EU partner Japan: IMF staff concluding statement on 2023 Article IV Mission

January 26, 2023

Washington, DC:

The economic recovery in Japan is being supported by pent-up demand, supply chain improvements, border reopening, and policy support. Inflation has accelerated in recent months. The policy challenge in the near term is to ensure that the 2 percent inflation target is reached durably, without overshooting significantly, while preserving financial stability. In the medium term, the priority is to reduce fiscal vulnerabilities and transition to a more dynamic, resilient, and inclusive economy.

Recent Economic Developments, Outlook, And Risks

Japan is navigating the recovery from the pandemic and the implications of the war in Ukraine. The government has been gradually relaxing COVID-19-related restrictions and the borders were reopened with very limited restrictions in October. Inflation has accelerated in recent months, with more wide-spread price increases mainly due to pass-through from the rise in import prices, and Japan core inflation (i.e., excluding fresh food) recording levels not seen in four decades.

The economic recovery is projected to continue in the near term supported by pent-up demand, supply chain improvements, border reopening, and policy support. The output gap is projected to close in 2023. The consumption of services will be underpinned by savings accumulated during the pandemic. Exports will rise as order backlogs are cleared and supply side constraints eased. High corporate profits from a depreciated yen and delays in implementing earlier projects will support business investment. The primary fiscal deficit will stay elevated in 2023 following the adoption of the October 2022 fiscal package. Core inflation is projected to peak in the first quarter of 2023 and gradually decline to below 2 percent by end-2024 as cost increases from higher import prices wane. The current account surplus is estimated at 1.8 percent of GDP in 2022, and 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. Downside risks include: 1) deepening geo-economic fragmentation and geopolitical tensions; 2) an abrupt slowdown of the global economy; 3) outbreaks of new lethal and highly contagious COVID-19 variants; 4) lingering supply-side constraints; 5) natural disasters, 6) debt sustainability, and 7) cyberthreats. In addition, there are risks to the economy that could arise from an abrupt change of the current monetary policy framework. Upside risks include a more robust recovery of consumption, especially services, and a stronger-than-expected recovery of inbound tourism.

Economic Policies

The main challenge is to calibrate a combination of policies that are needed in the near term to ensure that the 2 percent inflation target is reached 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.

In the near term, there is very significant uncertainty regarding the inflation outlook in Japan –with both upside and downside risks. Without substantial acceleration in wage growth, Japan’s inflation is expected to fall back below the 2 percent inflation target by end-2024. Hence, an overall accommodative monetary policy stance remains appropriate. Nonetheless, upside risks to inflation are more prominent amidst a narrowing output gap and lower real interest rates. To better manage risks given increased uncertainty regarding 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, such flexibility would automatically lead to 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. Changes in monetary policy settings should be well communicated. Macroprudential and other policies should seek to curb financial sector vulnerabilities. Pandemic-related fiscal support should be withdrawn more quickly, and new measures limited and targeted only to vulnerable households. Steps are needed to boost labor income and achieve a virtuous cycle of income and growth.

Over the medium term, fiscal consolidation must be growth-friendly—including taking account of the economic situation—and credible in order to put public debt on a downward path and to rebuild fiscal buffers. Financial support measures should be limited to viable 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.

Fiscal Policy

Amid the ongoing recovery, rising inflation, tighter labor markets, and a closing output gap, fiscal policy support should be withdrawn more quickly. The large fiscal package adopted in October 2022 led to a narrowing of the already limited fiscal space. Moreover, the package could add to inflation, which would require a stronger monetary tightening response. Energy subsidies could have been better targeted to contain fiscal costs, protect the vulnerable, and encourage efficient energy consumption. As government spending pressures continue to rise, any additional spending measures should be targeted 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. 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. Against this backdrop, with the public debt-to-GDP ratio on an upward path, interest rates could increase suddenly, and sovereign stress could emerge.

Fiscal consolidation is warranted to rebuild fiscal buffers and ensure debt sustainability. This should be underpinned by a credible fiscal framework to reduce the primary fiscal 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 more realistic projections. GDP growth rates and fiscal balances projected by the Cabinet Office have historically been too optimistic. 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.

· Strengthening the fiscal framework. Budget expenditure 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 to ensure binding expenditure ceilings and consistency between the annual budget and medium-term fiscal targets. The target should be underpinned by specific measures, and supplementary budgets should be infrequent and deployed only when exceptionally large macroeconomic shocks occur.

· Balancing debt sustainability while protecting growth. The authorities should continue to assess the progress towards the FY2025 primary balance target, weighing fiscal consolidation against the need to provide fiscal support to preserve growth if adverse shocks materialize.

Fiscal consolidation requires both revenue and expenditure measures. Japan has relatively low tax revenues and relatively high age-related spending compared to peers. In this context, fiscal consolidation should include:

· Policies to contain health and long-term care costs. Possible measures include a mix of reforms to: (i) improve spending efficiency and (ii) target measures such as increasing copayments for high-income seniors. These measures could help contain 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 raising the consumption tax standard rate; increasing corporate taxation; strengthening property taxation by removing the preferential treatment of residential land; rationalizing allowances and deductions in personal income taxation; raising the capital income tax rate; and increasing premiums of social insurance.

· Policies to strengthen the safety net. There seems to be a clear gap in the safety net for the working poor. In that context, an earned income tax credit (EITC) scheme, which provides tax credits for low-income earners, could be considered. An EITC would also help to rationalize existing untargeted transfers.

