Japan: 2023 Article IV consultation-Press Release; Staff Report; and Statement by the Executive Director for Japan

International Monetary Fund. Asia and Pacific Dept

doi:10.5089/9798400237362.002.A001

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Japan: 2023 Article IV consultation-Press Release; Staff Report; and Statement by the Executive Director for Japan

Author: International Monetary Fund. Asia and Pacific Dept

Publication Date:: 30 Mar 2023

eISBN:: 9798400237362

Language:: English

Keywords:: inflation expectation; headline inflation; upside inflation risk; wage growth; base wage; Inflation; Labor markets; Global

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1. Japan is navigating the recovery from the pandemic and the implications of the war in Ukraine. Since 2022, the government has been gradually relaxing COVID-19-related restrictions and the borders were reopened in October. Death rates from COVID-19 remain well below other advanced economies and the economic recovery is firm. Japan has been hit by the war in Ukraine as a commodity importer alongside lingering supply chain disruptions; and headline inflation has recorded levels not seen in four decades. An important challenge going forward is that the economy regains dynamism to overcome structural challenges from population ageing and low productivity growth.

Abstract

Context

1. Japan is navigating the recovery from the pandemic and the implications of the war in Ukraine. Since 2022, the government has been gradually relaxing COVID-19-related restrictions and the borders were reopened in October. Death rates from COVID-19 remain well below other advanced economies and the economic recovery is firm. Japan has been hit by the war in Ukraine as a commodity importer alongside lingering supply chain disruptions; and headline inflation has recorded levels not seen in four decades. An important challenge going forward is that the economy regains dynamism to overcome structural challenges from population ageing and low productivity growth.

2. This is occurring against a longer-term background of slow growth, muted inflation pressures for decades, large fiscal deficits, and a remarkable build-up in government debt. Japan has achieved modest real GDP growth rates since the bubble burst in the early 1990s.¹ Fiscal policy has featured persistent fiscal deficits and a steady increase in the public debt-to-GDP ratio.² CPI inflation has recorded an average of 0.3 percent since 1992, with periods of deflation especially in the early 2000s.

3. The Kishida administration started in October 2021 and aims to make capitalism more resilient and sustainable. The cabinet published the economic policy agenda on “a new form of capitalism” in June. The goal is to overcome challenges such as inequality and climate change, and to enhance economic security. Policy priorities include: (i) human capital and distribution, (ii) science, technology and innovation, (iii) start-ups and open innovation, and (iv) Green Transformation and Digital Transformation, with the latter two expanding on efforts by the previous Suga administration.

Recent Developments

4. The economy continues to recover driven by domestic demand while a weaker global economy has been weighing on external demand. Real GDP increased by 1.1 percent in 2022 and remains below the level in 2019 (on an annual basis). Private consumption led the recovery and private investment also rebounded (Figure 1). Industrial production recovered strongly during the summer as supply chain constraints due to lockdowns eased.

5. Inflation has accelerated in recent months, with more wide-spread price increases. Headline inflation has been above 2 percent y/y since April driven by external factors including the lagged effects of higher commodity prices and yen depreciation. In January, headline inflation was at 4.3 percent y/y and staff’s estimate of underlying core inflation was at 3.3 percent y/y.³ The share of price-increasing items is rising steadily as the higher cost of raw materials has been passed on to many goods and services. Survey-based medium-term inflation expectations for firms have risen above 2 percent (Figure 2, middle left) whereas households’ expectations remain around 1 percent in 2022Q4 (Annex I). Market-based inflation expectations remain well below 2 percent (Figure 2, middle right).

6. The passthrough from inflation to wages has been limited so far. Wage growth has been outpaced by inflation despite an unemployment rate at 2.5 percent, a labor force participation rate at a historical peak of 63 percent, and a steadily growing job opening-to-applicants ratio (Figure 5). The modest wage pressures reflect the outcome of the annual wage negotiations in spring 2022 in which the agreed average base pay increase was only 0.6 percent and a history of stagnant nominal wages in the last 25 years (see 2023 Japan: Selected Issues paper “Structural Barriers to Wage Income Growth in Japan”). That said, total wage growth has accelerated to 4.8 percent y/y in December, while base wage (i.e., excluding bonuses) growth was 1.9 percent y/y.⁴

7. The Japanese authorities announced a large fiscal package in late October.⁵ It was designed to cushion the impact of higher inflation on households and corporates, and to accelerate the agenda of the new form of capitalism. It included subsidies to electricity, gas, oil, and cash transfers to child-rearing households (see paragraph 18). This package was preceded by smaller ones that were adopted in April and September after the budget for FY2022 was adopted on April 1.

Japan: Fiscal Packages Released in 2022

Sources: Japan Cabinet Office, Japan Ministry of Finance, and IMF staff calculation.

^{^1/}The authorities count the fiscal measures announced in September as a part of the October package, but we categorize them as an independent one, since they were announced separately. Also, the authorities spent ¥0.3 trillion from their contingency reserve fund in July.

8. Monetary policy remains ultra-accommodative, with the recent tweak to Yield Curve Control (YCC) by the Bank of Japan (BoJ) aimed at making it more sustainable. The BoJ has underscored that monetary easing will continue unless inflation picks up durably, and that stagnant wage inflation could limit a sustainable pickup in inflation. Amidst upward market pressure on its yield cap from rising global interest rates in December, the BoJ widened the band around its zero percent 10-year Japanese Government Bond (JGB) yield target from 0.25 to 0.50 percent as well as significantly expanded its purchases of JGBs. Meanwhile, it left its short-term policy rate at minus 0.1 percent. In January, the BoJ also expanded its fund-supplying operations against pooled collateral – i.e., provision of funds to banks to indirectly push down JGB yields by incentivizing banks to invest in JGBs. Private sector credit growth remains strong at 4.5 percent y/y (end-December)—including due to firms’ elevated demand for financing amidst higher input costs and economic recovery (Figure 3)⁶.

9. Balance sheet accommodation has increased in recent months. The BoJ’s balance sheet expanded significantly in response to the pandemic—rising from 110 percent of GDP at end-2019 to 135 percent of GDP in 2022Q1. While unwinding of COVID-related special lending measures has led to a decline in the BoJ’s balance sheet and monetary base, it is being offset by a substantial increase in its quantitative easing across JGB maturities to defend its yield cap (since the Fed started to raise rates in March 2022) as well as by the recent expansion in its fund-supplying operations (Figure 3).

10. The monetary policy divergence between Japan and its peers has contributed to a large yen depreciation, triggering foreign exchange intervention (FXI) to support the yen for the first time since 1998. By mid-September, the yen had weakened by nearly 27 percent against the US dollar since the Fed started to raise policy rates in March 2022. Worried that the yen’s excessive volatility could hurt the Japanese economy, the authorities intervened to support the yen: (i) on September 22, there was a first intervention of nearly USD20 billion; (ii) in October, there were further interventions amounting to around USD43 billion. This is equivalent to 5 percent of forex reserves at end-August, with forex reserves declining to US$1.08 trillion at end-October.

11. The financial sector weathered several headwinds last year, including monetary policy tightening by other central banks and the global economic slowdown. Capital adequacy ratios of internationally active banks continue to remain well above regulatory minimums, despite valuation losses on overseas securities holdings and higher foreign currency funding/hedging costs. Common equity Tier 1 capital ratio of internationally active banks have declined by close to 1 percentage point on average from end-March to end-September 2022, while the core capital ratio (excluding unrealized valuation losses) has been flat for domestically-oriented banks. Non-performing loans ticked up only marginally (reaching 0.8 and 1.8 percent for major and regional banks as of end-September 2022, respectively). Interest rate risks on banking books are elevated, especially for smaller banks given their higher and longer-tenor JGB holdings since the start of the pandemic. The direct exposure of the financial sector to the war in Ukraine has been limited.

12. The current account surplus has narrowed significantly due to a sharp rise in the value of commodity imports. It declined to 2.1 percent of GDP in 2022 from 3.9 percent in 2021 and a 3.8 percent of GDP average in 2016-19.⁷ This is mainly driven by a deterioration in the trade balance reflecting higher commodity import prices amid Japan’s high reliance on imported energy sources, outpacing the rise in exports as supply bottlenecks gradually ease. The external position in 2022 is assessed as broadly in line with medium-term fundamentals and desirable policies (Annex II). This assessment is preliminary; a final assessment will be presented in the 2023 External Sector Report.

Outlook and Risks

13. The economic recovery is projected to continue in the near term amid pent-up demand, supply chain improvements, border reopening and policy support. Growth is expected to increase modestly to 1.3 percent in 2023 driven by private consumption and business fixed investment. The output gap is projected to close in early 2023.⁸ The consumption of services will be supported by savings accumulated during the pandemic and transfers included in the October fiscal package. Exports will rise as supply side constraints ease and inbound tourists return. High corporate profits from a depreciated yen and delays in implementing previous projects will support business investment. The primary fiscal deficit will stay elevated in 2023 following the adoption of the October 2022 fiscal package. The current account surplus is projected to bounce to an average of 3 percent of GDP in 2023 driven by lower commodity prices and inbound tourism.

14. Inflation is expected to rise further in early 2023 due to the delayed effect of yen depreciation and border reopening before declining again. Inflation is projected to peak in 2023Q1 and gradually fall below 2 percent by end-2024 as cost increases from higher import prices and a more depreciated yen wane, along with the impact of the new energy subsidies included in the October fiscal package. Amid a tighter labor market, base wage growth is expected to accelerate in 2023 but will likely stay below the level that the BoJ considers consistent with achieving the 2 percent inflation target in a sustainable manner.⁹

15. An aging and declining population will continue to be a major macroeconomic challenge in the medium and long term. Official projections anticipate the population will rapidly age and shrink by about 30 percent in the next 40 years. This will be a drag on potential growth as well as a risk to fiscal sustainability, with potential financial stability implications. Labor market rigidities also limit productivity growth and the reflation of the economy. Under baseline assumptions, headline inflation is projected to remain around 1.5 percent in the medium term, below the BoJ’s 2 percent inflation target. The current account surplus is projected to remain close to 3.8 percent of GDP, broadly corresponding to the income surplus arising from Japan’s large positive net international investment position and high net returns.

16. While domestic risks are balanced, there are significant external downside risks. Downside risks to growth include: 1) deepening geo economic fragmentation and geopolitical tensions; 2) an abrupt slowdown of the global economy; 3) commodity price volatility; 4) natural disasters and 5) cyberthreats. In addition, there are risks to the economy that could arise from any abrupt change of the current monetary policy framework. Upside risks to growth include a more robust recovery of consumption, especially services, and a stronger-than-expected recovery of inbound tourism (Annex IV). As regards inflation, risks are two-sided, albeit with the upside more prominent in the short term.

Authorities’ Views

17. The authorities broadly agreed with the Fund staff’s assessment on the economic outlook and near-term risks. Like staff, they expected real GDP growth to remain strong in 2023, before gradually converging to its medium-term potential. They expected inflation to decelerate in 2023 due to energy subsidies from the government and the waning effects of high import prices in 2022. The authorities concurred with the preliminary assessment that Japan’s 2022 external position was broadly in line with medium-term fundamentals and desirable policies.

Economic Policies

The discussions focused on the combination of policies that are needed in the near term to achieve the 2 percent inflation target durably, without overshooting significantly, while preserving financial stability, and in the medium-term to reduce fiscal vulnerabilities and transition to a more dynamic, resilient, and inclusive economy.

Near term policies: Given the high uncertainty on the inflation outlook and the narrowing output gap, more flexibility in longer-term yields should be considered. Prospectively, this could lead to a smoother transition to a neutral monetary stance, once it is clear that the inflation target will be durably achieved. Changes in monetary policy settings should be properly planned and communicated, including to reduce financial sector risks. Macroprudential and other policies should seek to curb financial sector vulnerabilities. Pandemic-related fiscal support should be withdrawn quickly, and new measures limited and targeted only to vulnerable households to avoid overheating the economy. Steps are needed to boost labor income and achieve a virtuous cycle of income and growth.

Medium-term policies: Growth-friendly and credible fiscal consolidation is necessary over the medium term to put public debt on a downward path and to rebuild fiscal buffers. Financial support measures should be limited to viable firms to prevent the survival of low-productivity firms. Labor market and fiscal reforms are warranted to raise potential growth, reduce gender inequalities, and offset the drag from fiscal consolidation. Promoting green and digital investment could help achieve climate targets and reap the benefits of the digital economy.

A. Fiscal Policy

18. The large fiscal package adopted in October 2022 could have been smaller and better designed. The package is expected to mitigate the fiscal drag for 2023 and 2024 as the effect of past stimuli measures dissipates. However, there are some concerns. First, the size of the stimulus is too large given the output gap is projected to close in 2023, while the debt to GDP is already at a high level. Second, on the composition side, the new electricity¹⁰ and gas subsidy, as well as the existing petroleum subsidy, which is being extended, are not targeted towards vulnerable households. Targeted subsidies would have had a stronger impact on GDP growth and less distorted energy consumption (Annex V). Also, the cash transfer to child-rearing households could have been targeted. Untargeted support will lead to higher household savings (see Annex VI) because of the low propensity to consume in Japan. Lastly, measures relating to needed structural reforms, such as digitalization and climate change, are limited.

19. Amid the ongoing recovery, rising inflation, tighter labor markets, and a closing output gap, fiscal policy support should be withdrawn more quickly. The combination of the fiscal packages and the budget for FY2023 will result in a primary deficit of 6.2 percent of GDP in 2023. Although Japan still has some fiscal space in the near term, the stimulus measures lead to a further narrowing of that space. Amid resilient private demand and a closing output gap, the projected fiscal support in 2023 will have very limited impact in further raising output and instead would aggravate fiscal vulnerabilities. Moreover, it could add to inflation, which would require a stronger monetary tightening response, increasing the cost of fiscal financing and worsening the debt dynamics (Section D). Staff recommends a significantly faster consolidation in 2023 compared to the baseline mainly by unwinding the non-targeted transfer measures with a fiscal multiplier of 0.1¹¹, and a more significant consolidation over the medium term (see Text Figure below). As government spending pressures continue to rise in certain policy areas, such as national security, green transformation, and child-related policies, any additional spending measures should be targeted to low-incomes and come hand in hand with revenue raising measures.

