Recent Economic Developments

While the Japanese economy is picking up, it faces a range of risks. With the normalization of economic and social activities and supported by unprecedented stimulus measures, the economy continues to show signs of picking up, and real GDP has nearly recovered to its pre-COVID level. However, risks and uncertainties remain significant, including from supply constraints, an external economic slowdown, are surgence of CO VID-19 variants, and commodity price volatility. Russian aggression against Ukraine is posing additional risks through soaring energy and commodity prices and supply chain disruptions.

Fiscal Policy

The Government adopted an economic package in November 2021 and the FY 2022 budget with a view to achieving a virtuous cycle of growth and distribution putting the economy back on a self-sustaining growth path. In November 2021, the Cabinet formulated comprehensive economic measures to realize a “New Form of Capitalism”, that is to achieve growth in the post-COVID society and to realize a virtuous cycle of growth and distribution. Preventing a resurgence of COVID-19 is of the greatest importance, and Japan will continue to take all possible measures to respond to COVID-19 outbreaks in a flexible manner. The November 2021 economic package included pandemic containment policies such as measures to strengthen the medical care system, and five trillion yen has been set aside in the FY2022 budget as contingency funds to address the pandemic. Aligned with staff s advice, policy support is shifting towards more targeted measures such as limiting benefits only to those businesses and households most affected by the pandemic, and facilitating resource reallocation to growing business areas by expanding job training.

The Government will advance expenditure and revenue reform to achieve the fiscal target, while working on overcoming deflation and revitalizing the economy. Due to the pandemic response, the public debt to GDP ratio is expected to be around 217 percent at end-March 2022. In addition, given the declining birthrate and aging population, Japan’s public finances face the structural challenge of an imbalance between the benefits from and contributions to social spending. Against this backdrop, the Government will pursue reforms in the social security system, which accounts for most of the future growth in expenditure. For example, from October 2022, out-of-pocket medical expenses will be raised for late-stage elderly with income above a certain level, and further reform efforts will be continued. Furthermore, we will work on improving the quality of the budget by addressing challenges posed by the one-year-budget principle. The Government will continue consolidation efforts to achieve the fiscal target of consolidated (central and local Government) primary balance surplus in FY2025.

Monetary Policy

The Bank of Japan (BO J) will continue with Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner. The year-on-year rate of change in the CPI is likely to increase clearly in positive territory for the time being due to a significant rise in energy prices, a pass-through of raw material cost increases, and dissipation of the effects of the reduction in mobile phone charges. Meanwhile, the underlying inflationary pressure is projected to increase, mainly on the back of improvement in the output gap and a rise in medium-to long-term inflation expectations. The BOJ will continue to support financing mainly of firms and maintain stability in financial markets through the Special Program to Support Financing in Response to the Novel Coronavirus (COVID-19) and other measures, while examining important sources of risks such as increased vulnerabilities from the prolonged low-interest rate environment. In order to facilitate higher corporate profits and improved labor market conditions, the BOJ will continue to persistently pursue powerful monetary easing that can generate a virtuous cycle where wages and prices see sustained increases. Regarding the staffs recommendations on monetary policy, the BOJ considers that the current framework is effective and flexible, and does not need to adjust it.

Financial Sector

Japan’s financial system has maintained stability on the whole, despite the pandemic. Regarding Russian aggression against Ukraine, while global financial and capital markets have been volatile and prices of commodities such as crude oil have risen significantly, market reactions in Japanese financial markets have been limited compared to those following the outbreak of the pandemic, and market functions have been maintained. Also, there has been no significant impact on the operations of Japanese financial institutions so far. Backed by the BOJ’s measures to support financing, the Government’s measures, and efforts made by private financial institutions, the external funding environment remains accommodative. Also, according to the results of the BOJ’s macro stress testing, Japan’s financial system is likely to remain highly robust in the case of a future resurgence of COVID-19 or adjustments in global financial markets and emerging economies due to arise in U.S. long-term interest rates. On the other hand, prolonged downward pressure on financial institutions’ profits due to the low interest rate environment and excess savings in the corporate sector could create the risk of a gradual pullback in financial intermediation. The risks of greater vulnerability in the financial system, mainly as a result of financial institutions’ search for yield behavior, also deserves attention.

As discussed in the Article IV consultation, the environment surrounding the financial sector is evolving due to digitization accelerating, demographic changes, and climate change. Against this backdrop, the Government is offering comprehensive administrative support, such as developing sustainable business models for regional financial institutions, encouraging digitalization to create user-oriented services, and attracting domestic and foreign funding for Japanese companies’ pursuit of net-zero. In addition, Financial Services Agency is developing a policy and regulatory framework for so-called stable coins. In July 2021, the BOJ published its Strategy on Climate Change and introduced Climate Response Financing Operations, disbursing loans of more than 2 trillion yen in December 2021. As staff noted in the Selected Issues Paper, further efforts are needed to strengthen climate financial risk management. Japan’s authorities will continue to strengthen and support confidence towards the financial system amid significant changes to the financial and economic environment, including from risks such as cyber-crime.

