Public Information Notice No. 02/85

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Japan

August 8, 2002

On July 24, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.¹

Background

In 2001, Japan experienced its third—and worst—recession of the past decade. After a strong first quarter, real GDP fell for three successive quarters, with a drop of ½ percent on an annual basis compared to 2¼ percent growth in 2000. This slump was largely attributable to the reversal of the engines of growth in 2000—business investment and net exports. With the downturn in the global electronics market last year, profits, investment, and exports plunged, the latter leading to a sharp turnaround in the external sector's contribution to growth. At the same time, private consumption remained anemic in the face of weak incomes and uncertain job prospects.

The economy rebounded strongly in the first quarter of 2002. Global recovery underpinned a large net export contribution, while special transitory factors—including unseasonably warm weather and anomalies in the small single-family spending survey—boosted household spending. Earlier fiscal stimulus measures boosted public demand, but business and residential investment continued to slump.

Deflation persists, magnifying real debt burdens. In terms of the core CPI (which excludes fresh food and energy), deflation remains at 1 percent. While relative price declines for telecommunications, household goods, and clothing may reflect structural change—e.g., telecom deregulation and increased imports from Asia—deflation in the general price level reflected weak demand and the rising output gap. Land prices also continued to decline, and surveyed expectations point to ongoing deflation. Reflecting these trends, nominal GDP has fallen by 2½ percent over the past year, magnifying corporate debt burdens, and contributing to a surge in bankruptcies to their highest level since 1984.

Following last year's narrowing, the current account surplus widened strongly in the first quarter of 2002. The trade surplus—which had narrowed sharply during 2001 as the global slowdown took its toll on exports—widened as export volumes recovered and imports declined. Strong profits from overseas subsidiaries of Japanese companies (recorded in the statistics with a lag) and a decline in payments overseas also boosted the investment income surplus. In the financial account, outward direct investment has increased as companies have sought to improve competitiveness by relocating operations overseas.

Equity prices, which spiraled downwards last year amid the deterioration in the economy, rebounded during March–May 2002, but have since followed world markets down. In contrast to other major stock market indices, the Nikkei and Topix did not rebound from their September

lows through February, with both indices falling by one-half from their cyclical peaks in March 2000, as bank stocks weighed heavily on the market. As well as the sharp deterioration in the earnings outlook, structural factors impacted the market, including the continued unwinding of cross shareholdings between banks and corporates. The stock market's rally in March coincided with a tightening of short-selling regulations on equities, but improved foreign sentiment toward Japanese stocks amid the strengthening of the global economy sustained the rebound. The Nikkei and Topix, however, have subsequently dropped 15–20 percent from their recent peaks.

The yen was under downward pressure for most of the past year, but reversed course from March 2002. Following its downtrend in the first half of 2001, the yen briefly rallied in the wake of the post-September 11 terrorist attacks. Subsequently, it weakened sharply against the U.S. dollar through early March 2002. From then on, and despite significant intervention to stem its rise, the yen has strengthened, especially against the U.S. dollar which has weakened in world markets. This said, the yen remains 5–10 percent depreciated in nominal and real effective terms (CPI and ULC basis) relative to average levels in 2001, and 10–20 percent below levels in 2000.

Since the introduction of its quantitative framework in March 2001, the Bank of Japan has gradually raised its operating target for current account balances (bank and nonbank reserves at the BoJ). The BoJ first increased the target in August 2001, and then again in December 2001. In the runup to the removal of the blanket deposit guarantee in March 2002, moreover, the BoJ allowed current account balances to exceed the target, and it stepped up its outright Japan Government Bond (JGB) purchases to -1 trillion a month from February 2002. Notwithstanding the impact on base money—which saw year-on-year growth of 25 percent in July 2002—broad money and bank lending have not responded.

Current policy is set to deliver a fiscal contraction in FY2002, following the expansionary stance in FY2001 (fiscal year runs from April 1 to March 31). To meet the Prime Minister's pledge to limit net JGB issues to -30 trillion, the FY2002 budget included spending cuts—on public works, public enterprise subsidies, and ODA—that will result in the first decline in discretionary spending in four years. These cuts, however, will be cushioned to some extent by two supplementary budgets in late FY2001, and the general government structural budget deficit is expected to decline by around ½ percent of GDP in FY2002. Gross government debt rose to around 146 percent of GDP at end-2001, and net debt (excluding social security assets) rose to 112 percent of GDP. JGB yields have fluctuated in a narrow range over the past year, despite the downgrades of Japan's sovereign credit rating, mounting public debt, and concerns that another round of public funds may need to be injected into the banking system.

