Japan: Staff Concluding Statement of the 2022 Article IV Mission
January 27, 2022
A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.
The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.
Washington, DC:
The Japanese economy is recovering from the pandemic amid strong policysupport and high vaccination levels. The recovery is expected tostrengthen in 2022, although the balance of risks is tilted to thedownside. In the near term, policies should remain accommodative butincreasingly targeted. Looking further ahead, to reflate the economyand move to a sustained growth path, comprehensive and mutuallyreinforcing policies will be needed after the pandemic to: (i) put thefiscal position on a stronger footing amid an ageing population; (ii)enhance the sustainability of monetary policy accommodation whileprotecting financial stability; and (iii) advance growth-enhancingreforms and digital and green transformation to promote strong andinclusive growth.
RECENT ECONOMIC DEVELOPMENTS AND POLICIES
Japan’s policy response to the pandemic has been exceptionally strong,helping mitigate the downturn. Japan had much lower rates ofCOVID-related infections and deaths than most advanced economies,including due to containment measures. The Government adopted threelarge supplementary budgets leading to a jump in the primary deficitfrom 2.4 percent of GDP in 2019 to 8.3 percent of GDP in 2020 and 7.2percent of GDP in 2021. Measures were aimed to provide relief tohouseholds, maintain employment, and provide credit lines for firms.The Bank of Japan (BoJ)’s swift response facilitated financing forfirms and maintained financial market stability by providing ampleliquidity and expanding asset purchases. The Financial Services Agency(FSA) allowed a temporary relaxation of prudential requirements tosupport liquidity and credit supply
Thanks to this strong and timely policy support, the Japanese economy is recovering from the pandemic. Following a contraction of 4.5 percent in 2020, real GDP growth is estimated to have grown by 1.6 percent in 2021. Reflecting high energy prices, inflation has risen gradually during 2021 but remains well below the 2 percent inflation target. The current account surplus is estimated at 3.1 percent of GDP in 2021, and the external position is preliminarily assessed as broadly in line with medium-term fundamentals and desirable policies. Business bankruptcies and non-performing loans are at historical lows due to strong fiscal and monetary support as well as liquidity and credit supply facilitated by regulatory easing measures. The banking system remains well-capitalized and liquid, and near-term vulnerabilities are contained.
OUTLOOK AND RISKS
Growth is expected to accelerate to 3.3 percent in 2022 amid continued strong policy support, a high vaccination rate, and easing global supply constraints. Consumption will lead the recovery, with pent-up demand being unwound. As pandemic-related uncertainty and supply constraints subside, investment would bounce back. Buoyant external demand is expected to continue as the world economy emerges from the pandemic. The current surge of the Omicron variant in Japan could slow the growth momentum in the first quarter, but a strong rebound is expected in the second quarter as the wave dissipates. Inflation momentum is expected to pick up further, spurred by higher import prices and domestic demand.
An ageing and declining population will continue to weigh on the economy in the medium to long term. With significant scarring effects from the pandemic unlikely, real GDP growth is projected to converge to its potential of 0.5 percent. Under current policies, inflation is expected to remain below the BoJ’s 2 percent inflation target over the projection period. After declining to about 2 percent of GDP in 2024 absent new policy initiatives, the primary deficit is projected to rise gradually over the long term due to age-related spending pressures. The current account surplus is projected to remain at slightly above 3 percent of GDP, broadly corresponding to the income surplus arising from Japan’s large positive net international investment position and high net returns.
The unusual uncertainty around the pandemic pose downside risks. Strict containment measures may be needed to deal with the Omicron variant and the recovery in services consumption may be delayed. A sharp tightening of global financial conditions and a global economic slowdown could weigh on Japan’s economic recovery and crystalize macro-financial risks. Debt sustainability concerns and excessive risk taking by financial institutions under the low-yield environment could undermine financial stability. The reallocation of resources could be impeded by labor market rigidities and delayed exit of non-viable firms.
SUPPORTING THE RECOVERY
Continued policy support is warranted in the near term to provide relief to vulnerable households and prevent permanent economic damage from the pandemic.
The fiscal stimulus package announced in November 2021 will provide needed support; under current policies, IMF staff projects the primary deficit at 6.7 percent of GDP in 2022. Nevertheless, the package could have been better targeted, for example, by lowering the income threshold for the cash transfer to child-rearing households. Moreover, it could have included further measures to facilitate resource reallocation towards sectors with high growth potential and to promote a digital and green recovery. Looking ahead, given the large uncertainty surrounding the pandemic, fiscal policy should be nimble and flexible, adjusting the scale and the composition of support in response to epidemiological and economic developments.
