The FINANCIAL -- The Japanese economy continues to grow above potential, but downside risks have increased relative to last year. Moreover, macroeconomic challenges will increase as demographic headwinds intensify. While the strategy of Abenomics remains appropriate, reinvigorated policies are needed to reflate the economy, boost potential growth, and put public debt on a sustainable path.
A comprehensive, credible, and coordinated effort to achieve these objectives should entail: a well-specified medium-term fiscal framework; an ambitious effort toward labor, product market, and corporate reforms; and a continued accommodative monetary policy accompanied by clear forward guidance. Strengthened financial sector policies should be implemented to safeguard financial stability.
RECENT ECONOMIC DEVELOPMENTS AND POLICIES
Economic growth is projected at 1.1 percent in 2018, above its estimated potential, but inflation remains low. After a temporary soft patch early in the year, domestic demand recovered in the second quarter. With external demand expected to remain supportive, real GDP growth is projected to remain above its estimated potential at 1.1 percent in 2018. Headline and core inflation have gained momentum on the back of higher energy prices but remain well below Bank of Japan’s 2 percent target.
The external current account (CA) surplus increased marginally in 2017, due to a stronger income balance. The sizable income surplus, arising from Japan’s large net foreign asset (NFA) position and high net returns, accounts for most of the CA surplus (about 90 percent in 2017). The CA surplus is expected to shrink from 4.0 percent in 2017 to 3.6 percent of GDP in 2018, reflecting smaller goods trade and income balances. The yen has appreciated slightly in the first seven months of 2018 (in real effective terms) relative to end-2017. As with the 2017 external sector assessment, the projected 2018 current account balance is preliminarily assessed as broadly consistent with medium-term fundamentals and desirable policies. Based on this current account assessment, the 2018 real exchange rate is also preliminarily assessed as broadly consistent with medium-term fundamentals and desirable policies.
Progress on structural reform has been uneven. Labor market legislation was passed recently by the Diet, but its effectiveness in boosting productivity and wages will depend on implementation. This includes the detailed equal-pay for equal-work guidelines on acceptable reasons for worker wage differentials. Progress was made on enhancing labor supply—women and older workers’ participation rates are on a rising trend, and foreign labor is increasing. However, efforts to further eliminate disincentives to regular work stemming from the tax and social security system have been left out of the policy debate over the past year and progress remains slow regarding deregulation. In contrast, revisions and guidelines for the corporate governance code were done recently and trade reforms have accelerated, with the Japan-EU trade agreement and the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).
Monetary policy remains supportive, but the low interest rate environment exacerbates ongoing challenges for the financial system. The Bank of Japan (BoJ) has adopted a more patient approach to achieving its inflation target since the introduction of Yield Curve Control (YCC) in September 2016. Bond yields have remained relatively stable while reduced reliance on Japanese Government Bond (JGB) purchases has made the accommodative stance more sustainable. In its July monetary policy meeting, the BoJ further strengthened the monetary policy framework by allowing more flexibility in long-term yields and introducing forward guidance on interest rates. Nevertheless, the low interest rate environment, combined with ongoing demographic changes, is squeezing the profitability of financial institutions and encourages their search for yield. The resulting risks are likely to persist and pose particular challenges for regional financial institutions.
Near-term risks. Sharper-than-expected volatility in private consumption and investment due to the planned consumption tax increase in 2019 could undermine near-term growth momentum and further delay fiscal consolidation. Weaker global demand and heightened uncertainty—from trade or geopolitical tensions—could undermine growth, trigger yen appreciation and equity market shocks, and renew deflationary risks. Moreover, a disorderly tightening of global financial conditions could increase macro-financial risks, with financial institutions particularly sensitive to a sharp fall in equity prices or a spike in JGB yields. Rising foreign currency funding costs could further squeeze the profitability of internationally-active financial institutions.
Medium-term risks. Continued monetary accommodation amidst tightening by other advanced economy central banks could encourage financial institutions, particularly regional ones, to engage in excessive risk taking. If regional banks and life insurance companies do not adapt business models to the low interest rate environment and adverse demographics, their viability could be threatened in the medium term. Fiscal sustainability concerns and associated bond market stress could have adverse feedback effects on the financial system and the real economy.
CHALLENGES AND ECONOMIC POLICY PRIORITIES
Six years into Abenomics, notwithstanding considerable accomplishments, a fresh look at remaining challenges is warranted. On the positive side, unemployment rate is at a 25- year low and the fiscal deficit has been halved, employment and female labor force participation have increased substantially, deflationary risks have been reduced, and corporate cash reserves are at all-time highs. However, inflation remains well below BoJ’s target, fiscal policies have yet to put public debt on a sustainable path, and household incomes remain stagnant. These challenges will only grow as Japan’s population ages and shrinks—by a projected 25 percent over the next 40 years. Demographic change will depress growth and productivity due to a shrinking and ageing labor force and a shift toward consumption, while fiscal challenges will magnify with rising age-related government spending and a shrinking tax base. Additionally, labor market rigidities limit productivity growth and hamper the pass-through of demand stimulus to real wages and prices—effectively undercutting monetary transmission and blunting the impact of fiscal support.