The weak economy and falling equity prices have taken their toll on bank profits, and on market perceptions of banking risks. Major banks' loan-loss charges rose to -7.7 trillion in FY2001, four times as large as projected at the start of the financial year. Reflecting concerns about their financial health, spreads on bank debentures rose in early 2002 ahead of the removal of the blanket deposit guarantee, but have since narrowed. While operating profits did rise, with no gains on equity portfolios in contrast to previous years, net losses of -3.5 trillion were posted. The Japan premium (the spread between U.S. dollar borrowing costs of Japanese banks and U.S. LIBOR), however, has not resurfaced, as Japanese banks have been largely absent from the market. Life insurers' financial health weakened further in FY2001 due to falling equity prices and ongoing negative yield spreads.

Even with the strong growth in the first quarter of 2002, real GDP is nevertheless expected to decline by about ½ percent on an annual-average basis for 2002 as a whole. The sharp increases in private consumption and public investment in the first quarter are unlikely to be sustained during the rest of the year owing to the uncertain employment outlook and an expected withdrawal of the fiscal stimulus. Exports are likely to remain robust, but the external contribution to growth is expected to taper off as imports increase. A modest cyclical recovery in business investment is not expected before late-2002.

Executive Board Assessment

Executive Directors welcomed the recent improvement in the Japanese economy, but noted that there are still considerable downside risks to economic activity. They were concerned that the recovery is likely to prove short-lived unless Japan's deep-seated structural problems in the bank and corporate sectors are urgently and comprehensively addressed. They urged that complacency must be avoided at all costs, as this would only serve to prolong Japan's decade of stagnation, as well as heighten the vulnerabilities from the bank, corporate, and fiscal sectors. Directors therefore welcomed the government's reaffirmation of its commitment to press ahead with structural reforms, and to build on the progress that has been achieved during its first year in office.

Directors broadly endorsed the integrated policy strategy with four pillars advocated by staff, consisting of: addressing banking weaknesses; accelerating corporate restructuring; laying out a credible medium-term fiscal consolidation strategy while maintaining a broadly neutral stance in the near term; and a monetary policy aimed at securing an early end to deflation. They noted that these pillars are interlinked, not least because supportive macroeconomic policies will be needed to mitigate headwinds to activity in the near term from vigorous restructuring. Equally, Directors recognized that without such restructuring, supportive macroeconomic policies alone should not be counted on to lead Japan's economy out of its decade-long slump in a sustainable way.

Directors stressed that resolution of the problems in the banking sector is a prerequisite for restoring and sustaining healthy growth. Most Directors urged that the strategy announced by the authorities last year be strengthened to accelerate the process of bank restructuring. Time is of the essence, these Directors noted, given the final phase of the transition to partial deposit insurance next April, and the potential for contagion from weaker banks if systemic confidence is in doubt at that time. However, a few other Directors acknowledged that the pace and scope of structural reform are subject to institutional constraints, and stressed the need for realistic targets in this area. Against this background, Directors welcomed the authorities' intention to press ahead with the Financial Sector Assessment Program.

In the banking sector, many Directors welcomed the progress initiated by the FSA's special inspections and other measures to strengthen loan classification and provisioning practices. However, Directors stressed the need to go further, by extending the forward-looking approach of the FSA's special inspections to all loans, including those of regional and smaller banks. Most Directors acknowledged that a rigorous review of loan classification and provisioning practices could result in capital falling below regulatory minima. In this context, a number of Directors were of the view that the public support framework may need to be used to inject capital in systemically-important banks, subject to strong conditionality to limit moral hazard, in cases where banks are unable to raise sufficient private capital. If the presently-available -15 trillion support framework proved insufficient, these Directors noted that additional funds would need to be made available.

Most Directors stressed that all deposit-taking institutions—rather than just major banks as at present—should face a timetable for the disposal of non-performing loans (NPLs). Directors noted that several other steps will also be required to secure a return to healthy profitability in the banking sector, including: stronger regulatory pressure on banks to develop viable business improvement plans; strengthened governance and disclosure rules to increase market discipline; and a downsizing of public financial intermediaries, particularly where these compete unfairly with private banks. Directors also underscored the need for the FSA to remain vigilant to the risks associated with the financial links between banks and insurance companies, as there is potential for a cascading effect if either actor experiences difficulty in present circumstances.

Directors noted that banks, which own the bulk of corporate excess leverage, must take the lead in agreeing restructuring plans with their potentially-viable debtors, push nonviable firms into liquidation, and dispose of unwanted loans to third parties. For the needed proactive approach to be possible, however, Directors stressed that banks need to face appropriate incentives, which in turn will require strengthened regulatory pressure to ensure banks finally recognize the true value of loans on their books.

