core sector communique

Japan: Solid Recovery, But Europe Dampens Outlook

IMF Survey online

June 12, 2012

• Recovery fueled by reconstruction spending and private consumption
• Long-term challenges include tackling high public debt, low growth
• Financial sector has been resilient, but risks remain

J

apan is experiencing a solid recovery following the March 2011 Great East Japan earthquake, but the European debt crisis is likely to dampen demand for the country’s exports, and weigh on business sentiment, says the IMF in its annual health check of the world’s third largest economy.

Speaking at the end of a trip to Japan accompanied by IMF economists, First Deputy Managing Director of the IMF, David Lipton, said the country’s recovery would likely be sustained by reconstruction spending and stronger private consumption.

The Japanese economy is expected to grow by about 2 percent in 2012 and slow slightly to 1¾ percent in 2013, but “the intensifying strains in Europe highlight the significant downside risk to the outlook,” said Lipton.

Japan’s headline inflation remains near zero percent, but the exchange rate has appreciated over the last year, partly because of inflows of capital seeking a safe haven. IMF economists believe the Japanese yen is moderately overvalued from a medium-term perspective.

Long-term challenges

Japan also faces many longstanding challenges including tackling its high public debt, low growth, and deflation, according to the IMF.

Lipton said that in order to make “meaningful” progress in tackling these issues, Japan needed to “move forcefully on many fronts to take advantage of synergies between policies. This includes a combination of fiscal, structural, and monetary policies.”

IMF economists have identified Japan’s deep-rooted fiscal problems as the immediate priority. Over the last 20 years, Japan’s net public debt has increased tenfold, fuelled by a rapid rise in social security spending. The IMF believes that tax and social security reforms are crucial to demonstrate a commitment to fiscal reform and sustain investor confidence.

“Our estimates suggest that in total, Japan will need to achieve an overall fiscal consolidation of about 10 percent of GDP over the next decade,” said Lipton, who also called for a “bold and comprehensive” package of structural reform to help reduce the public debt-to-GDP ratio, as well as raise potential growth.

Constraints to growth

The IMF believes that reforms should focus on the most important constraints to growth, including the aging labor force, low female labor force participation, domestic sector regulations, and the limited availability of risk capital.

The IMF supports recent measures taken by Japan’s central bank to support the recovery and help the country escape deflation. But its economists say that additional easing could be delivered to increase the likelihood of achieving the 1 percent inflation goal by 2014 under the IMF staff’s baseline scenario. The IMF believes this could help reduce lending rates further, and raise inflation expectations.

“Strengthening communication would help increase the effectiveness of these measures,” said Lipton.

Reinforcing Japan’s financial sector

During meetings with authorities in Tokyo, IMF economists also discussed the update to the Financial Sector Assessment Program—a comprehensive and in-depth analysis of the country’s financial sector undertaken by developed and many emerging economies.

Japan’s financial system has remained stable despite recent strains in global financial markets. This has been helped by important steps taken to reinforce financial stability since 2003.

Japan’s financial institutions have limited direct exposure to peripheral European countries, and the number of nonperforming loans remains low.

In the near term, banks and insurers have the capacity to withstand a range of adverse macroeconomic and financial shocks, suggests the IMF. But the core profitability of many of the country’s banks remains weak, and their large holdings of Japanese government bonds and equities raise concerns about financial stability.

The IMF supports further improvements to the prudential framework to strengthen the resilience of the financial system. This would include tightening large exposure limits on lending by banks, and raising capital requirements for domestic-oriented banks, continuing oversight over systemically important financial institutions and market infrastructure, and improving crisis resolution for nonbanks.

This year marks the 60th anniversary of Japan’s membership of the IMF. Later this year, the IMF and World Bank will hold their Annual Meetings in the Japanese capital, the first such gathering in Tokyo after a gap of 48 years.