Public Information Notice No. 00/64

Public Information Notice: IMF Concludes Article IV Consultation with Japan

August 11, 2000

On August 4, 2000, the Executive Board concluded the Article IV consultation with JAPAN.¹

Background

Japanese economic growth fell markedly during the 1990s in comparison to previous decades. The deterioration in performance reflected mainly a prolonged slump in business investment, as corporates began to unwind the excess capital stock created during the bubble years of the late 1980s. It also reflected slow adjustment to the ongoing process of globalization and technological change, as Japan lagged in shifting to innovation and productivity improvements (rather than capital accumulation and exports) as the main engines of growth. The volatility of output increased, reflecting in part stop-go fiscal policies, which gave rise to unprecedentedly sharp movements in public investment, and in addition wide swings in the value of the yen.

In 1997–98, Japan experienced the most severe recession of any major industrial country in the post-war period. The downturn was initiated by a sharp fall in household spending after the April 1997 consumption tax hike, cuts in public investment, and the closure of three financial institutions in late 1997. Business investment was particularly hard-hit, reflecting the sharp cuts in bank lending associated with the financial crisis and the strengthening of bank regulation. Household spending also fell, as the financial crisis undermined confidence and unemployment mounted. The Asia crisis compounded the recessionary momentum.

Economic growth, as shown in the national accounts, has been uneven over the past year and a half. In the first half of 1999, GDP expanded by 3½ percent (annual rate), driven by a rebound in confidence and fiscal stimulus measures. The economy contracted again in the second half of 1999, reflecting renewed weakness in private consumption and a sharp contraction in public investment, though business investment surged in the fourth quarter, as profitability recovered and sentiment improved. GDP figures for the first quarter of 2000 suggest growth of 10 percent at an annual rate, with strong contributions from private consumption, business investment, and net exports. However, the confluence of a number of temporary factors—including the delay in the end-1999 bonus payment, the leap-year effect, as well as the unwinding of the pre-Y2K buildup of import stocks—seems to have accounted for about half the first quarter rise of 2.4 percent. The recent pickup in activity appears heavily concentrated in “high-tech” sectors.

The current account surplus narrowed in 1999, mainly due to higher imports following the sharp contraction in the previous year, but widened again in the first quarter of 2000. Export volumes grew modestly in 1999 overall, dampened by the appreciation of the yen, although the strength of the Asian recovery has contributed to an uptrend since mid-1999. Import values rebounded strongly in 1999, however, reflecting not only the effect of higher oil prices, but also the impact on volumes of the pickup in domestic demand, and a pre-Y2K buildup of import stocks. In the first quarter of 2000, export volumes continued to improve, while imports fell back.

The recession-cum-stagnation in 1997–99 widened the output gap and continued to put downward pressure on wages and prices. While a deflationary spiral has been avoided, consumer price inflation declined to about zero for most of 1999 and has been slightly negative in 2000 to date (compared to an average 2½ percent annual increase in the core CPI in the 1980s), and the GDP deflator has been declining by 1–2 percent annually. The unevenness of the recovery—with certain sectors experiencing strong growth while others undergo restructuring—has implied a combination of rising overtime and job offers, while earnings have continued to be weak and unemployment has remained on an uptrend.

The yen and stock prices strengthened markedly through early 2000, but have weakened since. Notwithstanding significant intervention to weaken the yen in mid-1999, upward pressures persisted in the second half of 1999 and the yen reached a high of almost ¥100/dollar at year-end. The yen fell in early 2000, aided by further exchange market intervention, which—on this occasion—came amid growing perceptions of a widening gap between short-term economic prospects in the United States and Japan, and was therefore more effective. Equity prices surged between early 1999 and March 2000—due mainly to rises in “new Japan” (high-tech) stocks while “old Japan” (including banks) stocks languished. Equity markets have since fallen back, likely reflecting not only the global downturn in high-tech stocks, but also recognition that corporate restructuring in Japan is likely to be a drawn-out process.

Following the premature move toward fiscal consolidation in FY1997, fiscal policy has been used to support growth, though the overall effectiveness may have been undercut by partial implementation at the local level and lack of transparency. The main vehicle for countercyclical fiscal policy has been a series of supplementary budgets designed to shore up public works spending, cut taxes, and increase credit guarantees for bank loans to SMEs. The budget for FY2000, together with the stimulus package announced last November, should help to maintain the fiscal stance broadly unchanged during the current fiscal year. However, absent a further significant supplementary budget, public investment could again fall off sharply in the second half of this fiscal year, as it did in 1999.

While the monetary stance has remained unchanged since the reduction in short-term interest rates to their floor in early 1999, the BoJ has in recent months increasingly signaled that the conditions for raising short-term interest rates by a small amount are gradually falling into place. Even with short-term nominal interest rates at their floor, however, real rates have remained positive, bank lending has continued to decline, and an appreciating yen since mid-1999 has implied a significant firming of monetary conditions. Nevertheless, with the gradual improvement in economic prospects, the BoJ has increasingly signaled—and markets have come to expect—that some firming of the policy stance is likely before the end of the year.

