Public Information Notice No. 98/60

Public Information Notice: IMF Concludes Article IV Consultation with Japan

August 13, 1998

On August 5, 1998, the Executive Board concluded the Article IV consultation with Japan¹.

Background

After a substantial strengthening in 1996 and early 1997, the Japanese economy subsequently fell into recession. Real GDP dropped sharply in the second quarter of 1997, largely due to the reversal of an earlier surge in household spending ahead of the increase in the consumption tax rate in April. Activity rebounded modestly in the third quarter, but declined again in the fourth quarter of 1997 and the first quarter of 1998. Monthly data suggest that activity continued to weaken in the second quarter.

Financial sector strains were an important factor behind the slowdown. Long-standing balance sheet fragilities in the banking sector, and the impending introduction of a stricter regulatory framework in April 1998, resulted in a tightening of credit conditions. The failure of several major financial institutions in late 1997 was associated with considerable turbulence in short-term money markets and a sharp increase in the Japan premium. Concerns about the health of the financial sector was reflected in a sharp drop in stock prices from mid-1997 and to a decline in consumer confidence.

Activity was further dampened by a shift toward fiscal consolidation and the Asia crisis. With a view to achieving a sustainable fiscal position ahead of demographic pressures, the policy stance turned contractionary in 1997. The structural deficit of the general government fell by an estimated 1½ percent of GDP, as a result of tax increases—including a 2 percentage point hike in the consumption tax rate on April 1, 1997 and a withdrawal of earlier income tax relief in June 1997—and sharp cuts in public investment. The Asia crisis contributed to the slowdown by eroding the support from net external demand and further sapping confidence.

Private consumption and residential investment have fallen sharply in response to the fiscal measures, a deterioration in labor market conditions, and uncertainty about the economic outlook. Business investment also has faltered owing to a tightening of credit availability, as well as lower growth and profit forecasts. After contributing 1¼ percentage points to real GDP growth in 1997, net exports declined in the first quarter of 1998, mainly reflecting weaker exports to the rest of Asia. Nevertheless, the nominal current account surplus continued to widen, rising from 2¼ percent of GDP in 1997 to 3 percent in the first quarter of 1998, as the fall in commodity prices and Asian trading partners’ export prices benefitted the terms of trade.

Employment growth surged in early 1997, but has since fallen sharply, causing the unemployment rate to rise to a post-war record of 4.3 percent in June 1998. Monthly earnings have been flat over the past year reflecting the combined effect of weak employment growth, moderating wage increases, and declining average monthly hours. Deflationary pressures have emerged owing to the rise in economic slack and a drop in international commodity prices. During the first six months of 1998 the core CPI fell by just over ½ percent.

The authorities responded to emerging signs of economic weakness by relaxing the fiscal policy stance. In February 1998, a supplementary budget for FY1997 was passed that included a ¥2 trillion income tax cut, effective in the first half of 1998, as well as commitments to frontload public works spending. An additional stimulus package was announced in April 1998, which included around ¥12 trillion (2½ percent of GDP) in measures with a direct impact on domestic demand. As a result, the structural deficit of the general government is projected to increase by 1¼ percent of GDP in FY1998, with the stimulus mainly concentrated in the second half of the fiscal year. More recently, the authorities have announced plans for further fiscal stimulus, including ¥10 trillion of additional spending and at least ¥6 trillion in tax cuts.

In addition, steps were taken to bolster confidence in the banking system and relieve financial strains. Public funds totaling ¥30 trillion (6 percent of GDP) have been made available to strengthen the financial position of the deposit insurance system and to inject capital into the banking system. Steps were also taken to relax accounting and capital adequacy standards to ease the regulatory pressure on banks to downsize their balance sheets. In July, the authorities announced a comprehensive plan to deal with banking sector problems, which included measures to promote the disposal of bad loans, increase transparency and disclosure, and set up a "bridge bank" facility for dealing with insolvent institutions.

The stance of monetary policy—as measured by the target for the overnight rate—has remained unchanged since September 1995. The Bank of Japan injected substantial liquidity into money markets, particularly in late 1997 and early 1998, in order to relieve short-term funding constraints.