The accommodative monetary policy stance is appropriate, given that inflation is projected to remain below the 2 percent target in the medium term. Funding strains for larger firms have improved significantly, allowing the BoJ to unwind its exceptional support and lower the ceiling of its corporate debt purchases back to its pre-crisis level starting March 2022. The BoJ extended its special program to support financing of SMEs by 6 months until September 2022, given their weak financial position, mainly in the face-to-face services sectors. The shift towards more targeted financial support to nonfinancial corporates is welcome as it should help mitigate downside risks to the economy and prevent the rise of new zombie firms.
Financial supervision should remain vigilant to contain vulnerabilities. Strong fiscal and monetary policy support during the pandemic provided life-line support to the economy, but they may delay loss recognition and provisioning. In order to avoid resources becoming locked into non-viable firms and hindering banks’ ability to support the recovery, banks should be further encouraged to make adequate loan-loss provisioning and proactively recognize non-performing loans. As the pandemic recedes, the authorities should continue scaling down pandemic-related measures, at a pace that does not jeopardize the recovery, including by shifting support towards viable but liquidity-constrained firms and reducing loan guarantee and concessional loan programs.
BUILDING BACK BETTER AFTER THE PANDEMIC
Comprehensive and mutually reinforcing policies will be needed to promote inclusive and sustainable growth and to reflate the economy. The main elements are: (i) fiscal consolidation to reduce debt sustainability risks; (ii) further measures to enhance the sustainability of monetary accommodation; (iii) strengthened financial sector policies to contain build-up of systemic risks; and (iv) reforms to increase labor supply, productivity, and investment, including a move towards a low-carbon and digital economy.
Fiscal Policy
Once the recovery is firmly in place, it will be important to rebuild fiscal buffers gradually and ensure debt sustainability over the medium to long term. The exceptional fiscal support and the sharp output drop during the pandemic raised the debt-to-GDP ratio from 236 percent in 2019 to 259 percent in 2021. Debt rollover and issuance risks are contained in the near term, helped by a large domestic savings base, home bias, and a debt profile with no foreign currency debt. However, debt sustainability risks will rise as demographic trends weigh in the medium and long term. Medium-term fiscal consolidation should aim to put public debt on a downward path and strengthen the ability to respond to future shocks.
The transition to a sustainable fiscal position should be guided by a fiscal framework balancing short-term stabilization and medium-term fiscal sustainability. The framework should be:
• Well-specified. The consolidation strategy should be underpinned by well-specified fiscal measures. The framework could contain contingent plans to be deployed in case a large downside risk materializes.
• Based on conservative projections. To safeguard the credibility of fiscal plans, the underlying macro-fiscal projections should be prudent and balanced. As an initial step, addition of a downside scenario to the existing baseline and high-growth scenarios could help anchor policy discussion around the baseline. Projections made by an independent fiscal institution could enhance the credibility of the framework.
• Sustaining growth momentum. Fiscal consolidation should take into account economic conditions, underpinned by measures conducive to an expansion in private demand. The authorities should continue to assess the progress towards the FY2025 fiscal target, weighing fiscal consolidation against the need to provide fiscal support in case of downside shocks and preserve growth momentum.
• Predictable. Sizeable supplementary budgets have been frequently assembled, leading to upward revisions of expenditures from the initial budgets. Additional appropriations in supplementary budgets should in general be limited to responses to large, unexpected shocks, such as the pandemic.
Fiscal consolidation will require policy initiatives both on the expenditure and revenue sides of the budget. On the expenditure side, healthcare and long-term care spending is projected to grow in the long run, driven by ageing and the use of new technology. There is room for efficiency gains by promoting the use of generic drugs, limiting the scope of covered services, and shortening the duration of in-patient care. Out-of-pocket spending for the non-poor elderly should be raised. While the government's decision to raise the copayment for the elderly is a step in the right direction, there is room to improve targeting.
On the revenue side, Japan's tax revenues in percent of GDP are low relative to G7 countries, pointing to room for increased revenue mobilization. Options that could be explored include: increasing the consumption tax standard rate; strengthening property taxation through removal of the preferential treatment of residential land; rationalizing allowances and deductions in personal income taxation; and increasing the capital income tax rate. Complementary measures may be warranted to mitigate any adverse distributional impact, including to better target vulnerable households. In this context, it is essential to support intergovernmental information flows to identify and reach households in a timely way with help of the My-Number system and other digitalization measures.
Monetary and Financial Policies
The BoJ's commitment to maintaining prolonged monetary accommodation remains appropriate. Since its introduction in September 2016, the current monetary policy framework (“QQE with YCC”) has helped ease financial conditions and enhance the sustainability of monetary accommodation, although the 2 percent inflation target has been undershot. IMF staff expects that a prolonged period of monetary policy accommodation, flexible fiscal policy, and inclusive growth-oriented reforms will be required to durably lift inflation expectations and inflation to the target.
