Public Information Notice No. 05/105

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Japan

August 8, 2005

On July 29, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.¹

Background

GDP growth slowed unexpectedly in the second quarter of 2004, after several quarters of above trend growth. For the full year, GDP rose by 2.6 percent, well below expectations. A significant part of the shortfall reflected a shift to a chain-weighted methodology—growth on the old methodology was 3.6 percent. The rest was associated with an unanticipated fall in partner country demand, owing to a slowdown in the global IT market as well as higher oil prices, and weaker private domestic demand. During 2005, economic activity has rebounded, with unexpectedly strong GDP growth in the first quarter (4.9 percent SAAR), partly reflecting temporary factors. Recent indicators, notably on retail sales, investment plans, and employment growth portend a continued expansion going forward. Despite the acceleration in activity, mild underlying deflation persists. Financial markets developments have been uneventful, with the Nikkei broadly flat and bond yields somewhat lower compared with a year ago.

The yen has been broadly stable against the U.S. dollar and on a multilateral basis. Over the past 12 months, the bilateral exchange rate vis-à-vis the dollar has been in a range of ¥102 to ¥115. Appreciation pressures emerged toward the end of 2004, driven largely by broad-based dollar weakness, but receded on expectations of faster tightening by the U.S. Federal Reserve. In effective terms, the nominal and real exchange rates have been little changed over the past 12 months. Unit labor costs have been declining, while growing in partner countries; and, given Japan's already sizeable external surplus, competitiveness is not a concern at present.

Pressure on labor markets from job shedding is slowly abating. The unemployment rate is at a six-year low, the ratio of job offers to applicants has continued to hover at post-bubble highs, and corporate surveys indicate declining labor market slack. Employment of regular workers is firming, as the past trend toward hiring temporary and contract workers begins to ebb. Thanks in part to the shift back towards regular workers (who are more highly paid), real wages have recently bottomed out, with positive implications for future income growth.

Progress in corporate restructuring continues. Cash flow and profits remain buoyant, bankruptcies have fallen to a ten-year low, and leverage continues to decline. Furthermore, the recovery in the corporate sector continues to broaden beyond large export-oriented manufacturers to include smaller enterprises and nonmanufacturers.

Further progress has also been made in strengthening the banking system. Tightened regulation of major banks under the Program for Financial Revival (PFR), together with corporate sector improvements, have reduced nonperforming loans (NPLs) and supported ratings upgrades. Major banks more than met the PFR's goal of halving the NPL ratio to around 4 percent by the program's expiration in March 2005. The pace of decline in bank lending has slowed, and according to the Tankan survey, borrowers perceive an increased willingness to lend. In addition, a blanket guarantee on bank deposits was lifted at end-March, with no signs of strain. Nonetheless, the process of revitalizing the banking system has further to go, with the quality of bank capital weakened by deferred tax assets, core profitability still low, and regional banks lagging in cutting bad loans.

Monetary policy remains highly accommodative, with liquidity ample and short-term interest rates at zero under the quantitative easing framework. The Bank of Japan has repeatedly stressed that the policy will remain in place until deflation is defeated. In May, it decided to allow temporary undershooting of its target range for current account balances at the Bank in light of seasonal volatility in liquidity demand. The move was generally perceived by markets as a technical step and not as a fundamental policy shift.

Fiscal consolidation was achieved in FY2004 (ending March 2005), but the deficit remains large. The general government deficit is estimated to have narrowed by 0.6 percent of GDP to 6.9 percent of GDP. The structural balance improved by 0.3 percent of GDP. About half of the decline in the general government deficit reflected stronger-than-expected revenues and some expenditure savings achieved in the supplementary budget. A decade of high deficits has fed rapid growth in gross public debt to 170 percent of GDP, by far the highest among advanced countries. Net debt is around 80 percent of GDP.

The near-term macroeconomic outlook is improving. The slowdown in world growth appears to have bottomed out, with strong first quarter growth in most regions, while inventory and production adjustments in the IT sector are advancing and other data point to a revival of private consumption and investment. Accordingly, annual average growth of Japan's GDP is projected at about 1¾ percent in 2005 and 2006. As economic slack is taken up, deflationary pressures should ease, with consumer prices finally bottoming out in 2006. Risks remain biased to the downside, and include weakening global growth (especially if new spikes in oil prices occur), and renewed upward pressure on the yen. For the medium term, growth is anticipated to slow to potential, estimated at 1.5 percent. Relatively low potential growth reflects muted total factor productivity, as well as a continued decline in the working-age population.

Executive Board Assessment

Executive Directors welcomed the further signs of progress in resolving the legacies of the bubble years in Japan. The financial system has been stabilized, the corporate sector is more resilient, labor markets have become more dynamic, and fiscal consolidation is under way. As a result, the economy appears better positioned to sustain an expansion.