20. Under current policies, the public debt-to-GDP ratio will increase steadily in the medium and long term (Annex VII). The primary deficit in percent of GDP is projected to decline in the near term as the stimulus measures phase out, but to rise in the medium and long term to accommodate age-related spending pressures, especially for health and long-term care. The interest-growth differential is projected to become less favorable as a declining working age population weighs on potential growth. Against this backdrop, with the public debt-to-GDP ratio on an upward path, interest rates could increase suddenly, and sovereign stress could emerge.

21. Fiscal consolidation is warranted to rebuild fiscal buffers and ensure debt sustainability over the medium to long term. This should be underpinned by a credible medium-term fiscal framework to reduce the primary deficit and put the debt-to-GDP ratio on a clear downward path. The following measures could help bolster the credibility of the fiscal framework:

Adopting realistic projections. GDP growth rates and fiscal balances projected by the Cabinet Office biannually have historically been too optimistic, particularly those under the high-growth scenario. The recent practice of including more realistic assumptions and implementing sensitivity analysis based on lower potential growth are steps in the right direction. However, more realistic scenarios are still warranted especially when discussing medium term fiscal targets. A fiscal council could be tasked to evaluate the realism of macro-projections provided that it has operational independence and resources commensurate to their remit.
Strengthening the fiscal framework. Budget expenditures ceilings do not limit actual government expenditures given the established practice of adopting supplementary budgets. This practice breaks the link between the annual budget and medium-term fiscal targets. The budget process should be reformed so that budget expenditure ceilings are binding, budget documents explain how the budget is consistent with achieving medium-term fiscal targets, fiscal targets are underpinned by specific measures, and supplementary budgets are formulated only when unexpected large shocks occur.
Balancing debt sustainability while protecting growth. The authorities should continue to assess progress towards the FY2025 primary balance target, weighing fiscal consolidation against the need to provide fiscal support to preserve growth if adverse shocks materialize (see 2022 Japan: Selected Issues paper “Post-Pandemic Fiscal Policy: Implications from the Buffer-Stock Model of Government).

22. Fiscal consolidation requires both revenue and expenditure measures. Japan has relatively low tax revenues and relatively high age-related spending compared to peers. The increase in government spending in the last 30 years is accounted for by social security. In this context, fiscal consolidation should include:

Policies to contain health and long-term care. Nozaki and others (2017) show that spending in these areas could increase to 14 percent of GDP by 2030. Possible measures include a mix of reforms to: (i) improve spending efficiency (e.g., more use of generic drugs, shorter duration of in-patient care, enhanced market-based drug pricing) and (ii) target measures (e.g., higher copayments for high-income seniors, limiting the scope of covered services and drugs). These measures could help contain the age-related expenditure while preserving the excellent health outcomes already achieved by Japan’s healthcare system.
Policies to increase government revenues. Options for raising revenues include: unifying and increasing the consumption tax standard rate; strengthening property taxation by removing the preferential treatment of residential land; rationalizing allowances and deductions in personal income taxation; increasing the capital income tax rate; and increasing premiums of social insurance (see 2022 Japan: Selected Issues paper “Options for Revenue Mobilization”).
Policies to strengthen the safety net. There seems to be a clear gap in the safety net for the working poor (see 2023 Japan: Selected Issues paper “Options to Strengthen the Safety Net in Japan”). In that context, an earned income tax credit (EITC) scheme, which provides tax credits for low-income earners, could be considered in Japan since it plays an important role in many advanced economies for poverty reduction while enhancing labor participation. An EITC would also help to rationalize existing untargeted transfers.

Authorities’ Views

23. The Ministry of Finance agreed on the need for a withdrawal from special supporting measures coping with the economic downturn and difficulties caused by COVID-19. Officials stressed that progress has been made in the withdrawal from COVID-related measures, including the termination in January of the temporary expansion of the Employment Adjustment Subsidy. The energy subsidies will be terminated this fall to help proceed with their decarbonization initiative. They added that the withdrawal from these supportive measures should be carefully undertaken in a growth-friendly manner.

24. They concurred on the need for fiscal consolidation in the medium to long term amid rising spending pressures. There is currently a planned increase in expenditure on national security, green transformation, and child-related policies. However, the concrete offsetting revenue measures are not yet finalized, such as the timing of the introduction of tax measures for national security and the details of growth-friendly carbon pricing. The Ministry of Finance agreed that any additional spending measures should be targeted and accompanied by revenue measures. On Japan’s fiscal framework, they acknowledged the argument that the practice of adopting supplemental budgets undermines fiscal discipline, which should be strengthened to put public debt on a downward path. They emphasized the necessity to work on achieving their medium-term fiscal target, while recognizing that policies should not be constrained by the current timeline to reach neutral primary balance by FY2025, and that the adoption of necessary policies can be consistent with achieving the fiscal consolidation target.

25. They stressed that fiscal structural reforms are in progress. These reforms included the further expansion of the employees’ health/pension insurance coverage to part-time workers last October. Also, they noted that information sharing among the central and local governments needs to be improved to make fiscal transfers more timely and better targeted.

B. Monetary Policy

26. An accommodative monetary policy stance remains appropriate but needs to be supported by other policies to achieve the 2 percent inflation target sustainably. With higher inflation, monetary policy is now more accommodative as measured by the gap between the actual and natural short-term interest rate. While an overall accommodative stance is helping stimulate domestic demand, without a more substantial acceleration in wage growth, inflation will fall below the 2 percent target by end-2024, as the effects of cost increases led by the rise in import prices and a more depreciated yen are likely to wane. It is thus necessary to simultaneously implement other policies to raise households’ purchasing power through improvement in wages, in line with the inflation target (see 2023 Japan: Selected Issues paper “Structural Barriers to Wage Income Growth in Japan”).

27. Nonetheless, there is exceptionally high uncertainty around baseline inflation projections with both upside and downside risks. Notwithstanding a long history of very low inflation, in the near term, upside risks to inflation are more prominent amidst a narrowing output gap and lower real interest rates. These include upside price pressures from delayed effects of yen depreciation, border reopening, second round effects of imported inflation, fiscal support, and higher-than-expected wage growth. Staff estimates that a 10 percent depreciation would lead to a 0.7 percent increase in the CPI level after three to four quarters. Moreover, border reopening is expected to boost services consumption and tighten the labor market. In addition, Japan’s largely backward-looking inflation expectations could prolong high inflation once it emerges. Downside risks arise mainly from a slowdown in the global economy along with rigidity in inflation expectations and prolonged weak wage growth due to structural factors in the labor market.

28. To better manage the two-sided risks around inflation, more flexibility in longer term yields should be considered. If inflation pressures appear more persistent, with sustained increase in nominal wage growth and economic recovery, more flexibility would automatically allow for a rise in long term rates. Prospectively, this could lead to a smoother transition to a neutral monetary stance once there is stronger evidence that the inflation target has been durably achieved. At the same time, it would also make monetary policy nimble in case further easing is warranted if for example a global recession materializes. Allowing such flexibility, while still underscoring the commitment to keeping the current negative policy rate unchanged until the 2 percent target is durably achieved would help avoid abrupt changes later. At the same time, providing clear guidance on the pre-conditions for a gradual policy rate lift off would help anchor market expectations and strengthen the credibility of BoJ’s commitment to achieving its inflation target.

29. This could also help address the mounting costly side-effects of prolonged easing. Given the BoJ’s outlier stance as other central banks normalize, market participants have continuously challenged the upper ceiling of the 10-year JGB yield target under the YCC framework. This market pressure has continued even after the December decision to widen the 10-year target band to +/-50 bps. In response, the BoJ has purchased large amounts of JGBs in recent months and it now holds close to 82 percent of outstanding 10-year JGBs as of mid-February, an increase of 15 percentage points since the Fed tightening cycle began in March 2022. These purchases have reduced liquidity in the JGB market, with market surveys indicating a sharp deterioration in bond market functioning since May. With markets repricing a higher U.S. terminal policy rate, there is a risk that pressures on the 10-year JGB upper ceiling target could increase, requiring additional intervention by the BoJ. Moreover, the yield curve has become distorted—the JGB yields of 8-9-year maturities have risen above that of the 10-year, and there is a sharp rise in yields for JGBs longer than 10-year maturity.

30. The impact on real activity of changes in the long-term rates would be smaller than those in the short-term rates¹²—hence, lowering potential risks of derailing the economic recovery and achieving price stability goals. This would also help reduce the degree of balance sheet accommodation, as the BoJ will likely need to purchase fewer JGBs. As of January 2023, about 80 percent of the BoJ’s total assets are composed of JGBs, followed by 5 percent of Exchange Traded Fund (ETFs) and 2 percent combined of equities, Real Estate Investment Trusts (REITs), corporate bonds and commercial paper. Moreover, allowing higher longer-term rates and reducing the size of the balance sheet before raising the short-term policy rate could help lower risks to the BoJ’s balance sheet–i.e., from a negative yield spread between assets and liabilities.¹³

31. In this context, the BoJ could consider the following options to allow further flexibility and increases in long-term yields— widening the 10-year target band and/or raising the 10-year target, shortening the yield curve target, or shifting from a JGB yield target to a quantity target of JGB purchases. While each of these options could allow higher long-term yields, and thus could imply some policy tightening, keeping its policy rate unchanged until the 2 percent target is durably achieved would keep monetary policy highly accommodative. The BoJ would need to carefully assess the pros and cons of each strategy. For instance, further widening the 10-year band around the yield target would entail a minor adjustment to the current YCC framework, however the fluctuation range will have to be wide enough for market forces to play a leading role thus minimizing the need for continued BoJ intervention. On the other hand, moving to a quantity-based approach instead would not entail defending a particular yield level and the side-effects that come with it, however the quantity of the BoJ’s JGB purchases would need to be state-contingent and adjusted if yields moved up too rapidly (such that it could impair financial stability). Lastly, moving to a shorter-term yield target would help ensure that the short-term yields (which matters more for real activity) continue to stay low until the 2 percent target is durably achieved, but the BoJ may face similar costly side-effects that come with targeting a particular yield level. Moreover, in the scenario that the upside inflation risk materializes sooner than expected, monetary stimulus withdrawal will have to be much stronger–short-term rates may have to rise much earlier and above the neutral rate to anchor inflation back towards its 2 percent target (Section D).

32. FXI was triggered by the volatility of the yen. While the yen depreciation since March 2022 largely reflects interest rate differentials, empirical analysis suggests that the exchange rate has depreciated more than implied by underlying drivers since June. In general, FXI could help lower “excessive” volatility and keep the pace of the yen’s depreciation better aligned with fundamentals and well-functioning markets, but its effects are likely temporary (Annex VIII). In principle, fluctuations in the exchange rate help absorb shocks. Hence, use of FXI should be limited to special circumstances such as disorderly market conditions, risks to financial stability because of sharp yen movements, and/or concerns that currency movements could de-anchor inflation expectations.

Authorities’ Views

33. The BoJ emphasized two-sided risks to inflation and stressed the need to stick with the current monetary framework and settings. Although they acknowledged that Japan could be at an inflection point when it comes to inflation, they project tepid wage growth, which stands in the way of achieving the 2 percent target in a sustainable manner and allows time to adjust monetary policy gradually once needed. Amid downside risks to inflation and a protracted battle to break decades of a “deflationary mindset", the BoJ’s key priority is to avoid a premature exit from monetary easing.

34. The BoJ is confident that the recent measures and modifications to the conduct of the YCC will help improve market functioning while maintaining accommodative financial conditions. Widening the 10-year yield fluctuation band will allow for more market-driven interest rates and should not be misconstrued as a move towards tightening. This combined with scaling up of the BoJ’s fixed-rate JGB purchase operations across various maturities would encourage a smoother formation of the entire yield curve. Enhancement of the funds supplying operation against pooled collateral in January would allow the BoJ to push down longer-term interest rates without needing to directly purchase bonds.

35. The authorities emphasized that the FXI conducted in 2022 was aimed at addressing excess volatility, and that their action was effective in this regard. They pointed out that the yen’s depreciation at that time was rapid and one-sided, and that speculative trading was behind such moves. They noted that the FXI was clearly in line with international norms of exchange rate policy as agreed at G7, G20 and IMFC, particularly in the sense that it didn’t target any exchange rate level. Moreover, they stressed that the Ministry of Finance (MoF) and BoJ pursue different policy objectives, with the BoJ aiming for domestic price stability while MoF responsible for exchange rate stability, and thus there is no inconsistency between the FXI by MOF and the BOJ’s monetary policy stance.

C. Preserving Financial Stability

36. While the financial sector has been robust to several global headwinds this year, risks have increased amid monetary policy tightening in other peer economies and the slowdown in global economic activity. Major internationally-active banks have increasingly been relying on more stable foreign-currency funding sources since mid-2010s (by lengthening the tenor of cross-currency swaps and strengthening the dollar deposit base), and steady efforts to further improve resilience to US dollar liquidity stress are warranted, including continuing to assess risks due to unused committed foreign currency credit lines at elevated levels. Amid the global slowdown and potential escalation of geopolitical risks, overseas credit risks, especially for leveraged borrowers, require close monitoring. Moreover, a global slowdown could weigh on large domestic customers.

37. Overseas exposures also weighed on non-bank financial institutions (NBFIs), in part mitigated by the yen depreciation. Against the backdrop of ultra-low domestic yields for long, life insurers and pension funds had been significantly increasing their overseas holdings over the past decade to help boost returns, and in turn are exposed to the sharp changes in overseas market valuations. Although the Japanese Government Pension Investment Fund (GPIF) had negative investment returns in 2022, cumulative investment returns rates remain well above long-term targets, given its diversified portfolio and prudent investment strategies. Life insurers’ statutory solvency margins remain well above regulatory minimums on average, though global headwinds weigh. Amid rising overseas yields and currency hedging costs, life insurers, along with banks, incurred valuation losses on securities holdings and reduced their overseas bond holdings significantly potentially contributing to the rise in overseas yields. They reportedly lowered hedging and re-allocated some of their overseas allocation toward riskier assets.