Building on the adjustments to the monetary policy framework following the BoJ’s assessment in March 2021, which help make monetary support more sustainable, further measures could be considered. One option could be to steepen the yield curve by shifting the yield target from the 10-year to a shorter maturity. This could help mitigate the impact of prolonged monetary accommodation on financial institutions’ profitability, while still keeping down the short- to medium-term yields that matter most for economic activity. Careful implementation and communication would be needed to avoid a market perception of withdrawal of monetary accommodation.
If the underlying inflation momentum remains weak, cutting the policy rate should be the first option. In addition, since a relatively small fraction of bank reserves is subject to negative rates under the BoJ’s three-tier system, increasing that fraction could help strengthen transmission of the negative policy rate to money markets and to deposit rates, particularly those of corporates. With careful calibration, this could help maintain a smooth functioning of money markets and increase private investment, in turn facilitating medium-term fiscal consolidation.
More could be done to strengthen communication. Committing to maintain accommodative monetary policy for a prolonged period by linking policy interest rates to the price stability target could help reinforce yield curve control and encourage households to spend more today. By the same token, delinking the overshooting commitment from the monetary base could simplify communication.
The pandemic could intensify long-standing financial vulnerabilities stemming from low profitability amid an ageing and shrinking population, especially for regional banks, which account for 40 percent of the banking system. Several welcome measures have been taken to address this challenge, including a special BoJ deposit facility for mergers or streamlining of overhead costs, subsidies for mergers and business integration, exemptions to the anti-monopoly law, and amendments of the Banking Act to support business diversification.
Macro-financial risks may arise against the backdrop of prolonged low interest rates. The FSA should leverage its Early Warning Mechanism and continue to encourage regional banks to upgrade their business models, better utilize IT/Fintech, and consolidate. It should continue to monitor and further strengthen supervisory oversight as needed for banks’ risk management and capacity in new business areas, including those allowed under the recent amendments of the Banking Act. The BoJ and FSA’s close coordination and exchange of views on the system-wide implications of potential risks are welcome initiatives. The FSA in close coordination with BoJ should continue to broaden the scope of systemic risk assessment and enhance its macroprudential toolkit to address risks as they emerge.
Reforms for Inclusive and Sustainable Growth
The government’s economic policy agenda is appropriately centered on advancing a cycle of growth and distribution. The priority policies to raise economic growth include the promotion of digital transformation and green investment, support for start-ups, revitalization of regions through digitalization, and enhancement of economic security. The income distribution strategy aims to raise the share of labor income, by promoting wage hikes including through corporate tax credits, increasing public wages for healthcare and childcare workers, narrowing wage gaps between genders and between regular and non-regular workers, supporting human capital investment, enhancing labor mobility, and facilitating the restructuring of SMEs.
Shifting to a Low-carbon Economy
Japan’s new impetus towards reducing carbon emissions is an important and positive step towards mitigating climate change. Japan committed in October 2020 to reduce net greenhouse gas emissions to zero by 2050.In April 2021, Japan raised its medium-term target to reduce emissionsby 46 percent relative to FY2013 levels in FY2030, up from its earliergoal of 26 percent, and will continue its efforts to further reduce itsemissions by 50 percent. Japan’s climate change strategy focuses ontechnological innovation and green finance, while making welcomecontributions to regional and global decarbonization.
The carbon neutrality objective could be achieved in a growth-friendly way while protecting the most vulnerable. Reducing emissions will be especially challenging, as Japan has relied heavily on fossil fuels for its energy needs since the 2011 earthquake and tsunami. IMF staff analysis finds that a comprehensive policy package—including green energy investment combined with a gradual rise in carbon prices—would have net positive impacts on growth, employment, and investment. More reliance on carbon pricing could be considered in order to amplify incentives for green private investment, accelerate a shift from high- to low-carbon energy sources, and underpin the emissions reduction target. Compensatory transfers financed partly by carbon revenues could be provided for vulnerable households.
Japan is making progress on developing green financial markets and managing climate change related financial risks. Sustainable and green bond issuance by Japanese entities is growing fast, supported by national standards for green financial products and a subsidy scheme to defray the costs of issuing green debt. Corporate climate disclosures are limited but improving. The revised corporate governance code is expected to enhance climate disclosures of companies listed on the Prime Market. The BoJ and FSA are studying the role of climate change for financial stability, and a pilot on climate scenario analysis is underway. The BoJ released a strategy on climate change, including a fund-provisioning measure to support private sectors’ various efforts in the field related to climate change, in July 2021.