The strategy of Abenomics remains appropriate, but reinvigorated and credible policies are needed. Bringing Abenomics to full strength requires that the three arrows are reinforced and are mutually supportive. Specifically:
Fiscal policy: Near-term fiscal and income policies should support BoJ’s reflation efforts and implementation of structural reforms. A credible and gradual medium-term consolidation plan—based on realistic growth assumptions—would help provide near-term fiscal space, help ensure debt sustainability, and bolster public confidence in the government’s capacity to manage the financial costs of the demographic transition.
Structural reforms: Credible macro-structural reforms are imperative to lift long-run growth and stabilize government debt. Confidence and anticipation effects accompanying a credible reform program will be key to avoid deflationary effects. Inflation will also be supported by more effective monetary policy transmission, resulting from a higher natural interest rate and reinvigorated wage-price dynamics.
Monetary and financial policies: The accommodative monetary policy stance should be maintained, but clear forward guidance and improved credibility of the monetary policy framework would help lift inflation expectations. Moreover, strengthened financial sector policies could mitigate the financial risks from demographic headwinds and prolonged low interest rates. This may result in improving BoJ’s ability to maintain its accommodative stance for longer.
Near-term fiscal tightening should be avoided—maintaining instead a neutral fiscal stance in 2019 and 2020 to make the planned consumption tax hike successful. The government has reaffirmed its commitment to the consumption tax hike in October 2019, which will bring in much needed revenue. But without mitigating measures, the 2019 and 2020 fiscal stance would be contractionary, as the effects of the supplementary budget for 2018 fade and the consumption tax increase comes into play. Therefore, measures should be implemented to support near-term reflation and growth momentum while helping advance accelerated structural reforms.
Mitigating the impact of the 2019 consumption tax rate increase. Temporary mitigating measures should be carefully designed to alleviate the adverse consumption impact from the October 2019 tax increase. In particular, mitigating measures should address concerns over durable consumption including automobiles and housing. Clear communication to the public on the timing and content of the measures will help alleviate adverse effects due to uncertainty.
Strengthening income policies and raising administered prices. Corporate tax incentives for wage increases should be strengthened, minimum wages should be raised further, and administratively-controlled wages and social transfers should be increased—including to reflect the impact of the consumption tax increase on prices. In addition, to support reflation efforts, reforming the price setting mechanism of administered prices should be considered to better reflect costs, with safeguards introduced for low-income households.
A credible fiscal framework for the medium and long-term is needed to reduce policy uncertainty, address demographic challenges, and mitigate debt sustainability risks. A well-specified medium-term fiscal framework would enhance fiscal space to respond to a downside shock. The fiscal framework needs to rely more on independent and realistic assessments of the economic outlook and budget projections, specify fiscal consolidation measures, and limit the use of supplementary budgets. For example, an independent fiscal institution could play an important role. In order to protect growth while putting debt on a stable path, medium-term fiscal consolidation should embed a gradual approach with annual consolidation of about 0.5 percent of GDP in the structural primary balance, starting from 2021. Essential steps include:
Gradual and steady increases in the consumption tax rate, beyond 10 percent. To finance growing social security costs and reduce debt sustainability risks, consolidation should center on gradual increases in the consumption tax until the rate reaches at least 15 percent. The unitary rate structure should be maintained as the tax rate moves beyond 10 percent, to enhance efficiency, reduce compliance and administrative costs, and support the revenue-raising capacity of the consumption tax.
Reforming healthcare. Measures to contain total healthcare spending should balance the objectives of delivering meaningful fiscal savings and preserving public welfare—focusing primarily on improving efficiency. Increasing the share of out-of-pocket spending can help contain the fiscal burden of future generations, but safeguards for low-income households should be included.
Addressing income inequality. Reforms to curb social security outlays should protect the most disadvantaged groups among the elderly. In addition, to reduce gender inequality, fiscal policy should support opportunities for women in the labor force, while eliminating disincentives to full-time and regular work embedded in the tax and social security systems.
A reinvigorated framework for Abenomics should place heavy emphasis on reform measures to boost productivity, labor supply, and investment. Implementation of such measures will be critical to raising potential growth, productivity, and future incomes. Credible implementation of the structural reforms outlined below, accompanied by a continued accommodative monetary stance and public debt stabilization, could boost real GDP by as much as 15 percent over 40 years. A high degree of government commitment with respect to the reform program would be key in helping reflation via confidence effects on consumption and investment.