Monetary Policy

An accommodative monetary policy stance remains appropriate but needs to be supported by other policies to achieve the 2 percent inflation target sustainably, including policies to improve productivity and real wages.

Nonetheless, there is exceptionally high uncertainty around baseline inflation projections with risks tilted to the upside. Upside risks to inflation include the delayed effects of exchange rate depreciation, border reopening, second round effects of imported inflation, fiscal support, and higher-than-expected wage growth. 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.

In addition, the Bank of Japan (BoJ) has purchased large amounts of JGBs in recent months, and it now holds close to 70 percent of outstanding 5-year and 10-year JGBs. These purchases have reduced liquidity in the JGB market and distorted the yield curve, with market surveys indicating a sharp deterioration in bond market functioning. Against this background, the BoJ modified the yield curve control (YCC) framework at the December monetary policy meeting.

Hence, as noted above, given the two-sided risks to inflation, more flexibility in long-term yields would help to avoid abrupt changes later. This would help better manage inflation risks and also help address the side-effects of prolonged easing. At the same time, 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.

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. The BoJ would need to carefully assess the pros and cons of each strategy. For instance, 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. 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 BoJ’s JGB purchases would need to be state-contingent and adjusted if yields moved up too rapidly. 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 significant upside inflation risks materialize, 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.

During 2022, the authorities intervened in the foreign exchange market (FXI), which was triggered by significant volatility of the yen. While the yen depreciation since March 2022 largely reflects interest rate differentials, empirical analysis suggests that the exchange rate had depreciated more than implied by underlying drivers after June. In general, FXI could help lower excessive volatility and keep the pace of the yen’s movement better aligned with fundamentals and well-functioning markets, but its effects are likely temporary. 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.

Preserving Financial Stability

The financial sector has been robust to several global headwinds in 2022, but risks have increased amid monetary policy tightening in other peer economies and the slowdown in global economic activity. Overall, 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. While major internationally active banks have increasingly been relying on more stable foreign-currency funding sources since mid-2010s, steady efforts to further improve resilience to US dollar liquidity stress are warranted, including assessing risks due to unused committed credit lines at elevated levels. A steeper JGB yield curve would benefit banks in the medium term, however, short-term costs warrant attention.

The authorities should closely monitor developments in credit risks. The quality of overseas credit portfolios is in general high, with a large share of investment-grade loans and low non-performing loans. Nonetheless, credit exposures, especially those to leveraged overseas borrowers, warrant attention given global headwinds. Moreover, a global economic slowdown could weigh on large domestic borrowers. Some regional banks are more exposed to yen depreciation through credit exposure to non-exporting firms, but the impact on the overall banking system is limited. Liquidity conditions of firms with limited ability to pass rising raw material costs to sales prices should continue to be monitored.

Credit imbalances are high by historical standards, in part driven by the sharp drop in GDP at the outset of pandemic. Although the growth in housing prices in Japan has been moderate compared to international peers, the authorities should remain vigilant to potential vulnerabilities that may arise due to increasing loan-to-income ratios, the rising share of borrowers with high debt servicing ratios, and the large fraction of floating-rate mortgages. Macroprudential policies aiming to curb vulnerabilities from growth in housing loans could be considered. Moreover, continued vigilance on credit risks that may arise as pandemic-related support measures taper and reducing the public credit guarantee ratio for new loans are warranted.

Supporting the New Form of Capitalism

Achieving the Virtuous Cycle of Income and Growth

The government’s new form of capitalism policies to boost income growth should focus on three dimensions: labor supply, wage growth, and productivity.

· First, policies should continue to promote 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. 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 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. 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.

Accelerating Startups and Open Innovation

Promoting startups in Japan requires a holistic approach to address the constraints in the labor market, as well as improving financing options and entrepreneurial education. The grand design of the new form of capitalism includes measures to support venture capital, 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. 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.

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. To encourage firms to invest, fiscal incentives can be used to increase the return on investment, especially in ICT technology and R&D.

Transitioning to a Low-Carbon Economy

The country’s green transformation (GX) strategy currently is centered around public investment in decarbonization, and green technology financed by GX bonds. The government will also provide incentives for private funding for green projects. The government is committed to expand carbon pricing from current low levels from FY2028, but details are yet to be decided. Sectoral plans to achieve emission targets are being developed by relevant ministries. 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.

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. Without carbon pricing at levels that provide strong incentives for CO2 reduction, 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. Climate policies should be underpinned by measures to protect vulnerable people and enable an orderly transition of high emission sectors to low carbon. Green finance should continue to play a supporting role for the transition through funding of green and transition activities and appropriate management of climate-related financial risks.

Continuing the Digital Push and Other Reforms

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. But data sharing between government agencies is still limited, impairing the government’s ability to conduct targeted transfers to vulnerable households. In this regard, we welcome the government’s policy to standardize local government IT systems and facilitate information sharing among the central government and local governments. 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.

Reform efforts in other areas, such as corporate governance and trade policies, should continue. Building on recent progress, corporate governance reforms could be further strengthened by ensuring effective corporate governance practices and disclosure. Japan should continue to work actively with international partners to strengthen the rules-based multilateral trading system, including ensuring effective WTO dispute settlement.

The IMF team would like to thank the authorities and other interlocutors in Japan for the frank and open discussions.

Source – IMF