38. Credit imbalances, measured by BIS credit-to-GDP gap, are high by historical standards, in part driven by the sharp drop in GDP at the outset of pandemic. The credit-to-GDP ratio is nearly 25 percent above its one-sided long-term trend (as of March-2022) and is still 16 percent net of corporate savings. Credit imbalances often point to less efficient monitoring of risks and macro-financial vulnerabilities (Annex IX), and hence calls for closer scrutiny. The recent expansion in credit is driven by increasing loans to corporates (nearly half of which are publicly guaranteed) as well as housing and commercial real estate loans. The growth in housing loans, albeit moderate compared to international peers, continues to be above its historical trend since the pandemic. Authorities should remain vigilant to potential vulnerabilities that may arise due to the large fraction of floating-rate mortgages (which are typically linked to short-term market rates), increasing loan-to-income ratios, and the rising share of borrowers with high debt servicing ratios. Macroprudential policies aiming to curb vulnerabilities from growth in housing loans could be considered. The recourse nature of mortgage lending could mitigate risks to lenders, though could imply adverse impact on household consumption if risks materialize. Moreover, real estate property acquisitions by foreign investors reached highest levels since over one-and-a-half decade, and could imply higher exposure to developments in foreign real estate markets going forward. Continued vigilance on credit risks that may arise as pandemic-era support measures taper and reducing the public credit guarantee ratio for new loans (to encourage better risk assessment by lenders going forward and mitigate risks arising from lending to potentially unviable firms are warranted (see also Japan - 2022 Article IV Staff Report). Finally, credit risks that may arise from firms with limited ability to pass rising raw material costs to sales prices require close monitoring.

39. The recent collapse of FTX has brought to the forefront potential hidden vulnerabilities in the crypto universe. Continued vigilance on risks, including vulnerability to runs and wider spillover effects, and greater transparency by exchanges of their reserves and balance sheets is warranted. The FSA has assessed the money laundering/terrorism financing (ML/TF) risks presented by crypto assets as high and passed legislation, expected to be in effect in 2023, on crypto asset transfers in line with the “travel rule” imposed by the FATF standards.

40. The direct exposure of the financial sector to the Russia-Ukraine conflict region is limited. Japanese banks’ claims on Russia and Ukraine prior to the War had been limited (about 9 billion US dollars, or less than 0.2 percent of total claims of banks in Russia). Japan-domiciled investment funds also have a low exposure to Russian assets, with less than 0.1 percent of their net asset values. Indirect effects via its contribution to a global economic slowdown and exposure to more affected regions, and elevated cyber risks warrant attention.

41. Overall, risks to financial stability appear higher compared to last year. This reflects the significant increase in overseas interest rates, the global economic slowdown, interest rate risk on some banking books at elevated levels, and credit growth continuing to be above its historical trend with some signs of build up of risks.¹⁴

42. The FSA’s continued efforts to strengthen supervision and regulation in line with the 2017 FSAP recommendations are welcome (Annex X), including broadening the scope of systemic risk assessment, further strengthening the foreign currency liquidity stress testing framework, revamping the “Early Warning System” to timely identify banks with medium-term profitability concerns, and transition to the economic-value-based solvency regime for insurers.

Microprudential supervision and regulation. Banks should enhance their risk management and capacity to harness the potential benefits of expanding into new business areas allowed by recent amendments to the Banking Act, including those that aim to support revitalization of regional economies. The pandemic-related policy support should be unwound as the recovery gains further traction to avoid delaying materialization of credit risks and enhance banks’ assessment of viability of borrowers.
Macroprudential supervision and regulation. Closer monitoring of market risks by the FSA is timely, and planned efforts to further strengthen risk monitoring of NBFIs and their interconnectedness with banks and other financial institutions is welcome. The FSA should continue to broaden the scope of systemic risk assessment and enhance its macroprudential toolkit available to address risks as they emerge.
Transition to economic-value based solvency regime for life insurers. Incentivized to match the duration of their assets and liabilities under the new solvency regime to be in effect in 2025, life insurers with low fee incomes may choose to employ leverage-based investment strategies. Going forward, close monitoring would be warranted if any vulnerability is built up in the medium-term horizon.

Authorities’ Views

43. The authorities broadly agreed with the Fund staff’s assessment. The FSA and the BoJ noted appropriate risk management by banks and non-bank financial institutions. The FSA has enhanced its market risk divisions and enlarged its dedicated teams monitoring not only major but also some regional banks. Authorities do not assess risks to housing loans as a significant concern at this time, given that the mortgage market is mostly bank-based in Japan unlike some other jurisdictions and well supervised, and the delinquency rate has remained low. Banks also set aside sufficient level of capital including for risks arising from mortgage loans. The BoJ expects no major change in corporate loan delinquencies going forward as pandemic-related support measures unwind. The FSA assesses risks from the FTX failure posed to Japan as limited, underlining that crypto asset trading platforms are registered and supervised at the FSA, and the law requires them to segregate customers’ asset properly. The FTX failure however highlights the importance of cross-border cooperation going forward.

D. Alternative Scenario: Sustained Inflation Pressures

44. In the alternative scenario, we consider the case where headline and core inflation reach 5 percent by early 2024, driven by higher-than-expected wage increases. Persistently high inflation would require fiscal, monetary, and financial policy responses.¹⁵

45. A much stronger monetary tightening response would be warranted to bring inflation back to the target. Given Japan’s highly backward-looking formation of inflation expectations, inflation will likely stay higher for longer and will need a much stronger monetary tightening response. Both short-term and long-term interest rates will have to rise–pushing interest rates above the neutral rate by mid-2024 resulting in a larger contractionary impact on the economy in comparison to when there is less inertia in expectations formation¹⁶–which would bring inflation down to the target by late-2025 (Text Figure).¹⁷, ¹⁸ Nonetheless, the BoJ may be constrained in normalizing policy too quickly especially given that the current stance is still far from its neutral rate. In this regard, the BoJ may need to implement targeted and temporary measures while tightening to ensure sufficient liquidity support and ensure proper market functioning.¹⁹

46. Fiscal policy should also respond if inflation is persistently above target. Faster withdrawal of pandemic-related spending would be warranted to dampen domestic demand. As interest rates rise, the cost of borrowing may increase and the transfer of BOJ profits to the government may decrease, worsening the debt dynamics and strengthening the case for fiscal consolidation. Targeted transfers could be made to mitigate adverse effects on the economy and protect the vulnerable, which would offset the fiscal withdrawal while avoiding inflationary pressure. Government spending should focus on priority areas, such as on green and digital transformation.

47. Any changes to YCC would have short and medium-term financial stability implications that should be monitored, and the authorities should be ready to intervene to preserve financial stability:

Domestic banks have increased their JGB holdings during the pandemic, in part driven by significant deposit inflows against the backdrop of pandemic-era fiscal stimulus, exposing them further to movements in JGB yields. While an increase in JGB yields could entail valuation losses on banks, with likely stronger losses for smaller banks compared to their capital, a steepening of the JGB yield curve will tend to improve banks’ profitability, as historically, lending margins improve with a steeper yield curve (see 2023 Japan: Selected Issues paper “JGB Yield Curve and Macro-Financial Stability: How would a steeper JGB yield curve affect bank profitability?”). Banks that have reduced duration risk would be better positioned to absorb the short-term negative impact on bond valuations.
Leveraged financial institutions with hedging strategies that cannot absorb large changes in yields may in principle feed an adverse loop of rising yields and deleveraging. An orderly change in yields is key and a proper assessment of risks on this front requires availability of high-quality data. According to the latest Financial System Report, Japan’s pension funds follow simple investment strategies without leverage.
A rise in short-term domestic interest rates could pose risks to households, amid higher loan-to-income and debt service-to-income ratios and high share of variable rates for mortgage loans.
Finally, a rise in JGB yields could have global spillovers, affecting overseas yields through portfolio rebalancing by international investors with implications for overseas financial and macroeconomic conditions (Annex XI).

Authorities’ Views

48. The BoJ views the likelihood of staff’s alternative scenario as highly unlikely, given labor market structural constraints that would limit a significant acceleration in wages. They are more concerned about a scenario where a global recession pushes Japan back into a low inflation/deflation environment. Nonetheless, they noted that once the 2 percent inflation target is expected to be achieved in a sustainable manner, modification of YCC could be possible. Risks of disruptions to the market from modifying YCC would be contained–given Japan’s low neutral rates and stock effects of BoJ’s large JGB holdings–which would help avoid large swings in sovereign bond yields.

49. The authorities broadly concurred with staff’s assessment on potential financial stability implications of higher domestic interest rates. The FSA highlighted that they have further strengthened market risk monitoring for both major and some regional banks amid the recent increase in yields and that NBFIs follow relatively conservative investment strategies unlike some other jurisdictions--which would limit potential amplification effects. The BoJ assessed housing market financial stability risks to be limited given historically low mortgage delinquency rates in Japan. The BoJ also pointed out that a potential rise in short-term rates could benefit floating-rate mortgage lenders.

E. Supporting the New form of Capitalism

The reform priorities under the new form of capitalism are in line with past recommendations to ensure a green, inclusive, and sustainable recovery in Japan. However, the detailed implementation plans are still being prepared and warrant fleshing out. A credible and decisive push on reforms along the lines indicated below is crucial to boost Japan’s potential growth.

Achieving the Virtuous Cycle of Income and Growth

50. Despite significant growth in hourly wages in the last decade, average monthly earnings have declined since 2000 in real terms. The decline in monthly income mainly reflects the rise of part-time workers and their declining hours (see 2023 Japan: Selected Issues paper “Structural Barriers to Wage Income Growth in Japan”). More women started working part-time partly thanks to improved childcare options, and seniors increasingly worked after retirement partly due to higher pension eligibility age. Although hourly wages have increased sharply among part-time workers, various benefit policies for dependent spouses imposed an implicit cap on women’s monthly income, such as the spousal deduction and the exemption of social security contributions. Such an implicit income cap has also reduced the effect of various minimum wage hikes and worsened the labor shortage, as women had to cut hours to stay below the income threshold to get such benefits. In general, the stagnant income level has weakened domestic demand and compromised the reflationary efforts by the authorities.

51. Raising labor income will help reinvigorate domestic demand and lift growth, which in turn would increase labor income, forming a virtuous cycle and helping achieve the 2-percent inflation target durably. The government’s new form of capitalism policies to boost income growth should focus on three dimensions: labor supply, wage growth, and labor productivity.

First, policies should continue to boost female and senior labor supply. To encourage more women to join the labor force, it is essential to advance the work-style reforms, including through telework.²⁰ Working from home during the pandemic has induced husbands to increase household production and allowed working mothers to put in an additional eight hours or more per week according to a recent study.²¹ Flexible work arrangements could help women retain their full-time jobs at childbirth and improve their career prospects. The social security and tax distortions related to dependent spouses should also be eliminated to allow for voluntary increases in working hours. Further removing obstacles to the employment of older persons would improve labor supply.
Second, the government can encourage higher wage growth through structural reforms. Reducing labor market duality and improving mobility can enhance workers’ bargaining power and speed up wage growth. Shifting to job-based employment and to merit-based pay will support wage growth.
And third, strengthening the workforce in STEM fields could enhance innovation, facilitate digitalization, and raise labor productivity. Japan is experiencing a slowdown in innovation and digitalization. A binding constraint cited by companies in pursuit of digital transformation is the shortage of skilled tech professionals. Compared to other OECD countries, the share of workers in Japan with ICT backgrounds is one of the lowest. The shortage in the talent pool is partly driven by the relatively low pay of tech professionals under Japan’s seniority-based promotion system. Women in Japan are also more under-represented in STEM fields compared to other advanced economies (see 2023 Japan: Selected Issues paper “A New Growth Engine for Japan: Women in STEM Fields”). To raise labor productivity, policies should strengthen training and reskilling in STEM fields for existing workers, and encourage more students to pursue STEM careers, especially among women. Raising the returns to STEM education, including through merit-based promotions and flexible work arrangements, can help achieve that goal. The work style reform since 2018 and the recent requirement to publish gender pay gaps can help in this regard.

Accelerating Startups and Open Innovation

52. Promoting startups in Japan requires a holistic approach to address the constraints in the labor market, as well as improving the financing options and entrepreneurial education. The “grand design of the new form of capitalism” includes measures to support venture capital, such as through public capital investment. In addition, it recognizes the constraint of personal guarantees on entrepreneurship, highlights the importance of entrepreneurial education, and strengthens the role of universities as startup hubs. Better availability of venture capital equity funding is crucial to support startups and innovation. Reduced personal guarantees could help encourage entrepreneurship and allow unproductive firms to exit, which could in turn support investment and innovation, generate employment, and improve productivity. Furthermore, a more flexible labor market and a gradual shift from the lifetime employment system could encourage the most talented college graduates to venture and create new companies and have a reasonable backup option in case startups fail (Annex XII).

53. The government can encourage corporate investment and innovation through tax incentives. Staff analysis suggests that Japanese firms are holding more cash due to their increasing share of intangible capital in the presence of financial frictions (see 2023 Japan: Selected Issues paper “Drivers of Corporate Cash Holdings in Japan”). Since intangible capital, such as patents, trademarks and other intellectual property, is hardly collateralizable, firms need to hold more cash for future investment and innovation. To encourage firms to invest, fiscal incentives can be used to increase the return to investment, especially in ICT technology and R&D.

Transitioning to a Low-Carbon Economy

54. Japan is exposed to risks associated with climate change (see 2022 Japan Article IV report). Japan’s exposure to climate-driven hazards is above average for advanced economies. A mitigating factor is Japan’s high adaptive capacity to natural disasters. The planned transition to net zero greenhouse gas (GHG) emissions by 2050 will require a substantial transformation of the Japanese economy, presenting risks and opportunities to businesses, and associated policies will have distributional consequences that need to be well managed to maintain support for emission mitigation, reduce the risk of disorderly adjustment, and protect vulnerable parts of society. High reliance on fossil fuels for energy production implies a challenging transition and the need for large investments in alternative energy sources.