Further policy efforts would strengthen Japan’s capacity to manage climate-related financial risks and help develop green financial markets. Better climate data and disclosures will be crucial, and consideration should be given to mandatory minimum standards for financial institutions, corporates, and investment funds. Using green taxonomies would be one of the ways to reduce greenwashing risks and provide certainty to market participants. Efforts to build expertise on climate finance among financial institutions, to develop risk measurement and management approaches including scenario analysis, and to publish supervisory guidance on climate financial risks to financial institutions are important and welcome.
Harnessing the Gains from Digitalization
The government’s digital transformation strategy will help improve Japan’s uneven state of digitalization and boost productivity. While Japan is a leader on several technology frontiers, including use of industrial robots, it has room to catch up with peers in digital adoption by businesses (including e-commerce), government services, and financial services. The government has set up the Digital Agency to accelerate digitalization of the public sector and introduced tax incentives to encourage digitalization in the private sector. IMF staff’s cross-country analysis suggests that these measures, through an increase in ICT investment, could help boost labor productivity over the medium term. Carefully designed policy support would be needed to protect unskilled workers, including enhanced training especially on IT skills.
While the pandemic has accelerated the usage of cashless payments and online commerce, their adoption could be further expanded. Initiatives to support a gradual move towards a less-cash based economy (e.g., reducing the issuance of high denomination notes, increasing the relative cost of cash payments) could further lower the effective lower bound on interest rates and enhance the stimulative impact of negative rates over the medium term. Moreover, enhancing the public’s trust by augmenting financial and digital literacy; improving the interoperability between different cashless payment platforms; and strengthening data privacy, consumer protection, and cybersecurity are important to accelerate digital adoption.
Building a virtuous cycle with priority reforms
Accelerating growth-enhancing reforms could boost productivity and wages and improve income distribution. The reform agenda should prioritize comprehensive measures to increase labor supply and productivity, accompanied by regulatory and corporate reforms to boost investment:
• Increase labor supply. Further expanding access to affordable and high-quality childcare and enhancing flexible work arrangements would help sustain the increase in participation by women and the elderly in the labor force. In addition, policies promoting foreign skilled professionals and foreign workers in sectors with labor shortages could be enhanced.
• Boost labor productivity and wages. The recently expanded corporate tax credit for wage increases will mainly benefit regular workers and large firms, and as such could be complemented by further reforms. In particular, following up on implementation of the Work Style Reform strategy would help shrink productivity and wage gaps between regular and non-regular workers. Existing training programs to improve skills could be complemented by a shift towards flexible employment and wage systems based on ability rather than seniority. Reducing labor market duality would help enhance career opportunities for non-regular workers, raising productivity and real wages.
• Improve corporate governance. Building on recent progress, corporate governance reforms could be further strengthened by setting more ambitious requirements to increase outside and diverse directors, reduce cross-shareholdings, and enhance transparency of beneficial ownership. These measures would help incentivize firms to deploy their substantial cash reserves and boost investment and productivity.
• Foster investment. In the context of a rapidly ageing society, the policies to support orderly exit of firms and incentivize non-family succession are steps in the right direction. In addition, to improve the business environment, deregulation (e.g., of professional services, land use, barriers to entry and protection of incumbents) and R&D investment efforts could be enhanced. Further efforts to address potential impediments to inward FDI, such as simplified procedures and speedy processes to allow the use of foreign labor, would also help facilitate FDI flows. Shifting corporate income taxation to a cash-flow based tax, with a higher statutory rate, could help increase investment in a revenue neutral way.
Trade Policy
Japan has taken a welcome lead on global and regional efforts to promote open, stable, and transparent trade policies. Japan's trade and FDI regimes are broadly open, although agricultural support policies remain relatively restrictive. The authorities are keen to advance WTO reforms that will ensure effective dispute settlement, modernize trade rules, and enhance the WTO’s monitoring and enforcement function. Japan also has been actively involved in negotiations on Joint Statement Initiatives on e-commerce and investment facilitation, and was an original member of the recently-concluded negotiations on a Joint Statement Initiative on Services Domestic Regulation.
The subsidy programs to strengthen supply chain resilience should bolster the efficiency of global value chains. Amid the supply chain disruptions caused by the COVID-19 pandemic, these programs were introduced in 2020 to strengthen the domestic production base and diversify supply chains in Asia. While global value chains continue to change along with the economic circumstances, it is important to guard against the potential for such subsidies to inadvertently fragment existing investment and trading relationships.
The IMF team would like to thank the authorities and otherinterlocutors in Tokyo for their frank and open discussions.
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