Public Information Notice No.  10/87

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation with Japan

July 14, 2010

On July 2, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.¹

Background

Japan’s economy continues to improve led by robust exports and policy stimulus. Following a deep recession in 2009, growth accelerated to 5 percent (seasonally adjusted annual rate) in the first quarter of 2010 amid signs of exports spilling over to domestic demand. Strong demand from Asia, especially for capital goods, has supported exports, while subsidies aimed at consumer durables has lifted household spending. With the sharp fall in demand last year, deflation has re-emerged with core inflation averaging around -1 percent since late 2009.

The current account surplus shrank further in 2009 to 2.8 percent of GDP, as a result of lower global interest rates and a stronger yen. The trade surplus remained unchanged at around 1 percent of GDP, while the income balance deteriorated in line with lower global interest rates.

Financial markets have been hit hard by the renewed global turmoil. After showing signs of recovering through March 2010, equity prices have fallen and the yen again appreciated on higher risk aversion. Since the Lehman shock, the yen has appreciated by 16 percent in real effective terms, while ten-year Japanese government bond (JGB) yields have been stable at around 1.2–1.4 percent.

Looking forward, the recovery is expected to continue but its pace will likely moderate. GDP growth is projected to rise to 2.4 percent in 2010 with the pace of the recovery likely to slow in the second half of the year as stimulus measures expire and export growth levels off. Growth of 1.8 percent is expected in 2011. With a narrowing of the output gap, headline inflation is projected to turn positive in late 2011. Considerable uncertainty surrounds the outlook from the global market turmoil, a possible slowdown in the advanced economies and China, and a potential worsening of deflation.

With global scrutiny of public finances on the rise, the need for early and credible fiscal adjustment has increased. The severe recession and the fiscal response have pushed the overall fiscal deficit to 10¼ percent of GDP in 2009 and the net public debt ratio to 110 percent of GDP, one of the highest among advanced economies.

To combat the recession and re-emergence of deflation, the Bank of Japan (BoJ) adopted a number of additional measures over the past year. These include introducing a 3-month funds supplying operation to lower short-term interest rates, re-activating its U.S. dollar swap line to ease emerging funding pressures, and introducing a new loan facility to support private bank lending to innovative firms.

Executive Board Assessment

Japan’s economy is gaining strength, helped by strong external demand and timely and sizeable policy support. With domestic demand gradually improving and deflation easing, the recovery is expected to continue—albeit at a more moderate pace. The recent turmoil in Europe, however, has heightened risks to the outlook and Japan’s vulnerability to sovereign risk.

Against this backdrop, Directors underscored the urgency of credible fiscal adjustment. The key challenge is to bring down public debt to more sustainable levels—through decisive and sustained fiscal action—while ensuring adequate support for the still nascent recovery and a more balanced economy. Directors welcomed the Fiscal Management Strategy recently announced, laying out a medium-term consolidation path, and looked forward to agreement on specific measures. They generally agreed that adjustment efforts should focus on a gradual increase in the consumption tax, supported by comprehensive tax reform, limits on non-social security spending growth, and reforms to entitlement programs. The pace, timing, and composition of consolidation measures would need to be carefully planned, with special attention to their impact on consumption, investment, and growth. Directors commended the government for its plan to adopt a “pay-as-you-go” expenditure rule. Introducing a cap on public debt would help strengthen the credibility of the fiscal consolidation plans.

Directors considered the accommodative monetary policy stance appropriate, and welcomed various measures by the BoJ to combat deflation and support growth. They encouraged the authorities to stand ready to take additional easing measures, if deemed necessary in response to weakening recovery or renewed deflationary pressures. In this regard, consideration could be given to extending the maturity of the funds supplying operations and broadening the range of asset purchases, while being attentive to moral hazard risks. Directors stressed that, given growing uncertainty, clear communication would be crucial, with a few recommending that the BoJ more explicitly link its intention to maintain policy accommodation to its inflation forecast, provided that financial imbalances remain absent.

Directors welcomed the authorities’ continued commitment to a market-determined exchange rate, which would help facilitate a rebalancing of growth away from exports. They noted the staff’s assessment that, following the sharp appreciation since the outbreak of the crisis, the yen’s current level is broadly in line with its longer-term equilibrium value. Nevertheless, carry trade activities and their impact on the exchange rate would need to be monitored closely.

Directors noted that, while the profitability and capital base of the banking sector have improved, banks still face risks from a slow recovery and their sizeable securities holdings, as well as challenges in adapting to new global financial standards. It would therefore be important for supervisors to ensure that banks follow proper risk management; take appropriate steps to facilitate borrower restructuring; and stand ready, when necessary, to assist banks in strengthening their financial positions.

Directors emphasized that the unprecedented size of required fiscal consolidation, including to address the challenges of population aging, brings to the fore the need for structural reforms to promote domestic demand-led growth. The formulation of the “New Growth Strategy” is a welcome step, entailing the development of potentially dynamic areas, such as energy, environment, health, and technology. This could be complemented by supply-side measures aimed at increasing employment, raising productivity in nontradable sectors, deregulating services, and encouraging more risk-based lending by private financial institutions.