The yen has depreciated significantly against the U.S. dollar over the past year and by June 1998 had returned to levels not seen since the early 1990s, which prompted coordinated intervention by the Japanese and U.S. authorities. The decline in the yen’s exchange rate has been more moderate on a trade-weighted basis, reflecting the sharp depreciation of other Asian currencies against the U.S. dollar.

In view of the sharp first-quarter drop in activity, the IMF staff projects that real GDP is likely to decline significantly in 1998 as a whole. Business investment is expected to weaken further, in line with recent surveys and the depressed profit outlook, and the deterioration of household confidence and labor market conditions are likely to dampen consumption and residential investment. Inventories, which were at record highs in early 1998, are also expected to be reduced, while the contribution from net external demand is expected to be subdued by the effects of the regional crisis. However, activity is expected to begin to recover in the latter half of the year, mainly reflecting the anticipated impact of the recent stimulus packages on public investment.

Executive Board Assessment

Executive Directors noted that the performance of the Japanese economy had been much weaker than anticipated at the conclusion of last year’s consultation. In retrospect, the underlying momentum of the economic recovery in 1996 and early 1997 had not been sufficient to absorb the impact of increasing financial strains and the substantial tax increase, as well as the Asian crisis, in 1997. The recent downturn, and the related weakness of the yen, was especially worrisome since it had exacerbated economic difficulties elsewhere in Asia, including by adding to instability in financial markets. Moreover, growth is expected to be low in 1999, and the downside risks are considerable.

In these circumstances, Directors stressed the need for swift and decisive measures to reverse the deteriorating economic situation and place Japan back on a path of sustained domestic demand-led growth. Such action is essential for the Japanese economy, and equally essential to underpin a turnaround in the Asia region more generally, in view of Japan’s crucial importance—as the world’s second largest economy—to the region and to the global economy. While the government has taken a number of welcome initiatives, the overall response thus far has fallen short of the timely, comprehensive, and forceful program that is required, given the seriousness of the present situation. The critical need is for the early implementation of far-reaching measures to deal with the bad loan problem in the banking sector and restore the Japanese financial system to health. It is also vital for the authorities to ensure that fiscal support for the economy remains in place until the recovery takes hold. Action in both these areas is key to a restoration of domestic confidence and thereby a revival of growth. Pointing to the window of opportunity available to the new government, several Directors encouraged the authorities to make a decisive break from the past toward more aggressive action. In this regard, they welcomed the recent statements by the new Prime Minister suggesting that substantial tax cuts and spending hikes will be introduced—they considered these measures as important steps toward addressing this situation.

As regards the banking sector, Directors acknowledged the progress that had been achieved since last year, but noted that there remains considerable uncertainty regarding the extent of underlying balance sheet problems and the sufficiency of the authorities’ strategy for achieving a comprehensive restructuring of the banking sector. Continuing market doubts about the financial strength of banks left the economy vulnerable to a further deterioration in confidence, deflationary pressures, and a prolongation of the credit crunch. Bolder and more aggressive action is necessary, therefore, to deal decisively with banking system problems.

In particular:

•Rigorous enforcement of the self-assessment framework is needed so that banks recognize and provision against the full extent of bad loans. Several Directors suggested that these results be published for individual banks to increase transparency.

•Recapitalization of the core banking system would require linking injections of public funds to strong restructuring plans. Most Directors called for a more proactive approach to such restructuring than had been implemented so far. In this regard, some Directors noted that there had been only limited use of the available funds to this point.

•Aggressive efforts to resolve problem loans are needed, including placing these loans with specialized asset management units with strong incentives to maximize value. Improved institutional mechanisms for debt workouts, including the reform of bankruptcy laws, are also necessary.

•To be effective, the new "Bridge Bank" scheme would require transparent guidelines for new lending and steps to identify buyers for bridge banks on a timely basis.

•While the establishment of the new financial supervisory authority was welcome, it needed to be strengthened, by rapidly increasing its resources, providing independent funding, and enhancing its autonomy.

Notwithstanding the longer-term need for fiscal consolidation, most Directors stressed that the immediate priority for fiscal policy is to provide adequate support for aggregate demand. Several Directors remarked that the risks of a deepening recession outweighed the costs of a further temporary fiscal stimulus, noting that, unless growth is restored, the medium-term fiscal and debt dynamics could only worsen. Directors emphasized that, in view of the underlying weakness in domestic activity, measures would be required that were at least sufficient to avoid any withdrawal of fiscal stimulus in the next fiscal year. Indeed, a few Directors suggested that an even more expansionary fiscal stance is warranted. However, they underscored that, irrespective of the stance of fiscal policy, the desired recovery in confidence and activity would not be forthcoming without decisively addressing the challenge of banking sector reform.

