Public Information Notice No. 03/112

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Japan

September 5, 2003

On August 20, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.¹

Background

Japan experienced a cyclical recovery in 2002, which included a strong pickup on activity in the second quarter followed by a gradual slowdown during the rest of the year. For 2002 as a whole, real GDP grew by only 0.2 percent, owing to the low base for the recovery that resulted from the sharp fall in output during the previous year.

During the first half of 2003, GDP growth was stronger than initially expected, although deflation continued. According to the first preliminary estimate, real GDP rose significantly in the second quarter, compared with consensus forecasts of little growth. Consumption, business fixed investment, and net exports were stronger than implied by monthly indicators. Notwithstanding the pickup in demand, the unemployment rate has remained near its record high, and the GDP deflator has continued to fall, extending the year-on-year declines that have been ongoing since 1998. The core CPI (excluding fresh food) has also decreased year on year virtually every month for about the past four years. Meanwhile, expectations of deflation remain entrenched.

Monetary policy has remained focused on maintaining financial stability, primarily by providing liquidity to ensure that banks could meet their funding needs without difficulties. Over the past 12 months the Bank of Japan (BoJ) raised the target for current account balances on several occasions, periodically injected liquidity, expanded the range of collateral eligible for operations, and removed the restriction on the maximum number of days for the use of Lombard loans, beyond which the penalty rate was applied. The BoJ has also helped banks reduce their equity risk with its program to buy banks' shareholdings for up to ¥3 trillion through September 2003. A program of outright purchases of asset-backed securities, up to ¥1 trillion through March 2006, commenced at end-July 2003.

Growth in base money has not fed into broad monetary aggregates or arrested the continuous decline in bank lending, although short-term interest rates have been kept at virtually zero. With persistent economic weaknesses and bank balance sheet problems limiting loan demand and banks' willingness to lend, bank loans continued declining by about 5 percent a year.

Fiscal policy was expansionary in FY2002, as the general government structural deficit widened by about 1 percent of GDP to 6½ percent of GDP. Unadjusted, the deficit rose to 7½ percent of GDP, mainly reflecting a fall in revenue. Continued fiscal deficits have fed rapidly growing government debt, with end-2002 gross and net debt estimated at 158 and 72 percent of GDP respectively.

In the external sector, the favorable trade performance in 2002 raised the current account surplus by about ¾ percent of GDP to 2¾ percent of GDP. Export volume rose strongly, reflecting a sharp pickup in demand from Asian partner countries (notably China) and the United States, although volume growth slowed in the second half of the year. Imports recovered along with domestic income, partly reflecting a pickup in imports from China.

Compared to June 2002, the yen is broadly unchanged against the U.S. dollar but is modestly weaker in nominal and real effective terms. In the second half of 2002, the yen/dollar rate ranged between ¥116 and ¥125 amid heightened geopolitical uncertainty and concerns about the pace and sustainability of recovery in the major economies. In the first seven months of 2003, the yen came under pressure to strengthen against the dollar, as the dollar weakened against the euro. This pressure prompted the authorities to intervene on a number of occasions over this period, in the total amount of some ¥9 trillion. In the event, for most of 2003 to date the yen/dollar rate has moved in a range of ±¥2 around ¥119. The yen has weakened against the euro, however, contributing to depreciation in real and nominal effective terms.

Long-term government bond yields hit record lows in June 2003 but subsequently rebounded. The decline in yields in the face of high and rising government debt partly reflected heavy buying of Japanese Government Bonds (JGBs) by financial institutions amid ample liquidity, weak loan demand, increased risk aversion, and banks' efforts to cut risk-weighted assets. The BoJ has also made outright purchases of JGBs, amounting to ¥1.2 trillion per month since October 2002. Starting in late June 2003, long-term yields rebounded. The rise in JGB yields, which occurred in the context of a less pronounced global pickup in long-term interest rates, may have reflected financial market considerations such as portfolio rebalancing from bonds to equities, profit-taking, and investor concerns that yields had fallen too far. Alternatively, it may have reflected a perceived improvement in economic prospects.

