Public Information Notice No. 06/81

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Japan

July 28, 2006

On July 21, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Japan.¹

Background

Deflation has ended and the economy is on a strong recovery path. GDP growth in 2005 was around 2¾ percent, led mainly by private consumption and investment. Labor markets are tightening and the unemployment rate remains around an eight-year low. The pace of activity in the first quarter of 2006 continued briskly at about 3 percent (seasonally adjusted at an annual rate), following an exceptionally strong fourth quarter. Core inflation (CPI excluding fresh food) has been clearly positive since November 2005 (year-on-year core inflation was 0.6 percent in May). The GDP deflator continues to decline, but the deflator for domestic demand is rising marginally. However, other measures confirm the upward trend in price pressures; land prices in urban areas have halted a fifteen year slide and are beginning to rebound.

The yen, in real effective terms, is currently about 6¾ percent weaker than a year ago. After depreciating nearly 15 percent in 2005 against the U.S. dollar as interest rate differentials widened, the yen has appreciated modestly this year (mainly against the dollar), reflecting the markets' reassessment of the likely pace of monetary tightening in major economies. No intervention has occurred since March 2004.

The external surplus is narrowing. The trade balance fell in 2005 by ¾ percent of GDP, in spite of yen depreciation. The current account declined more modestly as factor income surged. Heavy purchases of foreign bonds and repatriation of funds by foreign banks strengthened the financial account, notwithstanding record foreign purchases of domestic equities.

The financial and corporate sectors are in their best shape in over a decade. Under tougher regulation, major banks' nonperforming loans fell to below 2 percent of loans in March 2006. Progress at regional banks has been more uneven. Intense corporate restructuring has buoyed profits to record highs and unlocked productivity gains. With credit supply constraints eased and loan demand revived, bank lending (adjusted for provisions and write-offs) has been trending up since mid-2005, after eight years of contraction.

Monetary policy remains appropriately accommodative. On March 9, the Bank of Japan shifted its strategy from targeting banks' excess reserves (quantitative easing) to targeting the overnight interest rate. The exit from quantitative easing was smooth, with limited volatility in short-term interest rates and private money market activity picking up.

Fiscal consolidation is ahead of the authorities' schedule, but imbalances remain large, with net general government debt about 90 percent of GDP, among the highest in advanced countries. In FY2005, the general government primary deficit excluding social security is estimated to have narrowed by 1 percent of GDP to around 3 percent of GDP. The FY2006 budget, which rolls back past income tax cuts and curbs some discretionary spending, envisages a further fall of some ½ percent of GDP.

The near-term macroeconomic outlook is favorable. GDP growth is projected at nearly 3 percent in 2006 and slightly above 2 percent in 2007. CPI inflation will pick up slowly as capacity utilization rises. Risks are balanced, with downside risks mostly external (volatile oil prices, rising long-term interest rates, or a sharp global slowdown). Low inflation raises the possibility of renewed deflation, particularly if a disorderly unwinding of global imbalances occurs. On the upside, private consumption and investment could show further strength.

For the medium term, growth is anticipated to slow to potential, estimated at 1.7 percent, and the current account to narrow. Potential growth could be higher with stepped-up reforms, a recovery in R&D and greater business restructuring. Faster productivity growth in a broad range of sectors would also decrease the current account surplus over time, countering the effects of fiscal consolidation.

Executive Board Assessment

Directors welcomed the continued strong forward momentum in Japan's expansion. Remaining fragilities in the corporate and financial sector have been largely dealt with, and improvements in labor markets and disposable incomes have strengthened the underpinnings for durable growth driven by domestic demand, with an associated decline in the trade surplus. Directors welcomed the end of deflation as measured by several indices—a watershed for Japan. In this connection, they underscored that consumer prices are likely to continue rising and that the risk of a deflationary relapse has receded.

