Public Information Notice No. 08/92

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with Japan

July 29, 2008

On July 21, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.¹

Background

The Japanese economy has shown resilience to the U.S. slowdown and global financial turmoil. GDP grew by 2.1 percent in 2007 (above potential), down from 2.4 percent the previous year, mostly owing to lower private consumption growth and a regulatory-induced slump in construction activity. In the first quarter of 2008, activity continued to be led by robust export demand from non-U.S. destinations, while the recovery in residential investment provided additional support to growth. CPI inflation was 1.3 percent (y-o-y) in May, mainly driven by rising food and energy prices. Core inflation, which by staff's definition excludes both fuel and food prices, fell by 0.1 percent (y-o-y). Wage pressures are limited and unit labor costs continue to fall on a year-on-year basis.

Japan's external position remains strong. The current account surplus rose to 4.8 percent of GDP in 2007 on the back of strong external demand and a further surge in investment income. However, in Q1, the trade balance narrowed substantially owing to the large deterioration in the terms of trade, while income inflows continued apace. The yen appreciated against major currencies, particularly the U.S. dollar through March, supported by an unwinding of carry trades and the large current account surplus. Outflows by Japanese investors continued to provide an offset. The yen remains market determined and the authorities have not intervened since March 2004.

The fallout from the global market turmoil on the financial system has been limited. Money markets remain relatively stable owing to the banking system's lower exposure to subprime and other securitized products and the increased amounts and frequency of the Bank of Japan's (BoJ) liquidity operations. Subprime-related losses for banks have risen to $8 billion, but still remain well within banks' operating profits and capital. Financial conditions for nonbank lenders relying on wholesale financing and low-rated corporates have tightened somewhat, while bankruptcies have edged up led by small and medium-size enterprises.

Fiscal consolidation has paused this year and the authorities' medium-term plans fail to build on recent progress. The FY2008 budget targets a broadly unchanged primary deficit (excluding social security) with a slight increase in total expenditures due to higher social security costs and lower tax buoyancy, while the net public debt ratio is estimated to rise to 94 percent of GDP, up from about 85 percent of GDP three years ago. The authorities' revised fiscal plans continue to target a primary balance by FY2011. Under staff's lower growth projections, the authorities' plans would be insufficient to prevent net public debt from continuing to trend up.

Monetary policy is accommodative. The BoJ has kept the policy rate unchanged at 50 basis points since February 2007, implying a drop in real interest rates given the uptick in inflation.

The near-term economic outlook is for a soft-landing, although there remain risks from the global economy. GDP growth is expected to moderate to 1½ percent (slightly below potential) in 2008-09 in line with lower global demand and the less favorable terms of trade. Headline CPI inflation is expected to rise, but inflation risks appear contained. Risks to the growth outlook have become more balanced in recent months, but considerable uncertainty remains.

Over the medium term, growth is expected to converge to potential (about 1.7 percent) and the current account surplus to narrow. This scenario assumes continued efficiency gains in the corporate and financial sectors and a shrinking labor force.

Executive Board Assessment

Executive Directors commended the authorities on the resilience thus far of the Japanese economy to the U.S. slowdown and global market turmoil. Timely liquidity provisions by the Bank of Japan have helped to buffer the effects of global financial pressures, while generally buoyant exports to emerging markets, strong household and corporate balance sheets, and limited financial sector subprime exposure have helped to underpin the economy's strength. At the same time, given the terms of trade deterioration and weakening domestic confidence, Directors considered the Japanese economy to be headed for a modest slowdown. While the headline inflation rate has risen in recent months, core inflation—stripped of food and fuel prices—remains around zero, and is expected to stay contained.

While welcoming the prospect of a soft landing, Directors emphasized that the outlook remains subject to considerable uncertainty, with the recent renewed volatility in global markets tilting the risks to the growth projection more notably to the downside, and high commodity prices underscoring the upside risk to inflation. In these circumstances, Directors agreed with the authorities that monetary policy should remain accommodative—and backed by continued efforts to strengthen the financial sector—while fiscal policy should remain focused on medium-term challenges. Structural reforms should also be reinvigorated to boost productivity and Japan's medium-term growth prospects.

Directors recognized the recent progress made with fiscal consolidation, and welcomed the authorities' continued commitment to achieving primary balance, excluding social security, by FY2011. As the downturn in the current fiscal year is expected to be modest, Directors encouraged the authorities to meet the budget deficit target even if revenues fall short. Some Directors noted that automatic stabilizers could be allowed to work in the event that growth slowed sharply.

Most Directors considered that, beginning in FY2009, larger fiscal adjustments than currently envisaged by the authorities will be required to stabilize the high public debt and make room for the fiscal costs of population aging. The limited scope for further expenditure cuts suggests that the future fiscal consolidation will need to involve steps on the revenue side. In this context, Directors saw the merits of a comprehensive tax reform, and most Directors supported consideration of an increase in the consumption tax. They regarded the government's intention to increase its contribution to the basic pension during FY2009 as a good opportunity to raise the consumption tax rate, as this could be viewed as a step supportive of the intention to ensure the funding of social security. At the same time, Directors acknowledged that accelerating the pace of adjustment at this juncture will be challenging, and some stressed the importance of fulfilling the government's present fiscal commitments in the first instance. Directors welcomed the authorities' plans to end earmarking of gasoline tax revenue for road-related spending from next year.

On monetary policy, given the low underlying inflation and the uncertain economic outlook, Directors saw little risk in delaying monetary tightening. They supported the Bank of Japan's approach of adopting a "wait and see" attitude and standing ready to respond flexibly should downside risks to economic activity materialize, or should inflation expectations worsen. Directors welcomed the Bank of Japan's enhanced communication strategy, which should strengthen public understanding of the authorities' policy intentions and help guide inflation expectations. Directors looked forward to a gradual normalization of interest rates once downside risks to growth recede.

Directors supported the authorities' policy of a market determined exchange rate. Noting that the authorities have not intervened in the foreign exchange market since March 2004, Directors supported the authorities' policy of limiting intervention to counter excessive fluctuations and disorderly movements of the exchange rate. Directors noted the staff assessment that, although the focus of macroeconomic and structural policies is appropriate, the yen remains undervalued relative to its longer-term value in real effective terms. They also recognized that capital outflows related to Japanese investors' international diversification of assets might continue to contribute to the yen's weakness in the near future. Directors generally noted that, over the longer term, the yen could be expected to appreciate on the back of policy reforms that are expected to yield widespread productivity gains. A number of Directors underscored the importance of incorporating structural capital account factors into current account-based analyses of the equilibrium exchange rate.

Directors welcomed the steps taken by the Financial Services Agency to enhance transparency and support market confidence, in line with the recommendations of the Financial Stability Forum. They commended the Bank of Japan for its flexible liquidity management that has helped to keep money markets stable. Directors welcomed the proactive steps taken by the authorities to monitor and disclose the exposure of the subprime losses, and underlined that greater disclosure and transparency can only serve to strengthen market confidence and discipline. Looking ahead, Directors encouraged the authorities to remain vigilant to risks from further global market disruptions. Steps to bolster capital cushions and improve risk management will further strengthen the financial system and enhance financial intermediation. Directors also welcomed the progress toward privatizing the Japan Post Bank, and supported the authorities' emphasis on achieving a level playing field.

Directors welcomed the authorities' intention to press ahead with their structural reforms outlined in the Multilateral Consultation, and incorporated in the authorities' recently released FY2008 Basic Policies program. Further reforms to increase labor market flexibility, enhance product market competition, and encourage inward foreign direct investment will lift medium-term growth prospects and contribute to the orderly resolution of global imbalances.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.