Stock prices have also recently recovered from long-term lows. During most of the past 12 months, stock prices have fallen amid concerns about selling pressures from banks and pension funds. In early 2003, the Nikkei index declined broadly in line with other mature markets, but from already low levels, and in April bottomed out at 21-year lows. On the heels of rallies in overseas markets, the Nikkei subsequently rebounded largely driven by foreign buying. As of mid-August 2003, the Nikkei was up about 18 percent for the year and about 7 percent higher than a year earlier. The rise in stock prices during recent months has boosted the value of equities on bank balance sheets, while the increase in interest rates has reduced the value of bond holdings; as of August it was unclear whether the net effect on bank balance sheets was positive or negative.

Financial institutions' end-FY2002 results revealed some progress in dealing with their problems, but their financial difficulties persisted. Major banks' average ratio of nonperforming loans to credit declined from 8½ percent to 7¼ percent during the fiscal year, in line with the authorities' target to halve the ratio by end-FY2004. However, major banks' losses from equity holdings together with credit costs resulted in net losses of ¥4.4 trillion. Meanwhile, life insurers faced continued pressures from their equity exposures and high guaranteed rates on existing policies.

Data on stronger second-quarter growth along with other factors has led to an improvement in the outlook. Although national accounts data are subject to substantial revisions, GDP estimates for the first half of 2003 and more optimistic projections for partner countries imply that the pickup in activity may have begun earlier than previously anticipated. Incorporating such factors, real GDP is expected to grow by 2 percent in 2003 and 1½ percent in 2004. However, while the recent increase in stock prices and the firmer external environment suggest that the risks to the outlook may have become more balanced, important downside risks are still associated with the remaining fragilities on corporate and financial sector balance sheets.

Executive Board Assessment

Directors welcomed recent signs of improvement in the economic situation and outlook, and the progress in tackling the major economic challenges facing Japan. The volume of banks' nonperforming loans has declined, and corporate profits have increased. Supportive monetary policy has helped maintain financial stability and may have also contained deflation.

Nevertheless, Directors stressed that serious and interrelated problems remain, and that a sustained and strong economic revival is not yet in prospect. Significant weaknesses still exist in the financial and corporate sectors, which, if not resolved, will continue to restrain growth. Deflation is likely to persist and continue to exacerbate corporate and financial sector fragilities. A substantial medium-term adjustment in fiscal policies is still needed to prevent public debt from rising to levels that could put upward pressure on real interest rates, with negative implications for growth and the financial system. The economy remains vulnerable to significant downside risks, notably those associated with fragilities in corporate and financial sector balance sheets.

Directors agreed that a more comprehensive and integrated policy approach is needed to revitalize the corporate and financial sectors, tackle deflation, and address fiscal imbalances. They broadly endorsed the staff's recommended strategy involving four interrelated pillars of accelerated financial and corporate sector reforms, attacking deflation more aggressively through monetary policy, and implementing a framework for medium-term fiscal consolidation. Directors acknowledged that accelerated reforms could entail short-term economic costs, but most Directors considered that these costs are outweighed by the medium-term benefits of reduced vulnerability and higher potential growth. They also stressed that the social safety net and a more proactive labor market policy could mitigate the effects of adjustment and restructuring. However, a few Directors felt that in light of the potential severity of the short-term costs, a more cautious approach would be advisable.

Directors welcomed Japan's participation in the Financial Sector Assessment Program (FSAP), although a few Directors noted that more complete information should have been made available for stress testing the exposure of the banking system. Directors also welcomed the progress made in financial sector restructuring under the Program for Financial Revival (PFR). Most Directors considered that a more comprehensive and accelerated approach to financial sector reforms, in line with the FSAP recommendations, is still needed in order to tackle decisively the problems in banks and insurance companies. In this context, recent measures to address the problem of nonperforming loans should be applied to a wider set of loans and institutions, and supervisory-mandated provisions should be recognized as a cost for tax purposes. The regulation of insurance companies, which remain vulnerable to a deterioration in financial markets, should also be enhanced.