With an eye to addressing the government’s medium-term fiscal consolidation goals, Directors stressed that additional tax measures envisaged in the 1998 stimulus package should be consistent with improving the efficiency of the tax system and not have just one-off effects on activity. For example, reductions in tax rates for both individuals and corporations seemed warranted, given the high level of top marginal rates. Several Directors noted that consideration could also be given to a cut in the consumption tax—to be reversed once the recovery is fully established—to stimulate demand in the short term. Accompanying these cuts with a multi-year commitment to gradual base broadening would, Directors noted, help to alleviate concerns about the impact of tax rate cuts on income distribution and the longer-term fiscal situation. Broader tax reforms, including reforms relating to the treatment of pensions, are also needed.

Directors also encouraged further reforms to the fiscal system to help achieve medium-term fiscal sustainability. On the spending front, measures to improve the efficiency of public works are critical, in view of widespread concerns about the low social returns on such investment. Although Directors welcomed recent measures to relax the constraints of the Fiscal Structural Reform Act, they stressed that there remains a need to improve the transparency of budgetary policy and establish a more coherent multi-year framework for planning.

Directors endorsed the monetary authorities’ decision to maintain the current level of short-term interest rates for the time being. A few Directors noted, however, that, if signs emerged that fiscal stimulus had been unsuccessful in arresting the decline in activity in the second half of 1998, the balance of arguments would shift toward using the limited remaining scope to ease short-term interest rates. Most Directors, however, did not support a cut in interest rates now, as this could weaken the exchange rate and risk destabilizing regional financial markets. Further, in view of the already low level of rates, the impact of a rate cut on activity is not likely to be significant. A few Directors favored an explicit commitment to a small, but positive, inflation target, in order to signal the monetary authorities’ determination to resist deflationary pressures. Many Directors, however, considered that an inflation target would not be particularly beneficial in the current circumstances of low interest rates and would do little to address the fundamental problem of low confidence.

Directors agreed that the weakness of the yen since mid-1997 had been helpful from a cyclical perspective, but that further significant depreciation would be counterproductive because of the negative impact on the region, which would in turn have adverse feedback effects on Japan. The recent intervention in foreign exchange markets appeared to have helped stabilize market conditions for the time being. Directors cautioned, however, that failure to follow through with supporting policy actions could trigger further downward pressures on the yen.

Directors welcomed the authorities’ commitment to the "Big Bang" reforms of the financial sector, which are a key element in the necessary restructuring of the Japanese economy. Although the timing of the reform—in the midst of a major economic downturn—is far from ideal, it is necessary to avoid slowing the process, given its importance for achieving a durable solution to Japan’s structural problems. Indeed, more ambitious measures to scale back the public sector’s role in financial intermediation, including by eliminating the preferential treatment of the postal savings system, are needed. Noting the vulnerability of the life insurance sector,Directors stressed that it would be important to limit potential moral hazard associated with any government guarantees.

Directors observed that substantial benefits had already resulted from deregulation efforts, particularly in the areas of telecommunications, energy, and retail sales. Remaining regulatory restrictions are still substantial, however, and contribute to low productivity and lack of competition. Accordingly, Directors called for an ambitious, front-loaded approach to deregulation. In particular, they encouraged the authorities to push ahead with plans to further liberalize the telecommunications and power generation sectors, and stressed the need for more ambitious steps toward reducing nontariff barriers. Reforms to labor market and bankruptcy laws were also viewed as essential to encourage restructuring in the corporate sector.

Directors commended Japan for its role as the world’s largest donor of official development assistance (ODA), as well as the substantial support it had provided to the countries most affected by the Asian crisis. Directors noted, however, that fiscal constraints had led to cuts in ODA, and they encouraged the authorities to make every effort to maintain Japan’s generous record of development assistance.

Directors observed that Japan’s economic data suffered from important weaknesses, which complicated policy analysis. In particular, they encouraged the authorities to improve the timeliness, coverage, and quality of national accounts and fiscal data.