55. Japan’s commitment to achieving net zero emissions by 2050 with an upgraded interim target for a 46 percent reduction in GHG emissions by 2030, relative to 2013 levels, is welcome. As the seventh largest emitter of GHGs, Japan’s contributions to reducing global emissions are important. The country’s green transformation strategy currently is centered around investment in decarbonization, green technology, and measures to incentivize private funding for green projects. The government is committed to expanding carbon pricing from current low levels beginning in FY2028. They plan to rely on both emission permit auctions and surcharges, with details yet to be decided. Revenues from carbon pricing will be used to service green transformation bonds, which will fund public green investment. The government plans to restart nuclear power plants, and the development of new facilities is under consideration. On climate finance, the FSA has published the “Supervisory Guidance on Climate-related Risk Management and Client Engagement". In addition, the BoJ and FSA have completed a pilot scenario analysis exercise on climate-related risks with major banks and insurers, and the BoJ has disbursed about 0.6 percent of GDP to banks in its funds-supplying operations to support climate finance.

56. Japan will need additional policies to reach its climate targets. A comprehensive policy package with green investments to decarbonize electricity and transport, the largest sources of emissions, and gradually rising carbon pricing could help Japan to achieve its targets in a growth-friendly way (see 2022 Japan: Selected Issues paper “Japan: Climate Change Policy Options”). Without higher carbon pricing it would be difficult and more costly to achieve the targets. Regulatory actions and the elimination of untargeted subsidies for gas, electricity, and fuel would also support the transition.

57. Climate policies should be underpinned by measures to protect vulnerable people and enable an orderly transition of high emission sectors to low carbon. While firms on average would be able to absorb even a high carbon tax of $150 per ton of CO2, a significant percentage of financially weaker firms concentrated in high emission sectors (energy, utilities, materials) could be at risk (see 2023 Japan: Selected Issues paper “The Financial Impact of Carbon Taxation on Corporates”). To minimize the risk of a disorderly adjustment, policies should be designed to help high-emission sectors to begin the transition without delay including through clear carbon pricing pathways and transition finance support. Green finance should continue to play a supporting role for the transition through funding of green and transition activities, and appropriate management of climate financial risks. Vulnerable households should be protected with targeted transfers.

Continuing the Digital Push and Other Reforms

58. The Digital Agency should continue to coordinate and implement policies to digitalize the public sector. Significant progress has been made, including by expanding the coverage of the “My Number” digital ID cards. However, data sharing between government agencies is still limited, impairing the government’s ability to conduct targeted transfers to vulnerable households, which the government’s policy to standardize local government IT systems and facilitate information sharing among the central government and local governments will help address. Other priorities outlined by the Digital Agency such as further expanding the coverage of “My Number” digital ID cards and linking them to the provision of public and private services are also essential to ensure an inclusive digital transformation. Policies should also support a safe and inclusive digital transformation of the private sector, including by enhancing training on IT skills, ensuring data privacy, digital literacy, consumer protection, and cybersecurity.

59. Reform efforts in other areas, such as corporate governance and trade policies, should continue.

The Corporate Governance Code was revised in June 2021 to enhance board independence, promote diversity, and focus on sustainability and Environment, Social, and Governance (ESG). Building on recent progress, corporate governance reforms could be further strengthened by ensuring effective corporate governance practices and disclosure.
Japan has taken a lead globally and regionally to promote more open, stable, and transparent trade policies. Japan should continue to work actively with international partners to strengthen the rules-based multilateral trading system, including ensuring effective WTO dispute settlement.

Authorities’ Views

60. The authorities welcomed staff’s recommendations on labor market reforms. They acknowledged distortions in the current social security system that discouraged second income earners and have introduced measures to expand the employee’s insurance coverage to part-time workers. On labor mobility, they planned to encourage workers to take second jobs, but noted that firms’ life-time employment model was based on preferences of employees and employers and not due to labor laws. They appreciated the proposal to promote women in STEM fields and concurred with the need to reduce explicit and implicit gender gaps.

61. The authorities are committed to accelerate startups and deepen digitalization. The authorities intend to increase the amount of investment in startups by more than tenfold through the startup development five-year plan. The authorities noted that significant process has been made by the new Digital Agency, including by expanding coverage of the “My Number” digital ID cards. Other initiatives such as “the Vision for a Digital Garden City Nation” are aimed to achieve rural-urban digital integration and transformation.

62. The authorities are developing policy measures to achieve their emission reductions targets. The decarbonization of energy production is a priority and they expect to achieve this through expansion of renewable energy, a full restart of nuclear power plants, and investment in hydrogen and ammonia. The authorities are committed to further strengthening climate-related financial risk assessment and management and to developing green financial markets to support the transition to net zero emissions.

Staff Appraisal

63. Japan’s economic recovery is expected to continue, supported by pent-up demand, supply chain improvements, border reopening, and policy support. Following more wide-spread price increases in recent months, inflation is expected to rise further in early 2023, reflecting the delayed effect of yen depreciation and border reopening. The primary fiscal deficit is expected to stay elevated this year, following the adoption of last October’s supplementary budget. The current account surplus is expected to improve this year, driven by lower commodity prices and inbound tourism. The external position is preliminarily assessed as broadly in line with medium-term fundamentals and desirable policies. While domestic risks are balanced, there are significant external downside risks to growth. While risks to inflation are two-sided, upside risks are more prominent amidst a narrowing output gap and lower real interest rates.

64. Pandemic-related fiscal support should be withdrawn more quickly, and fiscal consolidation is warranted to rebuild fiscal buffers and ensure debt sustainability. As government spending pressures continue to rise in certain policy areas, any additional spending measures should be targeted to the vulnerable and come hand in hand with revenue raising measures. Under current policies, the public debt-to-GDP ratio will increase steadily in the medium and long term to accommodate age-related spending pressures. Growth-friendly fiscal consolidation should be underpinned by a credible medium-term fiscal framework to reduce the primary deficit and put the debt-to-GDP ratio on a clear downward path. Policy efforts should include both revenue and expenditure measures to contain the costs of health and long-term care, improve revenue mobilization, and strengthen the social safety net for the working poor.

65. While an accommodative monetary policy stance remains appropriate, more flexibility in longer term yields would help better manage inflation risks. This could also help address the costly side effects of prolonged easing. Providing clear guidance on the pre-conditions for a gradual policy rate change in the future would help anchor market expectations and strengthen the credibility of the BoJ’s commitment to achieving its inflation target. Well communicated changes to monetary policy settings will facilitate smoother transitions and protect financial stability. The exchange rate should act as the main shock absorber, with FXI limited to special circumstances including disorderly market conditions.

66. The financial sector has been robust to several global headwinds this year, but interest rate and credit risks have increased and warrant close monitoring. The banking sector remains resilient, with capital adequacy and liquidity ratios above regulatory requirements. Valuation losses on overseas securities holdings and higher foreign currency funding/hedging costs have weighed on bank and non-bank financial institutions. Steady efforts to further improve the resilience to US dollar liquidity stress are warranted, as well as a close monitoring of the credit exposures to leveraged overseas borrowers and large domestic borrowers. Furthermore, macroprudential policies aiming to curb vulnerabilities from growth in housing loans could be considered.

67. Structural policies should help boost income growth, support startups, deepen digitalization, and achieve climate targets. Labor market policies should encourage more women and older persons to join the work force, reduce labor market duality, improve mobility, and strengthen the workforce in STEM fields. Accelerating startups requires improved access to venture capital funding and entrepreneur education, more dynamic firm entry and exit with reduced personal guarantees, and additional flexibility in the labor market. The Digital Agency should continue to coordinate and implement policies to digitalize the public sector. Policies should also support a safe and inclusive digital transformation of the private sector. Higher carbon pricing could help Japan to achieve its targets in a growth-friendly way but should be companied by measures to protect vulnerable people and enable an orderly transition of high emission sectors to low carbon.

68. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

^{Table 1.}

Japan: Selected Economic Indicators, 2019-24

Sources: Haver Analytics; OECD; Japanese authorities; and IMF staff estimates and projections.

^{Table 1.}

Japan: Selected Economic Indicators, 2019-24

	2019	2020	2021	2022	2023	2024
Nominal GDP: US$ 4,234 Billion (2022)			GDP per capita: US$ 33,822 (2022)
Population: 125 Million (2022)			Quota: SDR 30.8 billion (2022)
				Est.	Proj.
	(In percent change)
Growth
Real GDP	-0.4	-4.3	2.1	1.1	1.3	1.0
Domestic demand	0.0	-3.4	1.1	1.7	1.5	1.0
Private consumption	-0.6	-4.7	0.4	2.1	1.7	1.0
Gross Private Fixed Investment	0.2	-5.4	0.4	0.8	2.5	2.0
Business investment	-0.7	-4.9	0.8	1.9	3.1	2.4
Residential investment	4.1	-7.9	-1.1	-4.7	-0.8	0.0
Government consumption	1.9	2.4	3.5	1.5	0.1	0.5
Public investment	1.9	3.4	-1.9	-7.1	1.4	0.4
Stockbuilding	-0.1	-0.5	0.2	0.5	-0.1	0.0
Net exports	-0.4	-0.8	1.0	-0.6	-0.1	0.0
Exports of goods and services	-1.5	-11.6	11.7	4.9	4.0	1.9
Imports of goods and services	1.0	-6.8	5.0	7.9	4.3	1.7
Output Gap	0.7	-2.9	-1.6	-0.9	-0.1	0.2
	(In percent change, period average)
Inflation
Headline CPI	0.5	0.0	-0.2	2.5	2.7	2.2
GDP deflator	0.6	0.9	-0.2	0.3	3.8	2.6
	(In percent of GDP)
Government
Revenue	34.2	35.5	36.6	36.2	35.7	35.4
Expenditure	37.3	44.6	42.8	44.0	42.1	39.4
Overall Balance	-3.0	-9.1	-6.2	-7.8	-6.4	-4.0
Primary balance	-2.4	-8.4	-5.6	-7.5	-6.2	-3.8
Structural primary balance	-2.6	-7.5	-5.6	-7.4	-6.2	-3.9
Public debt, gross	236.4	258.7	255.4	261.3	258.2	256.3
	(In percent change, end-of-period)
Macro-financial
Base money	2.8	19.2	8.5	-5.6	2.3	3.8
Broad money	2.1	7.4	2.9	2.7	5.5	4.0
Credit to the private sector	3.2	6.1	1.8	4.6	2.4	2.0
Non-financial corporate debt in percent of GDP	139.3	152.1	155.7	154.9	151.3	147.7
	(In percent)
Interest rate
Overnight call rate, uncollateralized (end-of-period)	-0.1	0.0	0.0	0.0	…	…
10-year JGB yield (end-of-period)	0.0	0.0	0.1	0.4	…	…
	(In billions of USD)
Balance of payments
Current account balance	176.3	147.9	197.3	90.0	131.8	180.3
Percent of GDP	3.4	2.9	3.9	2.1	3.0	4.0
Trade balance	1.4	26.6	15.6	-117.8	-83.0	-25.6
Percent of GDP	0.0	0.5	0.3	-2.8	-1.9	-0.6
Exports of goods, f.o.b.	695.0	630.6	748.6	751.2	779.3	814.6
Imports of goods, f.o.b.	693.6	604.0	732.9	869.1	862.3	840.2
Energy imports	131.9	89.1	127.8	194.0	162.3	152.1
	(In percent of GDP)
FDI, net	4.3	1.7	3.6	3.2	3.1	3.2
Portfolio Investment	1.7	0.8	-4.0	-3.4	-0.7	-0.8
	(In billions of USD)
Change in reserves	25.5	10.9	62.8	-47.4	11.5	11.5
Total reserves minus gold (in billions of US$)	1286. 3	1348. 2	1356. 2	1178. 3	…	…
	(In units, period average)
Exchange rates
Yen/dollar rate	109.0	106.8	109.8	131.5	…	…
Yen/euro rate	122.0	121.9	129.9	138.6	…	…
Real effective exchange rate (ULC-based, 2010=100)	75.2	75.3	73.0	62.0	…	…
Real effective exchange rate (CPI-based, 2010=100)	76.6	77.3	70.7	60.9	…	…
	(In percent)
Demographic Indicators
Population Growth	-0.2	-0.3	-0.3	-0.3	-0.4	-0.5
Old-age dependency	47.6	48.3	48.7	48.9	49.3	49.8

Sources: Haver Analytics; OECD; Japanese authorities; and IMF staff estimates and projections.