Directors noted, however, that—notwithstanding the prospect of above-potential growth for the near term—major policy challenges remain. They stressed that adopting an appropriate post-deflation monetary framework, undertaking a well-designed fiscal consolidation, and boosting productivity through structural reforms are complementary elements of a strategy for sustained non-inflationary growth. Directors thus urged the authorities to take advantage of the favorable conjuncture to make further progress on all these fronts.

Directors welcomed the smooth transition out of quantitative easing and a return to more normal monetary operations. They commended the Bank of Japan for skillfully managing the policy shift while avoiding undue volatility in financial markets. Directors agreed that, in the near term, the policy stance should remain accommodative—allowing inflation expectations to take a firmer hold and drift up.

Directors agreed that the Bank of Japan's monetary framework is well suited to the post-deflation environment and welcomed the improvement in transparency. They acknowledged that the framework also allows appropriate flexibility for the Bank of Japan to respond to a range of short- and long-term risks to price stability.

Directors suggested that further steps to elaborate various aspects of the new monetary framework could help guide market expectations and may bolster policy credibility. In particular, the clarification of the risks associated with near-zero inflation would help markets to form appropriate expectations about the conduct of policy, including with regard to the zero floor on the "understanding of price stability." Most Directors recommended introducing a higher floor over time, to signal the desirability of a buffer against deflationary shocks. A few Directors, however, noted that periodic reviews of the "understanding of price stability" could weaken the establishment of an anchor for inflation expectations.

Directors noted that the authorities' exchange rate policy remains grounded in the belief that the exchange rate should reflect economic fundamentals. They supported the policy of a market-determined exchange rate, and agreed that official foreign exchange intervention should be limited to counter disorderly movements in the external value of the yen. In that connection, several Directors noted the economy's ability to handle a stronger currency in view of its favorable outlook and improved underpinnings.

Directors welcomed the progress made in fiscal consolidation and noted that recent deficit reductions have not held back the expansion. They observed that the long cyclical upswing has contributed to revenue buoyancy and has made it easier to restrain spending. For the current fiscal year, they encouraged the authorities to save any tax windfall and avoid expansionary measures in the supplementary budget.

Looking forward, Directors observed that fiscal policy faces significant challenges if the public finances are to gain a sounder footing. They welcomed the authorities' commitment to medium-term fiscal consolidation and the recent proposals for achieving it. However, most Directors thought that, given the strength of the expansion, a somewhat more front-loaded and ambitious adjustment than envisioned by the authorities would be appropriate. Such an adjustment would stabilize the debt ratio, buy insurance against unanticipated fiscal or economic shocks, and bolster the credibility of the authorities' plan. Some Directors argued, however, that fiscal consolidation needs to be implemented as planned to minimize the risk of weakening the expansion as the global monetary tightening cycle advances.

Directors emphasized that further financial sector reforms will accelerate development of securities markets, improve the financial system's resilience to shocks, and help to sustain non-inflationary growth over the medium term. They welcomed the steps under way to reduce the government's role in intermediation, streamline and clarify securities regulation, and bolster financial risk management, which will help safeguard the stability of the financial system while improving its efficiency.

Directors welcomed Japan's progress in structural reforms. They noted that the current strong expansion reflects in part the payoff from vigorous financial and corporate sector restructuring in the past. Looking ahead, Directors observed that steps to downsize the public sector, make labor and product markets more flexible, and liberalize trade could lift productivity further.

Directors stressed that accelerating structural reform would pay additional dividends to Japan and the world. The stronger underlying growth these reforms would engender would facilitate fiscal consolidation, while helping to support living standards in the face of rapid population aging. Directors noted that, as part of a package of policy measures involving a number of countries, reforms would also support a more balanced pattern of global growth and an orderly resolution of global current account imbalances. For all these reasons, they encouraged the authorities to maintain an ambitious reform program.

Directors expressed appreciation for Japan's generous official development assistance, as well as for its financial and other support for the Fund's technical assistance activities.

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.