Nonetheless, Directors noted that low trend growth and rising demographic pressures pose risks to medium-term prospects. Population aging is pushing up social spending, and modest underlying growth leaves the economy susceptible to shocks. Against this background, further efforts will be needed to advance fiscal and structural reforms in order to strengthen the underpinnings for more robust self-sustained growth. Directors acknowledged that implementing such reforms will be difficult, but emphasized that they would strengthen the domestic economy and, together with concerted policy efforts in other countries to address external imbalances, contribute to making the global economy more resilient, thereby limiting the risk of a disorderly adjustment in currency markets.

Directors agreed that the priority for monetary policy remains to eliminate deflation. They welcomed the Bank of Japan's commitment to maintain an accommodative stance until both actual and expected inflation turn positive. Most Directors were of the view that, in the face of reduced liquidity demand, the target for current account balances could probably be reduced without tightening monetary conditions. Nonetheless, Directors agreed with the Bank of Japan that, in order to signal unambiguously the commitment to maintaining an easy monetary stance, keeping the target at its present level for the time being was appropriate.

Directors emphasized that continued clear communication of the authorities' monetary policy intentions will play a crucial role in promoting policy credibility and effectiveness as deflation ebbs and monetary operations shift back to using interest rates as a policy tool. Directors generally supported the Bank of Japan's preference for adopting a flexible approach in shifting to a new monetary policy framework, tailored to evolving financial and economic conditions. Some Directors supported the announcement of a quantified inflation objective to stabilize inflation expectations once deflation is incontestably defeated. Others noted that, in the current situation, the benefits of announcing an inflation target might be limited, in light of the uncertainties about the effectiveness of the monetary policy transmission mechanism.

Directors observed that the authorities base their exchange rate policy on the conviction that exchange rates should reflect economic fundamentals and that disorderly movements are not desirable for economic growth. They noted that the authorities had not intervened in the foreign exchange markets since early 2004. At the same time, given the primacy of protecting the objectives of eradicating deflation and supporting growth, a few Directors considered that intervention could be warranted as a last resort if appreciation pressures seriously threaten to lower the price level or risk the economic recovery, and taking into account the limited scope for more conventional monetary and fiscal policy. Most other Directors, however, pointed to the economy's improved ability to handle a stronger currency, and cautioned that intervention should only be used under extraordinary circumstances.

Directors welcomed the progress made in advancing fiscal consolidation in FY2004, but noted that the deficit remains large, the public debt is set to rise further, and the structural balance will decline only a little in the current fiscal year, despite steps to restrain nondiscretionary spending and raise revenues. They encouraged the authorities to save any potential tax windfall and to avoid any expansionary measures in this year's supplementary budget, assuming the expansion continues as envisaged.

Directors considered that stabilizing the public debt and making room for the fiscal costs of population aging will present challenges to fiscal policy in the medium term. They welcomed the authorities' objective of achieving primary balance excluding social security by early in the next decade. A number of Directors agreed that a steady and gradual reduction in the deficit is appropriate, to minimize any negative impact on the still-nascent economic recovery. Many other Directors, however, observed that a larger adjustment may be required to stabilize the debt, especially if real interest rates rise more than expected in the future. While such an adjustment would require difficult measures on both the revenue and expenditure sides, the adjustment should be manageable in light of the economy's improved resilience. Directors saw scope for further streamlining public investment and for civil service reform, as well as for comprehensive tax reforms, including an increase in the consumption tax. At the same time, they recommended that fiscal adjustment plans be given flexibility to adapt to changing economic circumstances.

Directors welcomed the progress made in resolving balance sheet problems in the banking system. They saw the smooth transition to partial deposit insurance as an important sign of public confidence in banking system stability. Looking ahead, Directors noted that the emphasis of financial sector policies is appropriately shifting toward revitalization, as highlighted in the new Program for Further Financial Reform. They welcomed the goals of the new program, and looked forward to prompt implementation of specific measures. The priorities include continued supervisory scrutiny to address remaining balance sheet weaknesses, particularly among the regional banks, and steps to improve risk management and enhance the environment for bank profitability. Directors also welcomed the planned privatization of Japan Post, the country's largest deposit-taker, which could help level the playing field for private financial institutions.

Directors stressed that structural reforms will be needed to mitigate the effects of population aging on potential growth and bolster Japan's productive capacity. Liberalizing factor and product markets will help strengthen underlying growth prospects, and in that vein, labor market flexibility should be increased further, product market competition enhanced, and inward foreign direct investment encouraged. Directors noted that reform of the agricultural sector could yield large benefits, given the sector's high protection and low efficiency. They encouraged the authorities to reduce import barriers and move toward direct payments to farmers.

Directors called on the authorities to make further trade liberalization a central element of their structural reform agenda, to the benefit of both Japan and developing countries. They welcomed Japan's continued support for the multilateral trading system, and encouraged the authorities to take a leadership role in helping to bring about a successful conclusion of the Doha Round negotiations.

Directors commended Japan's efforts to maintain official development assistance notwithstanding budget pressures. They encouraged the authorities to raise development assistance toward the UN recommended target.