^{Table 1.}

Japan: Selected Economic Indicators, 2019-24

	2019	2020	2021	2022	2023	2024
Nominal GDP: US$ 4,234 Billion (2022)			GDP per capita: US$ 33,822 (2022)
Population: 125 Million (2022)			Quota: SDR 30.8 billion (2022)
				Est.	Proj.
	(In percent change)
Growth
Real GDP	-0.4	-4.3	2.1	1.1	1.3	1.0
Domestic demand	0.0	-3.4	1.1	1.7	1.5	1.0
Private consumption	-0.6	-4.7	0.4	2.1	1.7	1.0
Gross Private Fixed Investment	0.2	-5.4	0.4	0.8	2.5	2.0
Business investment	-0.7	-4.9	0.8	1.9	3.1	2.4
Residential investment	4.1	-7.9	-1.1	-4.7	-0.8	0.0
Government consumption	1.9	2.4	3.5	1.5	0.1	0.5
Public investment	1.9	3.4	-1.9	-7.1	1.4	0.4
Stockbuilding	-0.1	-0.5	0.2	0.5	-0.1	0.0
Net exports	-0.4	-0.8	1.0	-0.6	-0.1	0.0
Exports of goods and services	-1.5	-11.6	11.7	4.9	4.0	1.9
Imports of goods and services	1.0	-6.8	5.0	7.9	4.3	1.7
Output Gap	0.7	-2.9	-1.6	-0.9	-0.1	0.2
	(In percent change, period average)
Inflation
Headline CPI	0.5	0.0	-0.2	2.5	2.7	2.2
GDP deflator	0.6	0.9	-0.2	0.3	3.8	2.6
	(In percent of GDP)
Government
Revenue	34.2	35.5	36.6	36.2	35.7	35.4
Expenditure	37.3	44.6	42.8	44.0	42.1	39.4
Overall Balance	-3.0	-9.1	-6.2	-7.8	-6.4	-4.0
Primary balance	-2.4	-8.4	-5.6	-7.5	-6.2	-3.8
Structural primary balance	-2.6	-7.5	-5.6	-7.4	-6.2	-3.9
Public debt, gross	236.4	258.7	255.4	261.3	258.2	256.3
	(In percent change, end-of-period)
Macro-financial
Base money	2.8	19.2	8.5	-5.6	2.3	3.8
Broad money	2.1	7.4	2.9	2.7	5.5	4.0
Credit to the private sector	3.2	6.1	1.8	4.6	2.4	2.0
Non-financial corporate debt in percent of GDP	139.3	152.1	155.7	154.9	151.3	147.7
	(In percent)
Interest rate
Overnight call rate, uncollateralized (end-of-period)	-0.1	0.0	0.0	0.0	…	…
10-year JGB yield (end-of-period)	0.0	0.0	0.1	0.4	…	…
	(In billions of USD)
Balance of payments
Current account balance	176.3	147.9	197.3	90.0	131.8	180.3
Percent of GDP	3.4	2.9	3.9	2.1	3.0	4.0
Trade balance	1.4	26.6	15.6	-117.8	-83.0	-25.6
Percent of GDP	0.0	0.5	0.3	-2.8	-1.9	-0.6
Exports of goods, f.o.b.	695.0	630.6	748.6	751.2	779.3	814.6
Imports of goods, f.o.b.	693.6	604.0	732.9	869.1	862.3	840.2
Energy imports	131.9	89.1	127.8	194.0	162.3	152.1
	(In percent of GDP)
FDI, net	4.3	1.7	3.6	3.2	3.1	3.2
Portfolio Investment	1.7	0.8	-4.0	-3.4	-0.7	-0.8
	(In billions of USD)
Change in reserves	25.5	10.9	62.8	-47.4	11.5	11.5
Total reserves minus gold (in billions of US$)	1286. 3	1348. 2	1356. 2	1178. 3	…	…
	(In units, period average)
Exchange rates
Yen/dollar rate	109.0	106.8	109.8	131.5	…	…
Yen/euro rate	122.0	121.9	129.9	138.6	…	…
Real effective exchange rate (ULC-based, 2010=100)	75.2	75.3	73.0	62.0	…	…
Real effective exchange rate (CPI-based, 2010=100)	76.6	77.3	70.7	60.9	…	…
	(In percent)
Demographic Indicators
Population Growth	-0.2	-0.3	-0.3	-0.3	-0.4	-0.5
Old-age dependency	47.6	48.3	48.7	48.9	49.3	49.8

Sources: Haver Analytics; OECD; Japanese authorities; and IMF staff estimates and projections.

^{Table 2.}

Japan: Monetary Authority Accounts and Monetary Survey, 2020-24

Sources: Bank of Japan; Haver; IMF staff estimates and projections.

^{^1/}Defined as the ratio of credits to the private sector and net credit to other financial in stitutions to customer deposits.

^{Table 2.}

Japan: Monetary Authority Accounts and Monetary Survey, 2020-24

	2020	2021	2022	2023	2024
			Proj.
	(In trillions of JPY)
Monetary Authority
Net foreign assets	-19.5	-17.5	-21.8	-21.5	-21.2
Net domestic assets	637.1	699.6	654.4	668.4	692.4
Net domestic credit	674.7	741.7	696.6	710.6	734.6
Net credit to non-financial public sector	437.3	454.5	464.4	474.4	494.4
Credit to the private sector	9.7	10.4	10.4	10.4	10.4
Net credit to financial corporations	227.6	276.8	221.7	225.7	229.7
Other items net	-37.6	-42.2	-42.2	-42.2	-42.2
Monetary base	617.6	670.1	632.6	646.8	671.1
Monetary Survey (Depository Corporations)
Net foreign assets	92.7	95.7	106.0	110.6	115.0
Net domestic assets	1,443.4	1,496.3	1,493.7	1,577.0	1,639.6
Net domestic credit	1,567.4	1,609.9	1,627.3	1,715.6	1,783.2
Net credit to nonfinancial public sector	700.4	706.4	729.9	801.7	855.4
Credit to the private sector	648.1	660.0	690.5	707.0	720.8
Net credit to other financial institutions	218.9	243.5	206.9	206.9	206.9
Other items net	-124.0	-113.6	-133.6	-138.6	-143.6
Broad money	1,513.8	1,557.4	1,599.7	1,687.6	1,754.6
Currency in circulation	112.4	116.2	113.8	121.5	127.8
Current deposits	854.9	908.6	955.3	1,029.5	1,084.2
Other deposits	546.5	532.6	530.6	536.6	542.6
	(In percent of GDP)
Net credit to other financial institutions	40.6	44.3	37.2	35.3	34.1
Credit to the private sector from depository corporations	120.2	120.1	124.0	120.7	118.7
Corporate debt (includes loans and securities other than shares)	152.1	155.7	154.9	151.3	147.7
Household debt in percent of disposable income	112.3	118.6	119.0	120.2	120.3
	(Y-o-Y growth in percent)
Base money	19.2	8.5	-5.6	2.3	3.8
Broad money	7.4	2.9	2.7	5.5	4.0
Credit to the private sector from depository corporations	6.1	1.8	4.6	2.4	2.0
Corporate loans by domestically licensed banks	8.1	-0.6	1 .5	1.7	1.4
Housing loans	3.0	3.5	3.2	2.0	2.0
Credit to the private sector from all financial institutions	8.1	1.9	4.7	2.5	2.0
Memorandum items:
Velocity of broad money	0.4	0.4	0.3	0.3	0.3
Money multiplier (broad money)	2.5	2.3	2.5	2.6	2.6
Loan-to-deposit ratio (percent)^1/	53.2	52.8	52.6	51.0	50.2

Sources: Bank of Japan; Haver; IMF staff estimates and projections.

^{^1/}Defined as the ratio of credits to the private sector and net credit to other financial in stitutions to customer deposits.

^{Table 2.}

Japan: Monetary Authority Accounts and Monetary Survey, 2020-24

	2020	2021	2022	2023	2024
			Proj.
	(In trillions of JPY)
Monetary Authority
Net foreign assets	-19.5	-17.5	-21.8	-21.5	-21.2
Net domestic assets	637.1	699.6	654.4	668.4	692.4
Net domestic credit	674.7	741.7	696.6	710.6	734.6
Net credit to non-financial public sector	437.3	454.5	464.4	474.4	494.4
Credit to the private sector	9.7	10.4	10.4	10.4	10.4
Net credit to financial corporations	227.6	276.8	221.7	225.7	229.7
Other items net	-37.6	-42.2	-42.2	-42.2	-42.2
Monetary base	617.6	670.1	632.6	646.8	671.1
Monetary Survey (Depository Corporations)
Net foreign assets	92.7	95.7	106.0	110.6	115.0
Net domestic assets	1,443.4	1,496.3	1,493.7	1,577.0	1,639.6
Net domestic credit	1,567.4	1,609.9	1,627.3	1,715.6	1,783.2
Net credit to nonfinancial public sector	700.4	706.4	729.9	801.7	855.4
Credit to the private sector	648.1	660.0	690.5	707.0	720.8
Net credit to other financial institutions	218.9	243.5	206.9	206.9	206.9
Other items net	-124.0	-113.6	-133.6	-138.6	-143.6
Broad money	1,513.8	1,557.4	1,599.7	1,687.6	1,754.6
Currency in circulation	112.4	116.2	113.8	121.5	127.8
Current deposits	854.9	908.6	955.3	1,029.5	1,084.2
Other deposits	546.5	532.6	530.6	536.6	542.6
	(In percent of GDP)
Net credit to other financial institutions	40.6	44.3	37.2	35.3	34.1
Credit to the private sector from depository corporations	120.2	120.1	124.0	120.7	118.7
Corporate debt (includes loans and securities other than shares)	152.1	155.7	154.9	151.3	147.7
Household debt in percent of disposable income	112.3	118.6	119.0	120.2	120.3
	(Y-o-Y growth in percent)
Base money	19.2	8.5	-5.6	2.3	3.8
Broad money	7.4	2.9	2.7	5.5	4.0
Credit to the private sector from depository corporations	6.1	1.8	4.6	2.4	2.0
Corporate loans by domestically licensed banks	8.1	-0.6	1 .5	1.7	1.4
Housing loans	3.0	3.5	3.2	2.0	2.0
Credit to the private sector from all financial institutions	8.1	1.9	4.7	2.5	2.0
Memorandum items:
Velocity of broad money	0.4	0.4	0.3	0.3	0.3
Money multiplier (broad money)	2.5	2.3	2.5	2.6	2.6
Loan-to-deposit ratio (percent)^1/	53.2	52.8	52.6	51.0	50.2

Sources: Bank of Japan; Haver; IMF staff estimates and projections.

^{^1/}Defined as the ratio of credits to the private sector and net credit to other financial in stitutions to customer deposits.

^{Table 3.}

Japan: External Sector Summary, 2020-28

Sources : Haver Analytics; Japanese authorities; and IMF staff estimates and projections.

^{Table 3.}

Japan: External Sector Summary, 2020-28

	2020	2021	2022	2023	2024	2025	2026	2027	2028
			Est.	Proj.
Balance of Payments	(In billions of USD)
Current account balance	147.9	197.3	90.0	131.8	180.3	182.2	190.1	194.7	210.4
Trade balance (goods)	26.6	15.6	-117.8	-83.0	-25.6	-27.6	-.27.8	-23.5	-13.2
Exports of goods	630.6	748.6	751.2	779.3	814.6	832.9	848.4	864.2	889.1
Imports of goods	604.0	732.9	869.1	862.3	340.2	860.5	876.2	887.7	902.3
Imports of goods, Oil	59.1	88.9	129.9	108.7	101.9	95.7	90.9	86.8	83.3
Services balance	-34.2	-38.5	-42.8	-16.5	-12.0	-12.2	-12.7	-13.1	-13.6
Credits	170.0	183.6	211.1	218.7	226.6	231.8	237.1	237.1	237.1
Debits	204.1	211.8	219.9	228.2	236.9	245.9	255.3	255.3	255.3
Income balance	179.6	242.4	269.7	25-0.3	237.0	242.0	251.7	249.9	253.3
Credits	277.3	346.0	379.9	371.7	346.4	349.3	364.6	364.8	368.1
Debits	97.7	103.6	110.2	121.4	109.4	107.3	112.9	114.9	114.8
Current net transfers	-24.2	-22.2	-19.1	-19.1	-19.1	-20.1	-.21.1	-18.6	-16.1
Capital account	-1.9	-3.8	-0.8	-2.6	-2.7	-2.5	-2.6	-2.7	-2.7
Financial account	130.1	154.5	63.8	129.1	177.6	179.7	187.5	191.9	207.7
Direct investment, net	85.4	177.8	134.1	135.4	142.8	142.6	162.5	164.6	173.9
Portfolio investment, net	38.5	-199.2	-143.2	-32.4	-36.3	-69.1	-77.6	-59.6	-57.4
Other investment, net	-12.4	91.0	80.9	-24.7	20.1	55.4	51.8	36.1	40.3
Financial derivatives, net	7.8	22.1	39.3	3:9.3	39.3	39.3	3:9.3	39.3	39.3
Reserve assets	10.9	62.8	-47.4	11.5	11.5	11.5	11.5	11.5	11.5
Errors and omissions, net	-15.8	-39.0	-25.4	0.0	0.0	0.0	0.0	0.0	0.0
	(In percent of GDP)
Current account balance	2.9	3.9	2.1	3.0	4.0	3.9	3.9	3.8	3.9
Trade balance (goods)	0.5	0.3	-2.8	-1.9	-0.6	-0.6	-0.6	-0.5	-0.2
Exports of goods	12.5	15.0	17.7	17.7	18.0	17.6	17.2	17.0	16.6
Imports of goods	12.0	14.6	20.5	19.6	18.6	18.2	17.8	17.5	16.9
Services balance	-0.7	-0.8	-1.0	-0.4	-0.3	-0.3	-0.3	-0.3	-0.3
Income balance	3.6	4.8	6.4	5.7	5.2	5.1	5.1	4.9	4.7
Global Assumptions
Oil prices (USS/barrel)	41.8	69.2	96.4	81.3	76.8	72.7	69.6	67.0	64.8
(Percent change)	-32.0	65.8	39.2	-15.6	-5.5	-5.3	-4.3	-3.7	-3.3
Memorandum items:
Nominal GDP (US$ billion)	5,048.8	5,005.5	4,233.5	4,409.7	4,526.5	4,731.5	4,923.4	5,077.1	5,344.0
Net foreign assets (NFA)/GDP, USS basis	67.7	72.3	87.0	86.4	88.1	88.1	88.5	89.6	89.0
Return on NFA (in percent), USS basis	5.3,	6.7	7.3	6.6	5.9	5.8	5.8	5.5	5.3
Net export contribution to growth	-0.9	1.1	-0.6	-0.1	0.0	0.0	0.0	0.0	0.0

Sources : Haver Analytics; Japanese authorities; and IMF staff estimates and projections.

