Public Information Notice No. 12/92

Public Information Notice: IMF Executive Board Concludes 2012 Article IV Consultation with Japan

August 1, 2012

On July 25, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.¹

Background

The Japanese economy has shown remarkable resilience and adaptability in the aftermath of the March 2011 Great East Japan earthquake. In addition to the devastating human toll and destruction, businesses and households had to grapple with disruptions to supply-chains, reductions in electricity supply, and spillovers from severe floods in Thailand in late 2011, which impacted Japan’s export sector.

Real GDP contracted by ¾ percent in 2011, because of the earthquake and Thai floods, but a recovery is now underway. Real GDP grew at a brisk pace of 4¾ percent (seasonally adjusted annual rate) in the first quarter boosted by reconstruction spending, a pickup in private consumption, and inventory rebuilding. Headline inflation was negative at -0.2 percent (year-on-year) in June and core inflation, excluding food and energy, was also negative at -0.6 percent (year-on year).

The trade balance moved into deficit in 2011 (1/3 percent of GDP), the first annual deficit recorded since 1980. Exports were impacted by the supply chain disruptions, weak global demand and an appreciation of the yen. At the same time, imports have risen, driven by reconstruction spending and higher energy costs following the closure of most nuclear power plants. The trade balance remained in deficit in early 2012, but the current account balance continued to record a surplus of about 1½–2 percent of GDP in 2011 and early 2012, because of sizable investment income earnings.

The recent turmoil in Europe has led to a flight to safety and impacted Japanese financial markets. Since mid-2011, equity prices have declined by about 15 percent and yields on 10-year Japanese Government Bonds (JGBs) have fallen to near historic lows of 70-80 basis points. Over the same period, the yen has appreciated by about 8 percent in nominal effective terms.

The Japanese economy is expected to expand by almost 2½ percent in 2012 helped by substantial public reconstruction spending of around 1½ percent of GDP and recovering consumer demand. Weak external demand is likely to weigh on exports and private investment. The recovery is forecast to slow in 2013 to 1½ percent, as reconstruction winds down. Over the medium-term, growth is expected to converge to around 1 percent as Japan’s aging population slows potential growth.

Japan’s fiscal deficit is set to increase to about 10 percent of GDP in 2012, while the structural primary deficit will rise slightly to 7½ percent of GDP. In an important step toward medium-term fiscal consolidation, the Lower House of the Diet approved a tax bill in late June that would increase the consumption tax to 8 percent in April 2014 and 10 percent in October 2015. The Upper House is now considering the bill. If implemented and added to already planned expenditure measures, the overall reduction in the structural fiscal deficit would be about 5 percent of GDP over the next decade.

The Bank of Japan’s (BoJ) recent actions strengthened its policy framework and supported the recovery. The adoption in February of a medium to long-term price stability goal of 1 percent has helped clarify the objective of monetary policy. In addition, the BoJ expanded its Asset Purchase Program by ¥15 trillion this year in two steps and extended the maturity of JGB purchases from 1–2 years to 1–3 years. Together with earlier commitments this is a sizeable monetary expansion, totaling about 5 percent of GDP over the next year.

The Financial Sector Assessment Program (FSAP) update found that important steps have been taken to strengthen the financial system since the last assessment in 2003. In particular, financial regulation and supervision has been effective in encouraging the large banks and insurance companies to strengthen their capital positions and resilience to shocks. As a result, while the global financial crisis, earthquake and spillovers from the Thai floods led to significant economic disruptions, the impact on financial stability was limited.

Looking ahead, the FSAP stress tests suggest that in the near term banks and insurers would be resilient to severe economic distress and moderate market shocks. However, the key challenges financial institutions face in safeguarding financial stability are to raise profitability in a low growth environment, while managing risk associated with their JGB and equity holdings.

Executive Board Assessment

Executive Directors noted that, despite a worsening of the global outlook, the Japanese economy is recovering, helped by reconstruction activity and private consumption. Directors saw risks to the outlook tilted to the downside and primarily stemming from the possibility of a further escalation of the crisis in Europe and a sharper than expected slowing of the Chinese economy. Directors agreed that, beyond the short term, the main challenge is to reduce the public debt burden in an environment of low growth and address continued deflation and the impact of a rapidly aging population.

Directors stressed that reducing the public debt burden is a key policy priority and requires sustained fiscal consolidation over the next decade. They welcomed passage by the Lower House of the Diet of legislation to double the consumption tax rate to 10 percent by 2015, and agreed that targeted transfers to lower income groups could be considered to address the regressive nature of the tax. Directors also noted that additional fiscal consolidation measures, designed so as to limit any adverse impact on growth, would be needed beyond 2015 to put the public debt ratio firmly on a downward path. Of particular importance will be pension reform to contain social security spending while balancing inter generational equity.

Directors underscored the importance of speedy implementation of far reaching structural reforms to raise growth. Given the rapidly aging population, policies aimed at increasing employment of women and older workers and facilitating immigration could have a large payoff. Directors also saw scope for productivity improvements by easing regulation of the agriculture and services sectors. Participation in additional free trade agreements would also help in this regard.

Directors commended the Bank of Japan for the conduct of monetary policy during the past year and the adoption of a 1 percent inflation goal. They generally supported further monetary easing as part of a comprehensive package of policies to defeat deflation, particularly if the growth outlook worsens, while acknowledging that the effectiveness of further easing is limited in the very low interest rate environment. Directors also underscored the importance of improved communication of policy intentions.

Directors took note of staff’s view that Japan’s external position is moderately weaker than that consistent with medium term fundamentals and desirable policies. They considered that Japan should continue to allow the exchange rate to be market determined, although intervention could be used to counter volatile or disorderly market conditions.

Directors agreed with the findings of the recent Financial Sector Stability Assessment Update. They noted that the financial system is stable and resilient to severe economic stress and moderate market shocks. However, banks’ low profitability and large holdings of Japanese government securities raise some concerns and should be monitored closely.

To safeguard financial sector stability, Directors saw scope to strengthen further systemic risk monitoring and to improve the prudential framework, including by tightening large exposure limits on bank lending, raising capital requirements for domestic oriented banks, and basing the assessment of insurance companies’ solvency on a more refined economic valuation. Directors also saw room to strengthen the crisis resolution framework for systemically important nonbank financial institutions. Directors encouraged reforms to promote more market based credit intermediation, including through a reduced role of government, to enhance the role of the financial sector in supporting growth.

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. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.