Directors considered that the Resolution and Collection Corporation (RCC) should rapidly step up its purchases of distressed debt over the next year. In this context, they stressed the need to clarify the RCC's mandate as far as value, pricing, and timeframe for its purchases are concerned. Rapid disposal of acquired NPLs should enable the RCC to play a useful role in expanding Japan's distressed debt market, especially by securitizing NPLs and creating pricing benchmarks and standards for such transactions.

Directors reviewed the range of structural reforms that will be required to ease the transitional costs from corporate restructuring and generate new investment and job opportunities. With respect to the labor market, they considered that regulations governing private employment placement and dispatching agencies should be liberalized further, public funding for retraining programs should be increased, and the social safety net should be improved by lengthening the maximum duration of unemployment benefits, at least for the next few years. At the same time, however, to support the needed reallocation of labor, Directors stressed the importance of liberalizing employment protection legislation to facilitate labor shedding.

With respect to regulatory reform, Directors highlighted the need to review rules limiting the size of housing developments and requiring large retail stores to obtain local government approval. While welcoming the reduction in entry barriers in the telecommunications and power sectors, Directors stressed the need to make more progress in reducing costs, which remain high by international standards. Directors also welcomed the recent revision of the Commercial Code, which should help to improve corporate governance by allowing firms to adopt managements with a majority of outside directors.

As the implementation of vigorous bank and corporate restructuring is likely to intensify headwinds against the fragile recovery, most Directors considered that a key role for fiscal policy is to achieve a broadly neutral stance in the near term. Many Directors, therefore, expressed reservations about the likely fiscal contraction from later this year—once the impact of last year's supplementary budgets fades—and recommended that the authorities take steps to counteract the contractionary impulse, through measures that would encourage economic restructuring. A number of Directors, however, considered that any additional fiscal spending could erode confidence and exacerbate the problems of a high and rising public debt ratio, unless it is part of a comprehensive strategy to reinvigorate growth. Directors considered that an improvement in the composition of government expenditure—with, for example, less emphasis on public works and subsidies to enterprises and more on the social safety net and urban rejuvenation—would boost the effectiveness of fiscal policy and better support private sector activity and economic growth.

Directors stressed that prompt implementation of a range of fiscal reforms to strengthen the credibility of the authorities' commitment to medium-term consolidation is even more important. On the spending side, Directors assessed that full liberalization of the earmarking of revenues for specific purposes and a more thorough cost-benefit analysis of public works projects were priorities. On the tax side, Directors supported current proposals to overhaul the tax system with a view to broadening bases of personal and corporate income taxes, and considered that the efforts to improve tax administration are also a priority. Regarding social security, Directors stressed the need to develop a strategy to curb the growth of total medical expenses of the healthcare system, and also to reduce unfunded pension liabilities in the pension system. Finally, on the public enterprises, Directors advised faster progress with privatizing or abolishing a number of special public corporations.

To enhance the impact of fiscal reforms, Directors stressed the need for the government to comprehensively spell out its medium-term fiscal consolidation strategy. A few of Directors believed that a permanent fiscal responsibility law could provide an appropriate vehicle for committing to a medium-term debt target, and for setting forth the broad objectives for tax, expenditure, and social security policies.

While Directors welcomed the efforts by the Bank of Japan to expand base money over the past year, they concurred with the view that these steps are unlikely to eliminate deflation soon. Many urged further quantitative easing, particularly in light of concerns about the likely adverse impact of the recent appreciation of the yen on deflation and external competitiveness. On the other hand, a number of Directors expressed skepticism over the effectiveness of further quantitative easing. Directors emphasized that the monetary transmission mechanism needs to be strengthened by accelerating structural reforms in the banking and corporate sectors, in order to increase the effectiveness of monetary policy. A number of Directors considered that a public commitment on the timeframe for ending deflation is also essential, while a few others raised concerns that such a commitment would erode the credibility of the Bank of Japan if it were not achieved. A few Directors also stressed that adoption of a modest positive inflation target over the medium term would help to minimize the risk of again being constrained by the zero bound on nominal interest rates.

Directors stressed the need to address weaknesses in national accounts and fiscal statistics. They welcomed the recent announcement of the new methodology for constructing the quarterly GDP data, and hoped this would reduce the volatility of the estimates. With regard to fiscal data, Directors noted the need to upgrade the timeliness and comprehensiveness of measures of the fiscal stance.

Directors welcomed the expansion of market access for least developed countries for industrial products, and urged the authorities to make progress in reducing protection of the agricultural sector and securing access to least developed countries for agricultural products.

Notwithstanding the recent reduction, Directors commended Japan's ongoing commitment to ODA. They also welcomed the authorities' efforts to strengthen Japan's ability to combat money laundering and terrorism financing.