Directors observed that some banks had recently strengthened their capitalization by raising capital in the markets, but they also noted that banks' regulatory capital relies too heavily on deferred tax assets (DTAs). Against this background, most Directors agreed with the recommendation to limit the use of DTAs as regulatory capital. Most Directors concurred that, given the lack of private interest in recapitalizing banks, public funds might have to be used selectively to recapitalize systemically important banks that fell below regulatory capital requirements, and that any transitional period of government ownership should be used to strengthen bank governance. A few Directors were concerned that this would nevertheless lead to undesirable government involvement. Directors agreed in general that reducing the involvement of government institutions in the financial sector could improve bank profitability. In the same vein, the requirement that banks that receive public funds commit to lend more to small- and medium-sized enterprises should not be imposed.

Directors observed that a durable resolution of banks' problems and the achievement of sustained growth over the medium term will require further progress in corporate sector restructuring, including small- and medium-sized enterprises, where progress has been slow. Further strengthening the banking system will be critical to speed up corporate restructuring, as banks must be able to absorb losses arising from restructuring. The Industrial Revitalization Corporation of Japan (IRCJ) could facilitate restructuring by helping to coordinate creditors, but it should not be used to keep nonviable firms afloat. Minimizing the period between the IRCJ's purchase and sale of loans, and ensuring transparency regarding its operations and progress in recovering public funds, would help to mitigate this risk.

Directors noted the benefits conveyed by quantitative monetary easing, and welcomed the Bank of Japan's recent initiative to buy asset-backed securities in order to strengthen the monetary transmission mechanism. Most Directors considered that a more decisive and proactive approach is required to tackle deflation effectively. This could include purchases of a wider range of assets, helping to reflate the economy through asset prices as well as the liquidity channel. Regarding the suggestion to extend asset purchases to foreign currency assets, many Directors were concerned about the related exchange rate effects on trade flows and global imbalances. At the same time, several Directors called attention to the positive impact of a more decisive Japanese monetary policy on global output, and considered that the potential risks to global imbalances related to such purchases were acceptable.

Most Directors considered that the risks to the Bank of Japan's balance sheet arising from extensive purchases of a wider range of assets should be manageable, including through loss sharing arrangements with the government. There was general agreement that it would be desirable to accompany this approach with a clear public communications strategy, including committing to end deflation in a limited time period. Regarding the recommendation that the authorities establish a medium-term inflation target, some Directors saw merit in setting such a target, pointing to its usefulness in anchoring medium-term inflation expectations. A number of Directors, however, cautioned that the credibility of the central bank could be affected if a declared inflation objective were not met, and referred to the lack of effective monetary instruments.

Directors welcomed the authorities' intentions to move toward fiscal consolidation, but cautioned that a substantial medium-term adjustment is needed to put the public debt on a sustainable trajectory and avoid a harmful rise in long-term interest rates. They thought that the adjustment may need to go beyond the official goal of achieving a primary balance by the early 2010s. Achieving fiscal sustainability will require a major reform of the social security system that eliminates its net liabilities in present value terms, with significant adjustments in pension contributions and benefits, along with measures to address the growing costs of the medical insurance system. It was also noted that there might be scope for broadening the personal income tax base, increasing the consumption tax rate, and further reducing public investment. Directors urged the authorities to define a transparent program of sequenced specific measures up front, as this would strengthen the credibility of the medium-term consolidation strategy.

Regarding the near-term stance of fiscal policy, Directors considered that the estimated small cut in the FY2003 structural deficit is broadly appropriate, as it balances the need for fiscal consolidation with the need to protect the still-fragile economic recovery. Looking to FY2004, the expected continued growth should facilitate a stronger push toward consolidation, and signal the government's commitment to the goal of medium-term fiscal sustainability.

Directors encouraged Japan to play a leading role in moving the Doha Round of trade negotiations forward, and to commit to ambitious reductions in agricultural support. Directors welcomed the recent widening of quota- and duty-free access for imports from less developed countries, and encouraged the authorities to take additional steps in that direction.

Directors commended Japan's continued commitment to official development assistance (ODA), observing that Japan remains the second largest ODA provider in absolute terms and that Japan's ODA relative to gross national income exceeds the average for the major industrial countries, notwithstanding its challenging economic situation.

Directors noted recent steps to improve the framework for anti-money laundering and countering the financing of terrorism (AML/CFT), and welcomed Japan's participation in an AML/CFT ROSC.