Public Information Notice No. 97/19

Press Information Notice: IMF Concludes Article IV Consultation with Japan

August 13, 1997

The IMF Executive Board on July 25, 1997 concluded the 1997 Article IV consultation¹ with Japan.

Background

Economic developments in Japan during the past year and a half have generally been favorable: growth in 1996 was the highest among the major industrial countries; capital stock imbalances, which had weighed on investment in previous years, were further reduced; and significant steps also were taken to address balance sheet problems in the banking sector. Moreover, the new government elected in the fall of 1996 has indicated a strong commitment to medium-term structural and fiscal reforms.

GDP growth accelerated to 3½ percent in 1996, compared with 1½ percent in 1995. Public investment contributed strongly to activity, due to the fiscal stimulus package introduced in late 1995. Growth also was bolstered by a pickup in consumption and private investment, reflecting the effects of low interest rates and the completion of capital stock adjustments. Real GDP rose by 1½ percent (quarterly rate) in the first quarter of 1997; this was largely related to a surge in household demand ahead of the April consumption tax hike, which the recent data suggest will be unwound in the second quarter.

Despite a pickup in activity, economic slack remains. While employment growth has accelerated, the unemployment rate has remained near or at the peak of 3½ percent reached in mid-1996, as increases in the participation rate have largely matched employment gains. As a result, underlying inflation remains near zero, while consumer and wholesale prices jumped in April by about 1½ percent, mainly reflecting the impact of the consumption tax increase. Largely reflecting a succession of fiscal stimulus packages, the general government budget position deteriorated steadily from approximate balance at the beginning of the decade to a deficit of about 7¼ percent of GDP in calendar 1996 (national accounts basis, excluding the social security surplus of about 2¾ percent of GDP). However, the FY 1997 budget (April-March) began the process of unwinding the fiscal stimulus of recent years. In particular, the consumption tax rate was raised from 3 percent to 5 percent, temporary income tax cuts were withdrawn, and investment spending, which had risen sharply during the economic downturn, is projected to fall sharply. A medium-term consolidation strategy also has been announced, which includes the objective of reducing the general government deficit (excluding social security) to no more than 3 percent of GDP by FY 2003, and cuts in government spending in FY 1998 have been announced.

The stance of monetary policy has been held steady since September 1995, when the official discount rate was lowered to a record low ½ percent. However, longer-term yields were volatile in late 1996 and the first half of 1997, in large part reflecting concerns about the effect of fiscal consolidation on growth. In particular, bond yields fell sharply from mid-1996, and the Nikkei 225 index also dropped by nearly 25 percent from its 1996 peak. While the Nikkei had recovered over half its earlier losses by July, bond yields remained close to historical lows. Urban land prices have declined steadily to less than half their peak values, but there are recent signs that prices are bottoming out, especially for residential and prime commercial properties.

The yen moved in a comparatively narrow range through most of 1996, following the 25 percent correction in the latter half of 1995, but depreciated sharply in late 1996 and early 1997. The yen’s weakness also reflected reduced confidence in growth prospects as well as widening long-term interest rate differentials. By end-April, the exchange rate had fallen to a level that completely reversed its appreciation against the U.S. dollar since 1992. However, the yen subsequently strengthened, partly owing to improved confidence; narrowing long-term interest differentials; statements by Japanese officials that the yen was undervalued; and the prospect of a rise in the Japanese current account. In particular, while the current account surplus fell from over 3 percent of GDP in 1993 to 1½ percent of GDP in 1996, the downward trend in the surplus reversed in the first half of 1997, as export and import volumes responded with a lag to the yen’s depreciation since mid-1995.

Executive Board Assessment

Executive Directors welcomed the robust growth of the economy in 1996, which reflected the impact of policies to support aggregate demand and the correction of imbalances that had contributed to the prolonged downturn. Directors broadly endorsed the staff’s view that the recovery was becoming self-sustaining, although some speakers pointed to uncertainties in the short term, including the effects of the recent consumption tax increase and continuing financial sector problems. Most Directors observed that the central challenge for policymakers was to return the fiscal balance to a more sustainable level over the medium term. Directors believed that the current easy stance of monetary policy should be maintained for the time being, but that it would likely be desirable to begin tightening later in the year, when the full effects of tax increases on activity would be apparent. While important steps had been taken to resolve the strains in the financial sector, Directors noted that a clear framework was needed for dealing with problems among financial institutions. They emphasized the importance of deregulation and structural reform in ensuring robust growth in Japan over the longer term, particularly in light of the aging of the population.