^{Table 3.}

Japan: External Sector Summary, 2020-28

	2020	2021	2022	2023	2024	2025	2026	2027	2028
			Est.	Proj.
Balance of Payments	(In billions of USD)
Current account balance	147.9	197.3	90.0	131.8	180.3	182.2	190.1	194.7	210.4
Trade balance (goods)	26.6	15.6	-117.8	-83.0	-25.6	-27.6	-.27.8	-23.5	-13.2
Exports of goods	630.6	748.6	751.2	779.3	814.6	832.9	848.4	864.2	889.1
Imports of goods	604.0	732.9	869.1	862.3	340.2	860.5	876.2	887.7	902.3
Imports of goods, Oil	59.1	88.9	129.9	108.7	101.9	95.7	90.9	86.8	83.3
Services balance	-34.2	-38.5	-42.8	-16.5	-12.0	-12.2	-12.7	-13.1	-13.6
Credits	170.0	183.6	211.1	218.7	226.6	231.8	237.1	237.1	237.1
Debits	204.1	211.8	219.9	228.2	236.9	245.9	255.3	255.3	255.3
Income balance	179.6	242.4	269.7	25-0.3	237.0	242.0	251.7	249.9	253.3
Credits	277.3	346.0	379.9	371.7	346.4	349.3	364.6	364.8	368.1
Debits	97.7	103.6	110.2	121.4	109.4	107.3	112.9	114.9	114.8
Current net transfers	-24.2	-22.2	-19.1	-19.1	-19.1	-20.1	-.21.1	-18.6	-16.1
Capital account	-1.9	-3.8	-0.8	-2.6	-2.7	-2.5	-2.6	-2.7	-2.7
Financial account	130.1	154.5	63.8	129.1	177.6	179.7	187.5	191.9	207.7
Direct investment, net	85.4	177.8	134.1	135.4	142.8	142.6	162.5	164.6	173.9
Portfolio investment, net	38.5	-199.2	-143.2	-32.4	-36.3	-69.1	-77.6	-59.6	-57.4
Other investment, net	-12.4	91.0	80.9	-24.7	20.1	55.4	51.8	36.1	40.3
Financial derivatives, net	7.8	22.1	39.3	3:9.3	39.3	39.3	3:9.3	39.3	39.3
Reserve assets	10.9	62.8	-47.4	11.5	11.5	11.5	11.5	11.5	11.5
Errors and omissions, net	-15.8	-39.0	-25.4	0.0	0.0	0.0	0.0	0.0	0.0
	(In percent of GDP)
Current account balance	2.9	3.9	2.1	3.0	4.0	3.9	3.9	3.8	3.9
Trade balance (goods)	0.5	0.3	-2.8	-1.9	-0.6	-0.6	-0.6	-0.5	-0.2
Exports of goods	12.5	15.0	17.7	17.7	18.0	17.6	17.2	17.0	16.6
Imports of goods	12.0	14.6	20.5	19.6	18.6	18.2	17.8	17.5	16.9
Services balance	-0.7	-0.8	-1.0	-0.4	-0.3	-0.3	-0.3	-0.3	-0.3
Income balance	3.6	4.8	6.4	5.7	5.2	5.1	5.1	4.9	4.7
Global Assumptions
Oil prices (USS/barrel)	41.8	69.2	96.4	81.3	76.8	72.7	69.6	67.0	64.8
(Percent change)	-32.0	65.8	39.2	-15.6	-5.5	-5.3	-4.3	-3.7	-3.3
Memorandum items:
Nominal GDP (US$ billion)	5,048.8	5,005.5	4,233.5	4,409.7	4,526.5	4,731.5	4,923.4	5,077.1	5,344.0
Net foreign assets (NFA)/GDP, USS basis	67.7	72.3	87.0	86.4	88.1	88.1	88.5	89.6	89.0
Return on NFA (in percent), USS basis	5.3,	6.7	7.3	6.6	5.9	5.8	5.8	5.5	5.3
Net export contribution to growth	-0.9	1.1	-0.6	-0.1	0.0	0.0	0.0	0.0	0.0

Sources : Haver Analytics; Japanese authorities; and IMF staff estimates and projections.

^{Table 4.}

Japan: General Government Operations, 2019-28

(In percent of GDP)

Sources: Japan Cabinet Office; IMF staff estimates and projections.1/ Including fines.2/ Fiscal year basis.3/ In percent of potential GDP.4/ Market value basis.5/ Nonconsolidated basis.

^{Table 5.}

Japan: Medium-Term Projections, 2020-28

Sources: Haver Analytics; Japanese authorities; and IMF staff est imates and projections.

^{Table 6.}

Japan: Financial Soundness Indicators, 2017-22 1/

Sources: IMF, Financial Soundness Indicators (FSI) database.1/ Data for these series are for Q1 of each year.2/ Including city banks and regional banks but not shinkin banks.3/ Aggregated based on a consolidated basis.4/ Aggregated based on an unconsolidated basis.5/ Including all deposit-taking institutions in Japan.

Annex I. Estimating Household Inflation Expectations

1. Households’ inflation expectations based on quantitative survey responses are biased upward. The Bank of Japan conducts a quarterly Opinion Survey on the General Public’s Views and Behavior. Households provide a number on their inflation expectations, as well as a qualitative response on whether prices will go up, or down, or remain the same. The quantitative responses are biased upward, as households tend to react more to positive inflation shocks than to negative inflation shocks, they are subject to bunching bias (most responses are integers and multiples of 5), and are influenced by outliers.¹

2. To avoid such bias, the qualitative survey responses can be used to quantify inflation expectations using a modified Carlson-Parkin method.² The original Carlson-Parkin method was modified to accommodate the five choices in the Opinion Survey: prices will “go up significantly, “go up slightly", “remain almost the same”, “go down slightly”, or “go down significantly”.³

3. The estimated household inflation expectations remain well below the 2 percent inflation target in 2022Q4. The average of household inflation expectations is calibrated to be equal to the average of actual inflation, eliminating the upward bias. Compared to the quantitative survey responses, the estimates are also less volatile. Based on this estimate, inflation expectations have risen since 2021 but remain well below BoJ’s two-percent inflation target.

Annex II. External Sector Assessment

^¹IMF staff recommends allowing the estimated credit-to-GDP gap to decline gradually over the medium-term from its currently estimated level of 25 percent (16 percent net of corporate savings) with a corresponding policy setting (P*) for the credit-to-GDP gap in five years of 9 percent of GDP. This is consistent with the reduction envisaged earlier in the 2022 External Sector Report.

Annex III. The New Methodology for Estimating the Output Gap¹

1. A new method is adopted to estimate the output gap in Japan to avoid issues with the HP filter and large GDP revisions. The previous method estimated potential GDP first and then the output gap as the difference between potential GDP and actual GDP. However, this method relied on the HP filter that suffers from various issues.² In addition, the output gap was subject to large revisions when actual GDP was revised. The new method, which is used by the Bank of Japan (BoJ), calculates the output gap directly, using the labor input gap and capital input gap.³ It relies on statistics on the utilization of labor and capital rather than on GDP statistics because factor utilization statistics are more timely and less prone to large revisions. In this report, the output gap is estimated following the BoJ methodology, with an update on the employment rate gap and some ad hoc adjustments for the supply shock during the pandemic.

2. The labor input gap, which is the sum of the labor force input gap, the employment rate gap and the hours worked gap, remained negative in the third quarter of 2022.

For the labor force participation rate (LFPR) gap, the BoJ methodology is used to allow for sharp kinks in the trend in each peak of the business cycle. The pandemic has slowed the trend growth of LFPR due to the economic downturn. LFPR gap turned negative during 2020-21 but has recently turned positive as the economy recovers.
For the employment rate gap, the BoJ methodology is updated by estimating the trend unemployment rate using vacancy and unemployment rate data after 2000.⁴ The pandemic disrupted the improving streak of employment gap since 2010. Nevertheless, the gap has remained positive due to various government support measures.
For the hours worked gap, the BoJ updated its methodology in 2017 to capture the structural decline in working hours due to the increase of female and senior workers. The hours gap slumped in the beginning of the pandemic and has since recovered. The gap remains negative as of 2022Q3.
Adding up the three factors, the labor input gap remained negative in Japan. This mainly reflects subdued hours by workers, especially in the services sector. Consumption of services remains below the pre-pandemic level in Japan due to repeated COVID-19 waves.

3. The capital input gap has turned positive thanks to external demand and improving supply chains. The utilization rate in non-manufacturing is estimated using the capacity utilization DI in the Tankan survey. The utilization rate in manufacturing is calculated by dividing the actual production index by the trend-adjusted capacity index. This approach incorporates the economic depreciation of technology by using the newly available depreciation-adjusted capital stock data, and the time trend. The utilization gap is then defined as the percent deviation of the utilization rate from its long-run average. After a sharp drop in 2020Q2, the utilization gap in manufacturing has been recovering, despite periodic disruptions from supply chain issues.

4. Based on the new method, there is a small negative output gap in 2022Q3. Staff’s estimate is close to the estimate by the BoJ. Going forward, the output gap will likely turn positive in the near term under supportive fiscal and monetary policies.

Annex IV. Risk Assessment Matrix¹

Source of Risk	Likelihood	Source	Expected Impact	Main Impacts → Recommended Policy Actions
Deepening geo-economic fragmentation and geopolitical tensions	High	External	High	Trade disruption and supply chain constraints. → continue to pursue open market policies and enhance supply chain resilience.
An abrupt slowdown of the global economy	High	External	High	Negative spillovers through financial and trade channels that could be offset somewhat by lower commodity prices. → Fiscal and monetary easing to support aggregate demand.
Commodity price volatility	Medium	External	Medium	Volatile commodity prices → Fiscal and monetary policy to support aggregate demand.
Stronger than expected rebound in inbound tourism	Medium	Domestic	Medium	The reopening of the borders may attract huge numbers of international travelers that may boost private consumption. → Be ready to withdraw policy support faster to avoid overheating.
Higher frequency and severity of natural disasters related to climate change	Medium	External	High	Climate-related losses could reduce real GDP and increase fiscal costs. Transition risks resulting in shifts in asset values could undermine investor confidence. → Strengthen climate adaptation and mitigation efforts and provide relief to affected households.
Disorderly exit from yield curve control framework	Medium	Domestic	High	Financial instability caused by the repricing of risky assets. → Communicate clearly to financial markets any revisions to the monetary policy framework.
Cyberthreats	Medium	External	High	Cyber-attacks on critical infrastructure and interconnected financial systems that trigger systemic financial instability or widely disrupt socio-economic activities and remote work arrangements. → Take-pre-emptive measures to prevent cyberattacks and do contingent planning to build resilience if there is an attack.
Bond market stress from a reassessment of sovereign risk	Low	Domestic	High	An increase in the sovereign risk premium would worsen public debt dynamics and cause distress in the financial sector. → Adopt a credible medium-term fiscal consolidation to put debt on a downward path.

Source of Risk	Likelihood	Source	Expected Impact	Main Impacts → Recommended Policy Actions
Deepening geo-economic fragmentation and geopolitical tensions	High	External	High	Trade disruption and supply chain constraints. → continue to pursue open market policies and enhance supply chain resilience.
An abrupt slowdown of the global economy	High	External	High	Negative spillovers through financial and trade channels that could be offset somewhat by lower commodity prices. → Fiscal and monetary easing to support aggregate demand.
Commodity price volatility	Medium	External	Medium	Volatile commodity prices → Fiscal and monetary policy to support aggregate demand.
Stronger than expected rebound in inbound tourism	Medium	Domestic	Medium	The reopening of the borders may attract huge numbers of international travelers that may boost private consumption. → Be ready to withdraw policy support faster to avoid overheating.
Higher frequency and severity of natural disasters related to climate change	Medium	External	High	Climate-related losses could reduce real GDP and increase fiscal costs. Transition risks resulting in shifts in asset values could undermine investor confidence. → Strengthen climate adaptation and mitigation efforts and provide relief to affected households.
Disorderly exit from yield curve control framework	Medium	Domestic	High	Financial instability caused by the repricing of risky assets. → Communicate clearly to financial markets any revisions to the monetary policy framework.
Cyberthreats	Medium	External	High	Cyber-attacks on critical infrastructure and interconnected financial systems that trigger systemic financial instability or widely disrupt socio-economic activities and remote work arrangements. → Take-pre-emptive measures to prevent cyberattacks and do contingent planning to build resilience if there is an attack.
Bond market stress from a reassessment of sovereign risk	Low	Domestic	High	An increase in the sovereign risk premium would worsen public debt dynamics and cause distress in the financial sector. → Adopt a credible medium-term fiscal consolidation to put debt on a downward path.

Annex V. The Impact of Japan’s Energy Subsidy¹

1. Although helpful in mitigating near-term headline inflation, energy subsidies can be fiscally expensive and worsen the current account. To illustrate the general equilibrium effects of the energy subsidy in the new fiscal package, a Quantitative model for the Integrated Policy Framework (QIPF) is calibrated to Japan. The simulation assumes a 28 percent subsidy of household energy consumption in 2023H1, declining to 14 percent in Q3, 7 percent in Q4 and 0 thereafter. Energy consumption will be higher with the subsidy, which will worsen the current account, depreciate the yen, and have negative environmental effects. Output will improve at the cost of a higher fiscal deficit and permanently higher debt levels.²

2. Furthermore, while the energy subsidies can help mitigate the inflationary impact of imported fuel, the effects will be temporary. Simulations suggest that after four quarters, headline inflation will be higher than without the subsidy. In addition, core inflation will remain persistently higher in the scenario with the subsidies.

3. At the same fiscal cost, targeted cash transfers to vulnerable households can boost output by more. Assuming 20 percent of the population are liquidity-constrained agents with higher propensity to consume, targeted transfers to those households are more effective in lifting aggregate consumption. The boost to output is even larger as households substitute away from imported energy towards domestically produced goods. A wider adoption of “My Number” could potentially help collect the necessary household data to conduct better-targeted transfers.

Annex VI. What Drives Japanese Household Savings?¹

This annex reviews the evolution of household savings behavior and analyzes its key drivers. There is a long-term downward trend in the household savings rate in Japan; however, this trend has reversed since 2016. While old-age dependency plays a key role, empirical analysis indicates fiscal and monetary policy has also affected household savings. Moreover, there is significant evidence of strong substitutability with corporate savings. The future trajectory of household savings decisions matters for the internal and external balance of the economy, especially given Japan’s high public debt. Going forward, the presence of a clear and credible fiscal framework and strengthening the sustainability of the social safety net, in combination with structural reforms, would help reduce households’ precautionary saving (boost consumption) and support corporate investment. Moreover, improving financial literacy will encourage households to diversify high cash/deposit savings into higher-yielding investments, which would help secure higher financial sustainability in their old age.

A. Developments in Household Savings

1. The composition of private savings in Japan has changed overtime, with a substantial compositional shift from household to corporate savings. Household savings have been trending down after peaking at 23 percent of household disposable income in 1974. While this is consistent with declining household savings trends across advanced economies, the decline in Japan has been much larger. However, this decline has been offset by changes in corporate net savings, which has kept the economy’s overall savings-investment balance positive leading to continued current account surpluses.

