contract, causing growth to rise and fall in 2019–20, delaying the closing of the output gap over the medium term. Together with strong backward-looking expectations, the negative output gap would keep inflation below the 2 percent target. Demographic headwinds will weigh on potential growth through a shrinking labor supply and lower productivity—intensifying over the next 10–15 years as the most productive segment of the working age population starts to fall.4 The current account surplus is expected to rise gradually over the medium term under the current policy mix, as an expansion of foreign demand generates a higher goods trade balance.

13. Risks to the outlook are tilted to the downside, particularly in the medium term. Japan’s prolonged experience with low growth and interest rates, together with underlying demographic headwinds, has created persistent macro-financial challenges that, if unaddressed, could amplify shocks originating outside of the financial system and make medium term vulnerabilities acute (see figure).

  • Near-term risks: Upside risks relate to a possible supplementary budget for 2018 and further strengthening of exports due to higher global demand. On the other hand, a sharp yen appreciation caused by geopolitical instability and safe-haven flows, or a loss of confidence in domestic policies, could renew deflationary risks. Weakened functioning of JGB markets could constrain the BoJ’s monetary operations, and market risks from a decline in equity prices or an increase in JGB yields could lead to substantial losses for banks and life insurers.5 Considering their expansion overseas for higher yields, some regional banks could experience negative funding gaps in foreign currencies under adverse liquidity scenarios. Finally, a global retreat from cross-border integration, disorderly rebalancing in China, and regional geopolitical shocks would generate significant spillovers to the Japanese economy.

  • Medium-term risks: Doubts about fiscal sustainability could lead to a jump in the sovereign risk premium, forcing abrupt fiscal adjustment with adverse feedback effects to the financial system and the real economy. Low bank profitability and demographic headwinds could pose solvency problems for regional financial institutions. Life insurers could fail to meet interest guarantees and face solvency pressures if low interest rates persist. Finally, some segments of the real estate market seem to be moderately overvalued, and could pose risks given the rapid expansion of real estate lending.


Macro-financial Challenges and Shock Amplification

Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

Note: ST= Near-term; MT=Medium-term

Authorities’ Views

14. The authorities were more optimistic about near-term growth while pointing to external factors as the main source of risk. The authorities did not foresee a significant growth slowdown in 2018, emphasizing sustained external demand and investment. They noted that consumption is likely to strengthen gradually due to rising base wage dynamics. The BoJ acknowledged that weak inflation expectations remain a major obstacle to reflation, but emphasized that a positive output gap and rising energy prices should gradually lift actual and expected inflation towards the 2 percent target in FY2018. The authorities agreed that risks are tilted to the downside and highlighted external risks as the main threat to the outlook, particularly spillovers from China’s rebalancing. They broadly agreed with the assessments of financial risks and highlighted recent efforts toward curbing FX risks through bilateral dialogue with financial institutions. The authorities also acknowledged that the low interest rate environment and adverse demographic trends are contributing to declining profitability of financial institutions and could spur excessive risk taking, impair financial intermediation, and potentially lead to solvency risk for regional financial institutions down the road, and noted that they have already initiated necessary reforms (see FSAP).

Making the Most of Current Tailwinds

15. The favorable economic environment presents an opportunity to push forward with an ambitious reform agenda. A comprehensive policy package exploiting complementarities between macro-critical structural reforms and coordinated income and demand polices should help lift potential growth and spur inflation. While the near-term fiscal stance should be at least broadly neutral, the package should include a credible medium-term fiscal consolidation plan, based on steady, gradual adjustments, to put public debt on a sustainable path. Finally, policies should be employed to contain financial risks stemming from the low interest rate environment and demographic headwinds. These measures should also help deliver an external position consistent with medium-term fundamentals.

A. Macro-Structural Reforms

16. The structural reform agenda should weigh trade-offs and synergies. Given Japan’s long struggle with low inflation, the strategy should prioritize measures aimed at reflating the economy, followed by those intended to lift potential growth. As some reforms (such as boosting the labor supply) may generate deflationary pressure in the near term, providing appropriate demand support will be key. However, reforms are also likely to be mutually reinforcing. For instance, reforms that lift labor supply—and potential growth in general—will also raise the return on investment and thereby the neutral real interest rate, making the accommodative monetary policy more effective.

17. Structural reforms should aim to boost labor market flexibility, investment, and labor supply. Many of the policy measures geared to spur wages and bolster growth have already been identified in the government’s strategy (Table 7 summarizes major structural reform plans and their possible growth impact). However, some gaps remain, implementation horizons could be more ambitious, and clearer prioritization is needed.