Growth Strategy and Structural Reforms

Japan has implemented various reforms under “Abenomics” and achieved significant results, despite the headwinds to growth from the declining population. Though, as noted by staff, further reforms are essential for a strong recovery and inclusive and sustainable growth. Under the “New Form of Capitalism”, Japan will update both its growth and distribution strategies and build a virtuous cycle of growth and distribution. The growth strategy will focus on digitalization, climate change, economic security, and technology and innovation. Distribution and reducing inequality will also be enhanced through raising wages, investing in human capital, and strengthening the middle-class cohort. The grand design of the “New Form of Capitalism” concept and its action plan will be published this spring.

The Government has made steady progress on structural reforms. On labor supply shortages, the Government has been reforming its labor market policies, including through promoting labor force diversification, female employment, and labor mobility along with pension system reforms. In addition, since April 2021, firms have been strongly encouraged to secure employment opportunities for older workers up to age 70. Supports for raising productivity and mitigating lab or market distortions have been expanded through “Equal Pay for Equal Work” regulations that launched in April 2020, and working time regulations in April 2019. Also, the Government will further support the trend of wage increases, such as through the expansion of corporate tax credits and minimum wage increases. As for strengthening corporate governance, Japan continues its efforts through the revisions to the Corporate Governance Code and Guidelines for Investor and Company Engagement, as well as enhancing disclosure of information regarding the proportion of females in managerial positions and sustain ability reporting. In order to improve business and investment, the Government will support business restructuring, de-regulation of employment in the agriculture sector and for foreign workers, fair sub-contracting, and striving to deliver a high-quality research environment. To attract FDI, the Government will also promote matching opportunities between foreign investors and potential recipients, simplify procedures, and enhance investor promotion. Japan will continue to lead a free, fair and rule-based international economic system, including rule-making in digital areas such as e-commerce.

Climate Change

Japan has committed to the goal of achieving net-zero by 2050. This involves reforming the energy supply structure, and promoting the transformation of the entire economy and society, including the industrial structure, individual consumption, and local communities. Japan has reduced greenhouse gas emissions for seven consecutive years since FY2014, representing an 18 percent reduction from the base year of FY2013. In order to bolster Japan’s climate change policies, the Act on Promotion of Global Warming Countermeasures was amended in May 2021, legislating the net-zero target as a basic principle. Going forward, Japan will double climate investment and promote decarbonization, while ensuring green investment is a growth driver into the future. In particular, through the development of the “Basic Guidelines on Climate Transition Finance” and the pathways to achieve net-zero by 2050 for high-emitting sectors, the Government will promote transition finance, and support high-emitting industries’ steady transition toward decarbonization. The Government will continue comprehensively analyzing climate issues such as regional decarbonization, individual lifestyle changes, green finance, and carbon pricing. The overall outlook of the transformation toward a net-zero economy and society will be presented in the forthcoming Clean Energy Strategy.

Digitalization

The Government is actively promoting digitalization with a user-centric focus and enhancing productivity to underpin the transition to a digital society. We welcome the in-depth analysis on Japan’s digitalization and policy effects in the Selected Issues Paper. The COVID-19 pandemic highlighted the effectiveness of digital technology and Japan’s lagging in digitalization. Digital technology is now an indispensable part of tackling social issues such as an aging society and rural economic decline. Against this backdrop, in September 2021, the Digital Agency was swiftly established to promote the development of rules and infrastructure from the user’s perspective. This will help to create a digital society where everyone can benefit from digital technology. The welfare of the elderly, disabled, and people in rural areas will be a high priority, especially as they are the most likely to benefit from digital services such as online medical care and autonomous vehicles. As Japan’s existing regulatory frameworks often do not meet the needs of new business models and services, the Government will review around 40,000 regulations under the guiding principle of digitalization, and encourage new markets supported by new rules in areas such as drones, autonomous vehicles, as well as in healthcare and education. Japan will also promote digitalization of administrative services, such as open data, sharing information on public platforms, and providing online services. For example, the law for registration of individuals’ public benefits-receiving account enacted in May 2021 enables prompt payment of benefits and subsidies with registered account data. The Government is also strengthening risk management and responses to cyber-attacks, addressing both user convenience and security aspects.

External Sector

We agree with staffs preliminary assessment that the projected 2021 current account (CA) balance is broadly in line with fundamentals and desired policies, and the related policy recommendations. As noted above, the Government will continue to promote fiscal consolidation as well as structural reforms. Regarding the EBA methodology, consideration of the income balance into the CA-REER elasticity separate from the trade balance is consistent with our previous arguments, and we welcome staff s recent refinements as a good start. The relationship between REER and the income balance is not significant. Thus, it would be difficult for the EBA methodology to adequately assess Japan’s current account level, where Japan’s current account surplus mainly reflects the income account surplus. The EBA model and its assumption on a strong linkage between the exchange rate and the current account balance assessment should also be reviewed.

Conclusion

Our authorities highly value their close collaboration with the Fund and look forward to deepening discussions with staff to tackle domestic and international macroeconomic challenges. Finally, the authorities wish to thank again the Mission Chief, Mr. Salgado and his team for their insightful analysis and policy discussions presented in the Staff Report.