2. Japanese household savings pattern has evolved over the years, and can be categorized in three phases before the pandemic:

The first phase was of an increasing and high savings rate until the 1980s driven by rapid post-war economic growth, increasing household incomes as well as tax incentives for saving,² and an under-developed social security system which incentivized higher savings for retirement.
The second phase is of a falling savings rate starting 1980s. Several factors are found to contribute to this: the country’s ageing population, abolition of the tax breaks for savings, decreasing/stagnant labor income growth and improvement in public pension benefits. In 2013, net household savings rate (as a percent of GDP and net disposable income) turned negative – as spending surged ahead of the consumption tax rate hike in April 2014.³
The third phase starts in 2016 when the household savings rate started to rebound but continued to remain at a low level until the COVID-19 pandemic. While there are no empirical studies explaining this reversing trend, there is conjecture that this could likely be driven by concerns about fiscal sustainability including the social security system given the already high public debt—which resulted in a fall in consumer confidence.

3. The household savings rate rose sharply during the pandemic amidst uncertainty, reaching a peak of more than 20 percent of household disposable income. This reflected cash handouts from the government which were mostly saved by the households. It led to an excess savings of close to 11 percent of GDP. However, more recently we see that households have started to spend some of their excess savings, although the saving rate remains above the pre-pandemic levels/norm (Saito, 2020).

4. These changing patterns in household savings are observed across all age groups, implying that it is driven by more than just demographic factors. According to the Family Income and Expenditure Survey, savings rates across different age groups seem to follow similar patterns over time.⁴ Moreover, younger Japanese (age groups below 45) tend to save the highest proportion of their disposable incomes (Japan Consumer Affairs Agency, 2017).

5. Japanese households mostly keep their savings as cash and deposits. Households have a strong bias towards less risky financial assets and hold close to 55 percent of their financial assets as cash and deposit, in comparison to about 20 percent in the United States (US), 25 percent in the United Kingdom (UK), and 34 percent in the Euro Area. As a result, and given the ultra-low interest rates in Japan, the value of household financial assets in Japan has increased only 1.4 times over the last 20 years—in comparison to the US where it has tripled and to the UK where it has increased by 2.3 times.⁵

B. Key Drivers of Household Savings

Box 1 lays out the empirical strategy and discusses the underlying data. Table 1 reports the results of the estimation. In the following sub-sections, we analyze the potential drivers of Japan’s household savings rate one by one.

Demographics

6. Japan is one of the fastest ageing societies. The share of population aged 65 and older (i.e., the old age dependency ratio) has increased from 10 percent in 1973 to 47 percent in 2019. When adjusted for the increasing old-age employment, the increase has been smaller from 8 percent to 36 percent. Moreover, life expectancy of the population has also been gradually rising.

7. Rising old age dependency ratio is associated with lower household savings. The predictions of the life-cycle hypothesis are supported in that the old age dependency ratio has a negative effect on household saving rates. On the other hand, young age dependency and life expectancy do not appear to have a significant impact.

Monetary Policy

8. Monetary easing is associated with lower household savings rate via the interest rate channel. Conventionally speaking, a falling interest rate discourages savings because of lower returns, i.e., the substitution effect. On the other, there is an income effect as the lower interest rates decreases the rate of return on savings so that people may try to compensate by increasing their aggregate amount of savings. We find that the substitution effect dominates the income effect. Moreover, since Japanese households have kept more than half of their total financial assets in cash and deposits, low interest rates have lowered their return/income from savings, further depressing their ability to increase their savings.

Fiscal Policy

9. Higher social security spending by the government is significantly associated with lower household savings. This is because households need to save less for retirement and health. Social security spending as a share of GDP has increased from around 3 percent in 1960 to close to 13 percent in 2019.

10. On the other hand, fiscal expansions are linked with increase in Japanese household savings. This is consistent with the theoretical and empirical findings in the literature, which suggest that rising public deficits could trigger precautionary savings of households as they expect higher taxes and lower government expenditure in the future (Takeda and Ookoshi, 2022). Moreover, given Japan’s high public debt, concerns about fiscal sustainability including the sustainability of the social security system could be driving higher savings (Nakata, 2009). This is consistent with the rise in household savings starting 2016—when reforms of various programs (including pensions) halted the rise in social transfers.

Corporate Savings

11. There is strong evidence of substitutability between corporate and household savings. The theory on substitutability between household and corporate savings assumes that households are the ultimate holders of companies. While Japanese households do not hold so much of corporate shares, some evidence suggests that a large share of firms in Japan are in private ownership among the wealthy⁶—who have been increasing their cash holdings, merely representing a shift from household to corporate savings (Matsubayashi, 2008).

C. Policy Implications

12. The future trajectory of private savings matters for the internal and external balance of the economy. Household savings as a share of GDP could resume its decline due to ageing of the population—Japan’s old age dependency ratio is expected to rise to more than 80 percent of the working age population in 2050 (see UN world population statistics). However, ageing will also put upward pressure on fiscal expenditure or lower fiscal savings as age-related fiscal spending (healthcare and pensions) will rise—which could encourage households to increase their precautionary savings and depress consumption activities.

13. A credible fiscal framework in combination with structural reforms will help shift the drivers of the economy from an unsustainable public saving-investment position to one driven by the private sector. A credible medium-term fiscal framework to reduce the deficit and put the debt-to-GDP path on a clear downward path could help bolster the credibility of the fiscal framework and diminish policy uncertainty, which would help bolster household consumption and corporate investment. This would include policies to ensure sustainability of the social security spending by containing health and long-term care expenditure, while also closing the gaps in the safety nets for the working poor (see Japan 2023 Selected Issues Paper “Options to Strengthen the Safety Net in Japan”).

14. Improving financial literacy will help facilitate diversification of household savings from cash and deposits to higher-yielding investments. Financial literacy in Japan remains low in comparison to peers, which is one of the key factors why Japanese households hold a large share of assets as cash. For example, Japanese respondents scored an average of 7 percentage points lower on comparable questions in the 2019 financial literacy survey than respondents in the United States, Germany, and the United Kingdom. Diversifying away from cash into higher-yielding investments would move households toward greater financial sustainability in old age by increasing their interest income and benefits of sustained increases in corporate value to all households.

^{Box 1.}

Empirical Estimation and Results

Based on data availability, yearly data spanning from 1980 to 2019 is used. In line with the empirical literature on household saving behavior, the following OLS equation is estimated:

ΔHH Saving_t = α + β_iΔX_i,t + ∈_t

where the household savings behavior, i.e., the dependent variable, is defined as the aggregate net household savings as a share of disposable income and also as a share of GDP. Following the literature, our regressors (X) include a standard group of variables: the rate of growth of real per capita income, current wage income deflated by the CPI (real wages), expected income which is approximated by labor productivity growth, and private credit flow relative to GDP to capture consumers’ access to borrowing. The monetary policy variable is the real interest rate, defined as ln[(1+i)/(1+π)], which is calculated using the Tokyo repo rate. We attempt to capture Ricardian effects by including as a regressor the public saving to GDP ratio, and also include government’s social security expenditure as a share of GDP to capture households’ precautionary savings. Demographic factors are represented by the old and young-age dependency ratios, defined as the share of population over age 64 and population under age 15 as a share of the productive population (aged 15-64), as well as life expectancy. To ensure stationarity, all variables (except income variables, real wages, labor productivity) are first differenced.

To tackle potential endogeneity related issues, two specifications were tested: (i) taking lagged values of the regressors; and (ii) using the system generalized method of moments (GMM) estimation method, which is commonly used in the private savings literature. The key estimation results are robust to both specifications, however, given the relatively short time series used in our regression, specification (ii) is not reliable.

Determinants of Household Savings

Standard errors are in parentheses. All variables are in first difference terms. All regressions include a constant term.*, **, *** denote statistical significance at the 1, 5 and 10 percent level.

Determinants of Household Savings

Variables	Net Household Savings as a % of GDP	Net Household Savings as a % of Disposable Income
Real Short-Term Rate	0.188* (0.092)	0.311 (0.146)**
Public Savings	-0.455 (0.153)**	-0.713* (0.243)**
Private sector credit	0.027* (0.030)	0.076* (0.043)
Social Security Expenditure	-1.877* (0.483)**	-2.974* (0.766)**
Real wages	8.477** (3.751)	13.442** (5.944)
Corporate Savings	-0.276 (0.127)**	-0.394* (0.201)
Labor productivity	0.300*** (0.103)	0.436** (0.163)
Real growth rate of per capita GDP	-0.089 (0.128)	-0.144 (0.203)
Old Age Dependency	-1.071* (0.548)	-1.778* (0.868)3
Young Age Dependency	-0.103 (0.673)	-0.034 (1.067)
Life Expectancy	-0.457 (0.468)	-0.653 (0.742)
Observations	45	45
R-squared	0.645	0.634

Standard errors are in parentheses. All variables are in first difference terms. All regressions include a constant term.*, **, *** denote statistical significance at the 1, 5 and 10 percent level.

Determinants of Household Savings

Variables	Net Household Savings as a % of GDP	Net Household Savings as a % of Disposable Income
Real Short-Term Rate	0.188* (0.092)	0.311 (0.146)**
Public Savings	-0.455 (0.153)**	-0.713* (0.243)**
Private sector credit	0.027* (0.030)	0.076* (0.043)
Social Security Expenditure	-1.877* (0.483)**	-2.974* (0.766)**
Real wages	8.477** (3.751)	13.442** (5.944)
Corporate Savings	-0.276 (0.127)**	-0.394* (0.201)
Labor productivity	0.300*** (0.103)	0.436** (0.163)
Real growth rate of per capita GDP	-0.089 (0.128)	-0.144 (0.203)
Old Age Dependency	-1.071* (0.548)	-1.778* (0.868)3
Young Age Dependency	-0.103 (0.673)	-0.034 (1.067)
Life Expectancy	-0.457 (0.468)	-0.653 (0.742)
Observations	45	45
R-squared	0.645	0.634

Standard errors are in parentheses. All variables are in first difference terms. All regressions include a constant term.*, **, *** denote statistical significance at the 1, 5 and 10 percent level.

References

Consumer affairs Agency, Government of Japan, 2017, “Consumer White Paper 2017”, Part 1, Chapter 3 [Special Feature] Consumption by Young People [White Paper] (in Japanese)
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International Monetary Fund (IMF). “Wealth Inequality and Private Savings in Germany”, Selected Issues Paper. IMF Country Report No. 19/124
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Matsubayashi, Y., 2008, “Substitutability of Savings by Sector: Japan-U.S. Comparison”, Kobe University Annual Report of Economics Research, Vol. 53, 67-86 (in Japanese)
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Nakata, K., 2009, “The Long-term Trend and Outlook of Japan’s Household Savings Rate”, Quarterly Journal of Policy and Management Studies, Vol.1, 113-128 (in Japanese)
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Saito, J., 2022, “Why is the household savings rate rising?”, Japan Center for Economic Research (in Japanese)
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Takeda, Y., and T. Ookoshi, 2002, “Household precautionary savings in Japan: theory and empirical evidence”, Quarterly Journal of Household Economics, No.55, 69-79 (in Japanese)
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Unayama, T. and Y. Yoneda, 2018, “Differences between household savings rates in Japan’s Family Income and Expenditure Survey and SNA,” Policy Research Institute, Ministry of Finance, Japan, Financial Review, Vol.134, 191-205 (in Japanese)
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Annex VII. Sovereign Risk and Debt Sustainability Analysis

The sizeable fiscal response to the COVID-19 outbreak and to the spillovers from the war in Ukraine pushed up the fiscal deficit in 2020–22 and is expected to gradually return to pre-pandemic levels, in percent of GDP, by 2025. Public debt is projected to rise as a share of GDP over the medium and long term as age-related expenditures feed into debt dynamics. Although gross financing needs are elevated, the risks of debt distress are moderate as rollover risks are mitigated by the large domestic investor base and by the debt profile. A credible medium-term fiscal adjustment containing social security spending and a revenue-enhancing tax reform is warranted to put public debt on a downward path.

1. Background. An unprecedented fiscal expansion was introduced to mitigate the impact of the pandemic and of the war in Ukraine, increasing the primary deficit from 2.4 percent of GDP in 2019 to an average of 7.2 percent of GDP in 2020–22. Sovereign borrowing costs remain low underpinned by accommodative monetary policy, but headline inflation is picking up. The yen has depreciated by 25 percent vis-à-vis the US dollar during 2022 due to diverging monetary policies between the Bank of Japan and other central banks in advanced economies.

2. Baseline. Staff’s baseline scenario is based on the budget for FY2022 and the fiscal packages adopted in April, September, and October 2022. Under this baseline, the primary deficit will remain elevated in 2023 and return to pre-pandemic levels in 2025 as policy support is withdrawn. Public debt is projected to rise over the long term driven by age-related spending pressures and by a less favorable interest-growth differential. Gross public debt is projected to increase from 255 percent of GDP in 2021 to 268 percent of GDP in 2031.

3. Realism. Historical forecasts point to some pessimism in staff’s projections for the primary deficit and public debt. Having said that, the projected debt path is within the normal historical range observed in peer countries. The projected fiscal adjustment appears as an outlier compared with historical and cross-country experience but is realistic given the large but temporary fiscal expansion put in place to mitigate the impact of the pandemic and the spillovers from the war in Ukraine.

4. Risks and mitigating factors. High and rising debt levels under the baseline erode fiscal buffers and expose Japan to a range of shocks. The debt-to-GDP ratio could jump significantly if growth slumps and could rise gradually (given the debt profile) but persistently if interest rates increase. However, mitigating factors include: a long average maturity that limits the pass-through from higher yields to effective interest rates, a large domestic investor base, and the yield curve control framework by the Bank of Japan.