While concerns about systemic risk in the banking sector have receded, bank restructuring is still at an early stage, and the financial position of the life insurance sector has continued to weaken. Under the framework established in late-1998, substantial progress has been made in stabilizing the banking system: the major banks have been recapitalized, the two banks nationalized in late-1998 have been or are about to be reprivatized, and four mega-mergers have been announced. However, concerns about major banks’ asset quality and core profitability remain. While a number of regional banks have made progress in raising their capital over the past year, weaknesses among the credit cooperatives are only now beginning to be addressed. The delay in reintroducing partial deposit insurance announced last December was largely related to concerns about the significant weaknesses in the credit cooperative sector. Finally, the financial strength of the life insurance sector has deteriorated further over the past year, reflecting negative spreads.

Beyond the financial sector, the authorities have made significant progress in their legislative agenda to foster corporate restructuring, but progress on regulatory reform more generally has been less impressive. A number of measures to encourage corporate restructuring have been legislated over the past year, including enactment of the Industrial Revitalization Law and the Civil Rehabilitation Law, and changes in the Commercial Code. Reforms to accounting standards are moving ahead, with the introduction of consolidated financial accounting in FY1999 and the phasing in of marking-to-market in FY2000–01. Most remaining “Big Bang” financial reforms came into effect in October 1999. While the authorities have moved to expand the coverage of their deregulation program and plan to shift the emphasis of regulation from prior intervention to retroactive supervision, implementation is proceeding slowly in other areas.

Despite positive recent signs of an emerging recovery, the staff expects the recovery to remain underpowered and uneven in 2000–01, and subject to significant downside risks. The baseline projection is for growth of about 1½ percent in 2000 and 1¾ percent in 2001, broadly in line with the private consensus forecast. However, achieving this outcome is by no means assured, given that a sustained recovery in private demand has not yet been established and corporate restructuring will continue to dampen both business investment and household expenditures for some time to come. In these circumstances, confidence could still be undercut by a “triple-dip” in activity after midyear, possible following the surge in output that likely took place in the first half of 2000 (repeating the pattern of 1999), particularly if the monetary stance is firmed and fiscal stimulus wanes. The decline in stock prices since March is a reminder that confidence is still fragile and provides further headwind against a sustainable recovery in private demand. Other downside risks arise outside Japan, including that of a “hard landing” in the United States.

Executive Board Assessment

Executive Directors considered that the macroeconomic policy support and structural reforms implemented over the past 2½ years have been instrumental in bringing about the economic recovery that appears to be finally underway in Japan. However, the recent pickup remains fragile and subject to downside risks. While business investment has turned around, household demand remains lackluster. Moreover, while the reallocation of capital and labor to more productive activities is now underway, uncertainties related to the process of corporate restructuring will continue to pose risks to the outlook for some time.

Against this background, Directors urged the authorities to maintain supportive macroeconomic policies until the recovery becomes more robust, while pressing ahead with structural reforms to lay the foundation for sustained medium-term growth. Directors considered that an early move to firm the stance of macroeconomic policies would pose risks for the recovery. The preferred way to promote economic restructuring, Directors emphasized, is to apply firmly the strengthened regulatory framework to ensure that a sound banking system and efficient capital markets exert appropriate discipline on firms, while continuing to remove tax and other impediments to corporate reorganization and to accelerate efforts to promote competition and deregulation on a broad front.

While recognizing the need for medium-term fiscal consolidation, Directors stressed that withdrawal of fiscal stimulus should wait until the economic recovery is on a firmer footing. Recent experience in Japan clearly illustrates the risks for growth—and ultimately public sector debt dynamics—of implementing fiscal consolidation prematurely, that is while economic prospects remain fragile. To cushion the withdrawal of fiscal stimulus in the latter part of FY2000 and FY2001 expected under present policies, many Directors underscored the need for early implementation of a significant supplementary budget. Some Directors, however, cautioned that a further increase in public spending would provide little additional stimulus, and urged the authorities to give even greater emphasis to promoting the supply side of the economy. In any case, Directors emphasized that any further increase in public works spending should be combined with efforts to increase the overall efficiency of public spending. Some Directors also considered that additional public spending on active labor market policies would be desirable.

Directors recommended that the authorities initiate a public process to develop a consensus on a credible strategy for eventual fiscal consolidation aimed at stabilizing and eventually reducing the general government net debt-to-GDP ratio, thus helping to raise confidence in long-term growth prospects and reduce the risks of volatile financial market conditions. As the authorities recognize, such a strategy would need to be responsive to the evolution of the economy rather than follow a predetermined adjustment path over a set period. Directors suggested that key elements of such a strategy would include a substantial scaling back of public works spending, together with revenue increases secured through a broadening of the personal income tax base and a rise in the consumption tax rate, and further reforms in the social security system.