  • First priority: Labor market reforms to boost wages and increase productivity. The government’s new Work Style Reform appropriately recognizes the need for broad labor market reform. Employment protection for regular workers is relatively high in Japan. Clarifying the legal framework for “intermediate” contracts could help promote their use, facilitate a better balance between job security and wage increases, and reduce labor market duality. Support for worker mobility across firms – including via contract reform, portability of pensions, and government programs – would improve resource allocation while increasing wages. Accelerating the “equal-pay for equal work” initiative, together with the introduction of job descriptions, should also help close the wage gap between regular and non-regular workers (Annex I).


    Difference in Employment Protection: Regular vs Temporary

    Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

    Source: OECD, Employment Protection Database.Note: Difference in index for protection of regular employment and index for protection of temporary employment. Each index is a scale 0-6 from least to most restrictive.

  • Second priority: Reforms to increase private investment and productivity. The restrictiveness of product and service sectors in Japan is high in some areas relative to G7 peers. Deregulation, including reduced barriers to entry and removal of protections to incumbents in some industries (i.e., telecoms and gas sectors) and deregulation of professional services, would increase productivity.6 There is also scope for further corporate governance reform; more ambitious requirements for outside directors, enhanced transparency of beneficial ownership, and explicit limits on cross-shareholdings should improve monitoring of firm performance and encourage firms to invest. Providing greater clarity on macroeconomic policy frameworks to reduce policy uncertainty, promoting trade and FDI, and expediting deregulation in Special Economic Zones should help boost productivity, investment, and long-term growth.


    Sectoral Regulation in Professional Services

    (Index scale of 0-6 from least to most restrictive)

    Citation: IMF Staff Country Reports 2017, 242; 10.5089/9781484313411.002.A001

    Source: OECD Product Market Regulation Database and Koske (et al) 2013 update.

  • Third priority: Diversification and enhancement of labor supply. Measures to boost female and older-worker labor force participation and to allow more use of foreign workers and their integration in the economy are crucial to compensate for a shrinking working-age population. Reducing excessive overtime and encouraging managerial practices that reward productivity rather than long hours could further increase labor force participation and productivity. Eliminating disincentives to full-time and regular work stemming from the tax and social security system, and increasing the availability of childcare and nursing facilities, including via deregulation could help boost labor supply (Box 3). Flexible employment and a wage system based on ability rather than seniority should be encouraged, and firms’ right to set a mandatory retirement age should be abolished. Efforts to increase the use of robotics and automation could help boost productivity and potential growth.

Table 1.

Japan: Selected Economic Indicators, 2012–18

article image
Sources: IMF, Competitiveness Indicators System; OECD, and IMF staff estimates and projections as of Jun 12, 2017.

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.

Bank of Japan Measures of Underlying Inflation; excluding fresh food & energy.

Based on normalized unit labor costs; 2005=100.


Table 2.

Japan: Monetary Authority Accounts and Monetary Survey, 2012–18

article image
Sources: Bank of Japan; Haver Analytics, and IMF staff estimations and projections.

Projections were made using the correlation between lending and non-residential investment in the 2002–15 period.

Projections were made using the correlation between lending and residential investment in the 2008–15 period.

Defined as the ratio of credits to the private sector and net credit to other financial instituions to customer deposits.

Table 3.

Japan: External Sector Summary, 2012–18

article image
Sources: Haver Analytics; Japanese authorities; and IMF staff estimates and projections.
Table 4.

Japan: General Government Operations, 2012–18

In percent of GDP

article image
Sources: Japan Cabinet Office; IMF staff estimates and projections.

Including fines.

Fiscal year basis.

In percent of potential GDP.

Market value basis.

Nonconsolidated basis.

Table 5.

Japan: Medium-Term Projections, 2014–22

article image
Sources: Haver Analytics; Japanese authorities; and IMF staff estimates and projections.
Table 6.

Japan: Financial Soundness Indicators (FSI), 2010–16 1/

article image
Sources: IMF, Financial Soundness Indicators (FSI) database; and IMF staff estimates.

Data for these series are for Q1 of each year besides 2016 series are Q3.

Including city banks and regional banks and but not shinkin banks.

Aggregated based on a consolidated basis.

Aggregated based on an unconsolidated basis.

Including all deposit-taking institutions in Japan.

2016 series are as of 2016Q1.