Labor market reforms that increase productivity and labor supply. These reforms would have the largest impact. Providing training and career opportunities to non-regular workers, including via contract reform, will help increase their productivity and real wages. Complementing equal-pay for equal-work legislation with job descriptions and a stronger reporting framework will increase its effectiveness. Greater labor participation by women, older workers, and foreign workers could partly offset Japan’s demographics. Eliminating disincentives in the tax and social security system to full-time and regular work, increasing availability of childcare and nursing facilities, and reducing the gender wage gap could increase female labor supply. Reducing excessive overtime and encouraging managerial practices rewarding productivity could further boost productivity and labor force participation, as could abolishing firms’ right to set a mandatory retirement age.
Product market and corporate reforms to lift productivity and investment. Facilitating exit of non-viable small- and medium-sized enterprises (SMEs) and entry of firms with stronger potential would increase productivity, along with reduced coverage of the credit guarantee system, incentivizing alternative sources of SME financing, supporting SME R&D investment, and supporting business succession of firms with high growth potential. Continued deregulation will help increase productivity and investment, including by lowering barriers to entry, removing incumbents’ protections in some industries (telecom and gas), deregulating professional services, and expediting deregulation in economic zones. Deeper corporate governance reform could help deploy cash reserves, and boost investment and productivity. Broader adoption of automation and AI could also boost productivity.
Trade liberalization and FDI promotion to strengthen investment and growth. Further removal of tariff and non-tariff barriers in the context of multilateral trade agreements would boost Japanese investment and growth.
Monetary and Financial Policies
The BoJ should maintain its long-term interest rate target while strengthening inflation expectations and policy credibility. BoJ’s recent emphasis on making the accommodative stance more sustainable is appropriate, and complements its shift to a more patient approach to reaching the inflation target. Nevertheless, more can be done to improve market communication and policy credibility to permanently lift inflation expectations. Specifically, the relationship between the forward guidance on the long-term interest rate target and the inflation target could be clarified and the quantitative guidance on JGB purchases could be removed. Moreover, to strengthen policy credibility, the BoJ should consider moving closer to a full-fledged inflation targeting framework by publishing BoJ’s staff baseline forecast together with underlying policy assumptions. This would also help strengthen market communication and prevent recurrent speculations of an earlier-than-expected normalization.
Demographic headwinds and continued low interest rates are creating macro-financial challenges. To safeguard financial stability, the Japanese Financial Services Agency (JFSA) should further enhance financial oversight—including the macroprudential framework—to prevent the build-up of systemic risk. The JFSA’s new supervisory framework is welcome and should help keep pace with more sophisticated activities among financial institutions. The JFSA should also encourage financial institutions (particularly regional) to improve risk management capabilities and adapt business models to demographic trends. This could include revenue diversification, better utilization of IT and Fintech, and consolidation. Finally, strengthening the crisis management and resolution framework would help reduce expectations of public support and facilitate the smooth exit of unviable financial institutions. The JFSA could further facilitate financial institutions’ efforts to leverage Fintech to reduce costs and improve efficiency. Measures should be taken to increase cybersecurity in Fintech firms (including crypto-asset exchanges) and regional financial institutions. JFSA will need adequate human and IT resources and should continue to promote the use of RegTech to reduce regulatory costs. Enhanced cross-border supervisory collaboration will help prevent regulatory arbitrage and avoidance.
Spillovers and resilience
Continued advancement of multilateralism and bolder domestic policies are needed to mitigate inward spillovers, including from potential trade-war escalation. A global retreat from cross-border integration would likely reduce Japan’s net exports, investment, and growth. Potential channels include direct and indirect effects via global value chains, and adverse spillovers to the financial sector. The impact will be more significant for Japan if cars and car parts trade is affected. Japan’s leadership in furthering multilateralism can help mitigate the possible effects of trade-war escalation. Alternatively, bolder and credible structural reforms and medium-term fiscal consolidation plans that support growth and domestic demand would help mitigate inward spillovers from external developments that could otherwise increase external imbalances.
Rising global interest rates amid Japan’s continued accommodative monetary policy could amplify outward spillovers. Monetary easing in Japan is helping offset tighter global financial conditions, with FDI outflows and institutional investors continuing to diversify overseas. However, speculation over early policy normalization in Japan could rattle bond markets and increase volatility. Moreover, growing differentials between global and domestic interest rates could encourage investors to take unhedged yen carry trade positions. A sharp reversal of these positions, due to heightened global uncertainty from trade or geopolitical tensions, could lead to a large and sudden appreciation of the yen, hurting BoJ’s efforts to reflate the economy.