Directors welcomed the authorities’ commitment to making sustained progress with structural reforms. Crucial to structural reforms in the fiscal area will be efforts to improve the quality of public works spending by applying cost-benefit analysis to project selection and improving the efficiency of bidding and procurement procedures, while accelerating private sector involvement in infrastructure provision. While welcoming the planned reforms to the Fiscal Investment and Loan Program (FILP), Directors considered that the benefits of the reforms would be maximized by requiring FILP agencies to rely to the greatest extent possible on market financing of their operations and strictly limiting the use of government guarantees. On tax reform, Directors noted that early introduction of taxpayer identification numbers would set the stage for measures to broaden the personal income tax base. Directors underscored the importance of improving fiscal transparency to provide a better basis for the assessment of the macroeconomic implications of fiscal policy. The most pressing objectives are the publication of more timely consolidated fiscal data and rolling multiyear projections of the main fiscal aggregates on a current services basis. The authorities were encouraged to complete a fiscal transparency ROSC module as soon as possible.

Directors welcomed the recent social security reforms aimed at improving the solvency of the public pension system. They stressed that a commensurate effort is still needed to put the public health care system on a sound financial footing, and that, over the medium term, further cuts in lifetime pension benefits and increases in the retirement age will be needed, given the longer-term pressure from population aging.

Directors cautioned against moving away from the “zero interest rate” policy at this time. They noted that, notwithstanding the inherent difficulty of assessing the degree of output slack under current circumstances, a range of indicators suggests that a still significant degree of economic slack remains in Japan, with the prospect that deflationary pressures are likely to persist for some time. While some Directors were sympathetic to the authorities’ desire to reestablish a more normal monetary environment, Directors considered that, in present circumstances, the potential costs of premature tightening—which could push the economy back into recession—outweigh the risks of waiting to move to a less accommodative monetary policy stance. Directors suggested that timely action could yet be needed to provide further monetary stimulus in the face of events that could undercut the recovery, including upward pressures on the yen unjustified by the strength of the economy, or an economic slowdown in the United States. Some Directors noted that a more transparent monetary policy framework—including early adoption of an inflation targeting framework with identification of the price goal and regular publication of the Bank of Japan’s inflation forecast—would further enhance the effectiveness of monetary policy.

Directors noted that, from a multilateral perspective, the yen appears at present to be broadly aligned with medium-term fundamentals. Directors were, nevertheless, concerned that a rapid appreciation of the yen, not justified by improving fundamentals, could yet undercut the recovery. Many Directors considered that the sterilized foreign exchange market intervention could at times be effective in mitigating unwarranted exchange rate pressures, although a substantial and lasting impact was likely to depend on a supportive monetary policy. Other Directors raised questions about the effectiveness of intervention policy in general, and stressed that foreign exchange market intervention was not a substitute for sound and credible macroeconomic policies.

Directors welcomed the progress made over the past two years in strengthening major banks’ balance sheets and allaying concerns about financial instability. However, much remains to be accomplished to ensure the soundness of the financial system and allow a smooth transition to limited deposit insurance in April 2002. The most pressing priorities are: to encourage major banks to strengthen their earnings base and achieve internationally comparable returns on equity; to implement rigorously the strengthened regulatory framework to address serious remaining weaknesses among smaller deposit-taking institutions (especially credit cooperatives); and to fill remaining gaps in the supervisory framework, including through a gradual increase in the minimum capital adequacy ratio to eight percent for all deposit-taking institutions. Directors believed that the effectiveness of the new procedures relating to deposit insurance will depend on the timeliness of interventions in financial institutions and their flexible application to maximize asset value, while ensuring that uninsured creditors as well as shareholders of failing institutions, bear the appropriate losses. Directors emphasized the need for firm implementation of the new framework for dealing with weaknesses in the life insurance sector. Some Directors suggested that leveling the playing field between the Postal Savings System and private banks in competing for funds would help to reduce over time the role of the public sector in financial intermediation. Directors welcomed the authorities’ intention to consider undertaking a Financial Sector Stability Assessment in the second half of 2001.

Directors commended the authorities for the recent progress in the legislative agenda to improve the environment for corporate restructuring, but cautioned that the momentum for structural reforms must be maintained to secure the basis for sustained market-led growth. They considered that the framework for corporate restructuring should be further enhanced by the early introduction of consolidated corporate taxation, the pragmatic implementation of the new bankruptcy legislation, and the rigorous application of the new accounting standards. To encourage labor mobility, Directors recommended the early introduction of portable, defined-contribution pension schemes, and further expansion of worker retraining programs to ease transitional costs on workers. Directors also stressed the need to move ahead with broad-based regulatory reform.

Directors noted that continuing weaknesses in economic statistics, especially in national accounts and fiscal data, complicate the monitoring of developments, the formulation of macroeconomic policies, and the exercise of Fund surveillance. They encouraged further efforts by the authorities to publish more timely, comprehensive, and accurate estimates of quarterly GDP and to improve the timeliness of fiscal data.

Directors welcomed the authorities’ efforts to increase ODA further in 1999 and Japan’s commitment to liberalize access for least developed countries’ exports. They considered that the initiatives taken over the past year to provide financial support to Asian countries, despite Japan’s own economic difficulties, had played an important role in supporting the strong economic recovery in the region. Japan’s willingness to provide debt relief to the HIPCs will be a key element of international efforts to alleviate poverty.