Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
IMF Survey: Next Policy Steps for Japan's Growth
September 13, 2007
- Japan's expansion rests on sound underpinnings
- But important policy challenges remain
- Ambitious reforms will benefit both Japan and the world
Global financial turbulence since late July has clouded the economic outlook of many countries.
Laser disc production in Yamanashi, Japan: labor, product market reforms are key to country's lasting growth, IMF says (photo: Reuters)
ANNUAL ECONOMIC HEALTH CHECK
It is still too early to gauge the full impact of unsettled investor sentiment and volatile asset prices on economic activity, but the IMF's annual assessment of the Japanese economy (based on a staff report prepared in June) gives grounds for optimism about Japan's ability to navigate choppy waters ahead. In short, the IMF's message is that the ongoing expansion—the longest in Japan's postwar history—rests on solid foundations and GDP growth should remain close to trend for the next few years.
Japan's emergence from a decade of economic stagnation began in 2002 with an export-led recovery that helped jump-start growth and break a cycle of falling prices and financial instability. Five years later, growth has become more broad based, confidence has improved, and Japan's engagement with the global economy has deepened. Worldwide market jitters have recently imparted volatility to some economic indicators but have not undermined these positive fundamentals.
The IMF's assessment focuses on the main policy challenges facing Japan and their international implications. What will be key to a lasting growth and make a strong contribution to the global economy are further improvements in the fiscal accounts, a well-managed return to more normal monetary conditions, additional progress in strengthening the financial sector, and steadfast implementation of reforms in labor and product markets.
Putting public finances on a sustainable path
Budgetary consolidation has proceeded faster than expected in the past few years on the back of strong corporate tax revenues and sustained efforts to contain government spending. Nonetheless, Japan's debt-to-GDP ratio is one of the highest among the industrial countries—and is still rising.
Continued efforts to put the public debt ratio on a downward trajectory are needed to make room for spending pressures due to a rapidly aging society. The Japanese authorities are committed to further budgetary adjustment over the medium term but, in the IMF's view, their plans could take better advantage of the expansion under way.
For example, revenue measures—including an increase in the consumption tax (which is low by international standards)—should complement the government's emphasis on expenditure cuts and speed up the pace of adjustment.
The IMF also argues that Japan's fiscal adjustment could have favorable international spillovers, although it may delay the resolution of global current account imbalances. In the last analysis, restoring Japan's fiscal health is in the world's interest because it would strengthen medium-term growth and limit financial risks.
Managing a return to more normal monetary conditions
Since exiting from a zero-interest-rate policy in July 2006, the Bank of Japan (BoJ) has tried to strike a balance between its desire to return interest rates to more normal levels and the danger of premature tightening. Higher rates would restore room for policy maneuver and forestall financial imbalances like those at the root of the late 1980s bubble economy.
Then again, too-rapid rate hikes could stop the expansion in its tracks, rekindle deflation, and worsen the debt dynamics. With these considerations in mind, the BoJ has opted for a very gradual adjustment, increasing its policy rate just ½ of 1 percentage point in 15 months. In the IMF's assessment, the cautious pace has been appropriate, given a virtual absence of inflation and no signs (so far) of worrisome financial excesses. The IMF goes on to note that very low prospective inflation calls for only a gradual tightening cycle in the quarters ahead.
While acknowledging that Japan's low interest rates have been contributing to excess global liquidity, large capital outflows, and a weak yen, the IMF stresses that no alternative policy mix aimed at a stronger yen would carry benefits that outweigh the attendant costs and risks. On the whole, the global economy seems better off with a gradual pace of monetary withdrawal in Japan that would secure a continued expansion with benefits elsewhere.
By the same token, the IMF stresses that the external value of the yen should remain market determined and could be expected to strengthen as the portfolio shifts that currently contribute to its weakness play themselves out.
Strengthening the financial sector
In this context, the IMF report notes that greater capital flows from and to Japan have enhanced the global intermediation of savings, but have also created the potential for sudden reversals and financial turbulence. Japan's financial policies should thus focus on ways to better manage these risks and enhance intermediation. The recent bout of financial turmoil has only added weight to this advice.
On the domestic front, a priority for financial sector policy is to raise bank core profitability. Despite significant progress in restructuring, banks' profits margins are well below those in other advanced countries. Further deregulation and development of the capital markets could expand income sources for financial institutions and improve returns on Japan's large pool of savings, but would require appropriate changes in supervision.
Structural reforms to boost productivity
A final key policy challenge facing Japan is to push ahead with reforms to raise long-term growth and strengthen international competitiveness. Initiatives have been under way for some time to streamline product market regulation and the public sector, improve labor utilization, and foster competition and trade. Yet, in the IMF's assessment, there is still room to deepen reforms in a number of areas.
Stepped-up implementation would have important payoffs for the domestic economy: improved resource allocation, higher productivity, and more resilience to shocks. But it would also open the door for positive international spillovers in terms of a greater role for domestic demand to drive growth and an environment more conducive to an orderly resolution of global imbalances.