Directors endorsed the fiscal correction measures enacted in the 1997 budget as a step in the right direction, given the large budget deficit and to prevent a further increase in the already high level of public indebtedness. Looking ahead, Directors welcomed the government’s announcement of plans for medium-term fiscal consolidation and proposals for spending restraint in next year’s budget. A number of Directors, however, thought that a faster pace of consolidation would be desirable to address the fiscal strains associated with population aging in the longer term, and broadly endorsed the staff’s suggestion that consolidation measures averaging 1 percent of GDP per year be taken over the next four years. In this context, some Directors noted that the confidence gains from the prior announcement of a credible fiscal consolidation plan could go a long way to help reduce the associated output costs. Several other Directors, however, considered that, while medium-term fiscal consolidation remained crucial, it would be important to balance the need for a front-loaded approach with the need to ensure a strong and sustainable pace of economic expansion. Several Directors noted the sharp rise in social security contribution rates that would be needed to keep the system solvent under current plans, and urged that measures be taken to moderate benefits and achieve a more balanced adjustment.

Noting the complexity and lack of consolidation of the Japanese budget, Directors agreed that increased transparency of government operations in fiscal accounts would permit a clearer assessment of the fiscal position, as well as enhance policy credibility. The inclusion of off-budget items and the identification of unfunded liabilities in the budget were of particular importance in that regard. Several Directors also held the view that reforms to the process by which government investment outlays were allocated would be helpful in ensuring fiscal restraint over the longer term.

Directors noted that, while the current low levels of short-term interest rates had played an important role in stimulating the economy since mid-1995, they were not appropriate over the medium term. The key monetary policy issue was, therefore, how to maintain support for the recovery, while not unduly delaying needed adjustments. Most Directors agreed that the current monetary stance should be maintained at present, and that the pace and timing of future interest rate increases would depend on indications of the strength of the recovery, including the effects of medium-term fiscal consolidation measures. A few Directors, taking into account the very low level of current interest rates, suggested that there was scope for an early, albeit cautious, move to raise interest rates in a preemptive manner.

Directors welcomed the increased independence granted to the Bank of Japan, and recommended that policy be given full operational effect. While a few Directors considered that setting a target range for inflation with a lower bound somewhat above zero would clarify monetary objectives and enhance accountability, most Directors were not convinced that the present policy framework needed changing, especially given Japan’s enviable record of low inflation.

Directors believed that the current level of the yen was broadly in line with fundamentals. Most Directors agreed that the associated rise in the current account surplus reflected a desirable redistribution of global demand pressures. They thought that the present level of the current account was not a cause for concern and that policies should not target a specific current account position. The view was held, however, that a rise in the surplus, if sustained, could fuel protectionist pressures abroad.

Directors strongly supported the government’s commitment to deregulation and structural reform, which would be an important element in ensuring robust, longer-term economic growth in the face of an aging population. Noting that the financial system remained vulnerable to shocks, Directors endorsed the "Big Bang" financial sector reform plan, and urged that it be implemented forcefully and fully. They also noted that the envisaged reforms heightened the need for a strengthened supervisory framework and a more arm’s length approach to regulation. Directors urged the authorities to push ahead with deregulation on a broad front, expanding and accelerating existing commitments.

Some Directors welcomed the recent proposal aimed at deregulating transportation, telecommunications, and power generation, and encouraged the authorities to press ahead with similar reforms in the areas of land use, distribution, and marketing. While noting the recent progress in trade liberalization, some Directors called for further actions to remove existing barriers to trade and to increase market access, including in agriculture. Such efforts would serve to enhance Japan’s welfare, as well as that of Japan’s trading partners. Directors also welcomed Japan’s commitment to the multilateral trading system and the World Trade Organization. Pointing again to demographic trends in Japan, some Directors underscored the importance of labor market reforms, including steps to enhance education and training, facilitate labor mobility, increase the flexibility of working hours, and encourage participation by older workers.

Directors welcomed the progress made over the last year in addressing financial sector problems, but noted that the strengthening of the banking system should remain a priority. Several Directors pointed to the continuing need to accelerate the pace of writing off bad loans. Actions were also needed to guard banks’ balance sheets against swings in share prices, to improve financial disclosure and accounting standards, and strengthen supervision and regulation. Directors believed that a clear framework was needed for resolving problems among financial institutions in a way that would avoid burdening healthy institutions. Some Directors also believed that an explicit commitment of public funds could help reduce systemic risks, while others expressed concern about the fiscal costs and the effects on incentives of such an approach. In addition, several Directors were of the view that market-oriented reforms should be applied to nonbank financial institutions.

Directors commended Japan for its role as the world’s largest donor of official development assistance (ODA). However, they also noted that ODA spending had fallen in 1996 and was projected to continue to fall in the future. They urged Japan to try to find new resources even during this period of fiscal restraint, and to ensure that everything possible was done to raise the quality of ODA spending.

In conclusion, Directors were gratified by signs that Japan’s recovery was becoming self-sustaining. They emphasized the need to ensure that the recovery matured into a balanced expansion by complementing fiscal consolidation with appropriate monetary policies, and vigorous deregulation and structural reforms. Directors welcomed the promising start made by the authorities in those areas, and urged that the current impetus for reform be used to accelerate and expand those initiatives.