Overall Assessment:On a preliminary basis, and adjusting for transitory factors, the external position in 2022 is assessed to be broadly in line with the level implied by medium-term fundamentals and desirable policies. A final assessment will be presented in the 2023 External Sector Report. The current account (CA) surplus declined to 2.1 percent of GDP in 2022 from 3.9 percent in 2021. This is because the impact of higher prices on Japan’s commodity imports largely offsets improvement in Japan’s exports (as supply disruptions fade) and a larger primary income balance reflecting the sharp depreciation. Japan’s CA surplus is expected to continue over the medium term, mainly driven by its income surplus arising from a large positive net international investment position (NIIP) and high net returns. Potential Policy Responses: Given the closing output gap and the high uncertainty around the inflation outlook, more flexibility in monetary policy accompanied by bold structural reforms and a credible and specific medium-term fiscal consolidation plan is needed to maintain an external position consistent with medium-term fundamentals and desirable policies. Priority should be given to labor market and fiscal reforms that stimulate private demand, raise potential growth, and promote digital/ green investment. While fiscal consolidation will push the current account surplus higher, this would be offset by higher investment and a decrease in private savings post pandemic-era highs and due to demographic related decline. Japan’s global leadership role to promote more open, stable, and transparent trade policies in regional/ multilateral trade agreements should continue.
Foreign Asset and Liability Position and Trajectory	Background. Japan’s NIIP has risen significantly reaching 83 percent of GDP at end-September 2022, up from 72 percent in 2021 and an average of 61.7 percent pre-pandemic (2016-2019). This has been largely driven by an increase in foreign assets related to outward FDI and the positive valuation effects from yen depreciation. On the back of CA surpluses, the NIIP is projected to stabilize at around 87 percent of GDP in the medium term. Japan holds the world’s largest stock of net foreign assets. Assessment. Japan’s foreign asset holdings are well diversified, both by geography and risk classes. As of September 2022, gross foreign assets largely comprise portfolio investment accounting for about 39 percent of the total, followed by 20 percent of FDI. At end-2021, portfolio investment was about 20 percent yen-denominated and 53.5 percent U.S. dollar-denominated. In the event of yen appreciation against the U.S. dollar, the risk of negative valuation effects could materialize. Liabilities’ vulnerabilities are contained, given that equity and direct investment account for a third of gross foreign liabilities. The NIIP is estimated to have generated a net annual investment income of 7.3 percent of GDP in 2022 owing to the sharp depreciation. Japan’s large positive NIIP is partly related to the asset accumulation for old-age consumption; a gradual deaccumulation of such assets is expected over the long term.
End-September 2022 (% GDP)	NIIP: 82.9	Gross Assets: 253.2		Debt Assets: 90		Gross Liab.: 170.3	Debt Liab.: 95.7
Current Account	Background. Japan’s CA surplus reflects a sizable income balance, reaching a historical high at 6.4 percent of GDP in 2022, owing to its large net foreign asset position. The CA surplus declined to 2.1 percent of GDP in 2022, from 3.9 percent in 2021. The merchandize trade balance shifted from a surplus of 0.3 percent in 2021 to a deficit of 2.8 percent in 2022, driven by higher prices for commodity imports. Offshoring of production overseas over the years has limited the positive impact of yen’s depreciation on exports, which may take time to materialize. The lower merchandize trade balance is expected to be offset by a 1.5 percent improvement in the primary income balance reflecting sharp depreciation. In the medium-term, the CA balance is projected to stabilize at a level of about 3.8 percent of GDP. Assessment. The 2022 CA assessment uses the EBA model, in which the estimated cyclically-adjusted CA is 3.2 percent of GDP and the cyclically-adjusted CA norm is estimated at 3.9 percent of GDP, with a standard error of 1.1 percent of GDP. The IMF staff estimates a 2022 CA norm range between 2.8 and 5 percent of GDP. After factoring in the transitory impacts of the COVID-19 crisis on the CA in relation to travel services including tourism equivalent to 0.3 percent of GDP (transport adjustor is at 0 percent) the 2022 CA gap midpoint is assessed at -0.4 percent of GDP, with the CA gap range between -1.5 and 0.7 percent of GDP. The EBA-identified policy gaps reflect relatively greater medium-term fiscal consolidation needs, as well as a positive credit gap, in relation to medium-term desired policy.¹ The overall gap is accounted for by the residual, potentially reflecting structural impediments and country-specific factors not included in the model, such as investment bottlenecks, including entrepreneurship entry barriers and corporate savings distortions.
2022 (% GDP)	CA: 2.1	Cycl. Adj. CA: 3.2	EBA Norm: 3.9	EBA Gap: -0.7	COVID-19 Adj.: 0.3	Other Adj.: 0.0	Staff Gap: -0.4
Real Exchange Rate	Background. The REER has depreciated sharply in 2022 by close to 14 percent, following a depreciation of 8.7 percent in 2021. This reflects a sharp rise in inflation in Japan’s major trading partners combined with the yen’s nominal depreciation against major currencies as a result of widening interest rate differentials amid global monetary tightening. Assessment. The IMF staff CA gap implies a REER gap of 2.4 percent in 2022 (applying an estimated elasticity of 0.17). The EBA REER level and index models deliver REER gaps of -29.4 and -29.2 percent, respectively, for the 2022 average REER. However, these models are not used for the assessment because they do not capture Japan-specific factors well. Consistent with the IMF staff CA gap, the REER gap is assessed to be in the range of -4.1 to 8.8 percent, with a midpoint of 2.4 percent.
Capital and Financial Accounts: Flows and Policy Measures	Background. The financial account recorded net outflows in 2022, mirroring the CA surplus, and declined to 1.9 percent of GDP in 2022 from 3.1 percent in 2021. Net FDI outflows are projected at 3.1 percent of GDP, primarily driven by outward FDI flows to North America, Asia and Europe. Net portfolio inflows recorded at 3.4 percent of GDP lower than 4 percent in 2021 reflecting both lower demand for yen-denominated assets due to divergence in monetary policy as well as lower net portfolio outflows amid increased global financial volatility. Net short yen positions have emerged since early 2021, due to the relative strength of the USD amid changes in monetary policy stances. Assessment. Vulnerabilities are limited. Inward investment tends to be equity-based, and the home bias of Japanese investors is strong. So far, outward spillovers from Japan’s policies to financial conditions in other economies (interest rates, credit growth) are contained.
FX Intervention and Reserves Level	Background. Reflecting legacy accumulation, reserves stood at US$1.3 trillion or about 30 percent of GDP at end-2021. They declined to US$1.12 trillion by end-2022 as the FX intervention and valuation effects from rising foreign bond yields more than offset other factors that would support reserves, such as income gains from foreign bond holdings. Assessment. The exchange rate is free floating. The authorities intervened to support the yen in September and October for the first time since 1998, with the size of the intervention equivalent to 5 percent of forex reserves in end-August. FX interventions should be isolated and limited to addressing disorderly market conditions.

Overall Assessment:On a preliminary basis, and adjusting for transitory factors, the external position in 2022 is assessed to be broadly in line with the level implied by medium-term fundamentals and desirable policies. A final assessment will be presented in the 2023 External Sector Report. The current account (CA) surplus declined to 2.1 percent of GDP in 2022 from 3.9 percent in 2021. This is because the impact of higher prices on Japan’s commodity imports largely offsets improvement in Japan’s exports (as supply disruptions fade) and a larger primary income balance reflecting the sharp depreciation. Japan’s CA surplus is expected to continue over the medium term, mainly driven by its income surplus arising from a large positive net international investment position (NIIP) and high net returns. Potential Policy Responses: Given the closing output gap and the high uncertainty around the inflation outlook, more flexibility in monetary policy accompanied by bold structural reforms and a credible and specific medium-term fiscal consolidation plan is needed to maintain an external position consistent with medium-term fundamentals and desirable policies. Priority should be given to labor market and fiscal reforms that stimulate private demand, raise potential growth, and promote digital/ green investment. While fiscal consolidation will push the current account surplus higher, this would be offset by higher investment and a decrease in private savings post pandemic-era highs and due to demographic related decline. Japan’s global leadership role to promote more open, stable, and transparent trade policies in regional/ multilateral trade agreements should continue.
Foreign Asset and Liability Position and Trajectory	Background. Japan’s NIIP has risen significantly reaching 83 percent of GDP at end-September 2022, up from 72 percent in 2021 and an average of 61.7 percent pre-pandemic (2016-2019). This has been largely driven by an increase in foreign assets related to outward FDI and the positive valuation effects from yen depreciation. On the back of CA surpluses, the NIIP is projected to stabilize at around 87 percent of GDP in the medium term. Japan holds the world’s largest stock of net foreign assets. Assessment. Japan’s foreign asset holdings are well diversified, both by geography and risk classes. As of September 2022, gross foreign assets largely comprise portfolio investment accounting for about 39 percent of the total, followed by 20 percent of FDI. At end-2021, portfolio investment was about 20 percent yen-denominated and 53.5 percent U.S. dollar-denominated. In the event of yen appreciation against the U.S. dollar, the risk of negative valuation effects could materialize. Liabilities’ vulnerabilities are contained, given that equity and direct investment account for a third of gross foreign liabilities. The NIIP is estimated to have generated a net annual investment income of 7.3 percent of GDP in 2022 owing to the sharp depreciation. Japan’s large positive NIIP is partly related to the asset accumulation for old-age consumption; a gradual deaccumulation of such assets is expected over the long term.
End-September 2022 (% GDP)	NIIP: 82.9	Gross Assets: 253.2		Debt Assets: 90		Gross Liab.: 170.3	Debt Liab.: 95.7
Current Account	Background. Japan’s CA surplus reflects a sizable income balance, reaching a historical high at 6.4 percent of GDP in 2022, owing to its large net foreign asset position. The CA surplus declined to 2.1 percent of GDP in 2022, from 3.9 percent in 2021. The merchandize trade balance shifted from a surplus of 0.3 percent in 2021 to a deficit of 2.8 percent in 2022, driven by higher prices for commodity imports. Offshoring of production overseas over the years has limited the positive impact of yen’s depreciation on exports, which may take time to materialize. The lower merchandize trade balance is expected to be offset by a 1.5 percent improvement in the primary income balance reflecting sharp depreciation. In the medium-term, the CA balance is projected to stabilize at a level of about 3.8 percent of GDP. Assessment. The 2022 CA assessment uses the EBA model, in which the estimated cyclically-adjusted CA is 3.2 percent of GDP and the cyclically-adjusted CA norm is estimated at 3.9 percent of GDP, with a standard error of 1.1 percent of GDP. The IMF staff estimates a 2022 CA norm range between 2.8 and 5 percent of GDP. After factoring in the transitory impacts of the COVID-19 crisis on the CA in relation to travel services including tourism equivalent to 0.3 percent of GDP (transport adjustor is at 0 percent) the 2022 CA gap midpoint is assessed at -0.4 percent of GDP, with the CA gap range between -1.5 and 0.7 percent of GDP. The EBA-identified policy gaps reflect relatively greater medium-term fiscal consolidation needs, as well as a positive credit gap, in relation to medium-term desired policy.¹ The overall gap is accounted for by the residual, potentially reflecting structural impediments and country-specific factors not included in the model, such as investment bottlenecks, including entrepreneurship entry barriers and corporate savings distortions.
2022 (% GDP)	CA: 2.1	Cycl. Adj. CA: 3.2	EBA Norm: 3.9	EBA Gap: -0.7	COVID-19 Adj.: 0.3	Other Adj.: 0.0	Staff Gap: -0.4
Real Exchange Rate	Background. The REER has depreciated sharply in 2022 by close to 14 percent, following a depreciation of 8.7 percent in 2021. This reflects a sharp rise in inflation in Japan’s major trading partners combined with the yen’s nominal depreciation against major currencies as a result of widening interest rate differentials amid global monetary tightening. Assessment. The IMF staff CA gap implies a REER gap of 2.4 percent in 2022 (applying an estimated elasticity of 0.17). The EBA REER level and index models deliver REER gaps of -29.4 and -29.2 percent, respectively, for the 2022 average REER. However, these models are not used for the assessment because they do not capture Japan-specific factors well. Consistent with the IMF staff CA gap, the REER gap is assessed to be in the range of -4.1 to 8.8 percent, with a midpoint of 2.4 percent.
Capital and Financial Accounts: Flows and Policy Measures	Background. The financial account recorded net outflows in 2022, mirroring the CA surplus, and declined to 1.9 percent of GDP in 2022 from 3.1 percent in 2021. Net FDI outflows are projected at 3.1 percent of GDP, primarily driven by outward FDI flows to North America, Asia and Europe. Net portfolio inflows recorded at 3.4 percent of GDP lower than 4 percent in 2021 reflecting both lower demand for yen-denominated assets due to divergence in monetary policy as well as lower net portfolio outflows amid increased global financial volatility. Net short yen positions have emerged since early 2021, due to the relative strength of the USD amid changes in monetary policy stances. Assessment. Vulnerabilities are limited. Inward investment tends to be equity-based, and the home bias of Japanese investors is strong. So far, outward spillovers from Japan’s policies to financial conditions in other economies (interest rates, credit growth) are contained.
FX Intervention and Reserves Level	Background. Reflecting legacy accumulation, reserves stood at US$1.3 trillion or about 30 percent of GDP at end-2021. They declined to US$1.12 trillion by end-2022 as the FX intervention and valuation effects from rising foreign bond yields more than offset other factors that would support reserves, such as income gains from foreign bond holdings. Assessment. The exchange rate is free floating. The authorities intervened to support the yen in September and October for the first time since 1998, with the size of the intervention equivalent to 5 percent of forex reserves in end-August. FX interventions should be isolated and limited to addressing disorderly market conditions.

Topics

Countries

Series

About

Resources

Abstract

Context

Recent Developments

Outlook and Risks

Authorities’ Views

Economic Policies

A. Fiscal Policy

Authorities’ Views

B. Monetary Policy

Authorities’ Views

C. Preserving Financial Stability

Authorities’ Views

D. Alternative Scenario: Sustained Inflation Pressures

Authorities’ Views

E. Supporting the New form of Capitalism

Achieving the Virtuous Cycle of Income and Growth

Accelerating Startups and Open Innovation

Transitioning to a Low-Carbon Economy

Continuing the Digital Push and Other Reforms

Authorities’ Views

Staff Appraisal

Annex I. Estimating Household Inflation Expectations

Annex II. External Sector Assessment

Annex III. The New Methodology for Estimating the Output Gap1

Annex IV. Risk Assessment Matrix1

Annex V. The Impact of Japan’s Energy Subsidy1

Annex VI. What Drives Japanese Household Savings?1

A. Developments in Household Savings

B. Key Drivers of Household Savings

Demographics

Monetary Policy

Fiscal Policy

Corporate Savings

C. Policy Implications

References

Annex VII. Sovereign Risk and Debt Sustainability Analysis

Annex III. The New Methodology for Estimating the Output Gap¹

Annex IV. Risk Assessment Matrix¹

Annex V. The Impact of Japan’s Energy Subsidy¹

Annex VI. What Drives Japanese Household Savings?¹