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This book focuses on Japan's recent recovery from a decade-long stagnation, with particular attention to the unfinished policy agenda and the international spillovers of Japan's policies, through background studies (both analytical and descriptive) by IMF economists.




1. Overview

Japan’s transition out of the economic stagnation that followed the bursting of the land and equity price bubble in the early 1990s has been long and tortuous. Undermined by a cycle of deflation and financial instability, growth was intermittent and narrowly based for much of the decade. Dislocations in the banking and corporate sectors weighed on confidence and activity, while policy slippages and external shocks added to the headwinds. By 2000—about ten years after the stock market went into a freefall—GDP was some 40 percent lower than what it would have been if growth has continued at the 1990–91 rate. The price level, as measured by the GDP deflator, was not much higher than at the time the bubble collapsed, but on a downward trajectory that proved hard to reverse. As the new millennium dawned, Japan seemed bogged down in the deepest slump of its postwar history.
Daniel A. Citrin, Alessandro Zanello

Growth and Demographics


2. Japan’s Potential Output and Productivity Growth

Japan’s economic re-awakening over the past five years raises the question of whether the country’s potential output growth rate may now be higher. Structural adjustments to the imbalances of the “bubble” years have strengthened fundamentals. At the same time, an aging population complicates the challenge of ensuring strong self-sustaining growth. With Japan’s birth rate well below the population’s replacement rate, the working-age population in fact has been contracting since 2000, and the elderly dependency ratio (the share in the working-age population of people at least 65 years old) is now the highest among industrial countries. With a declining labor force, per capita income growth will depend critically on higher productivity.1
Papa N’Diaye

3. Household Savings in Japan

Japan’s household savings rate has fallen dramatically since the early 1980s (Figure 3.1). The savings rate, based on national income accounts data, declined from 18 percent in 1981 to 6 percent in 2002 with a brief pause during the bubble years. This drop has prompted discussions about the prospective evolution of Japanese savings and Japan’s long-term growth prospects in the context of a rapidly aging population.1
Hali Edison

Fiscal Policy Challenges


4. Strategies for Fiscal Consolidation

Japan’s key fiscal challenge is to put public finances on a more sustainable footing. Large government budget deficits have boosted Japan’s net public debt to over 85 percent of GDP, one of the highest in the Organization for Economic Cooperation and Development (OECD) (Figure 4.1). In the years ahead, rising health and elderly care costs will add strain to public resources. The Cabinet Office estimates that in the absence of further policy adjustments, social security expenditure will reach 22 percent of GDP by 2025, up from about 18 percent of GDP in 2005.1 As a result, the government’s net debt could continue to rise. Rising debt could increase interest rates, lower investment, and ultimately hamper growth in the context of population aging.
Dennis Botman, Hali Edison, Papa N’Diaye

5. Tax Policy Challenges from Globalization and Aging: Issues and Options

The tax system in Japan, as in other countries, faces increasing pressures from aging and globalization. This chapter draws on recent international experiences and trends to identify and review some of the key issues likely to arise, and options for addressing them.
Michael Keen

6. Pension Reform Issues

Japan has the most rapidly aging population among developed countries. A number of factors contribute to this trend. The Japanese population has the longest life expectancy and one of the lowest birth rates in the world, and immigrants constitute a very small proportion of the population. Japan’s National Institute of Population and Social Security Research (NIPSSR) projects that the nation’s population will decline by half between 2006 and 2100. Over this period the elderly dependency ratio will increase rapidly—based on the NIPSSR projections, for every person above 65 there will be only 1.5 people of working age in 2050 (Figure 6.1).
Dora Iakova

Monetary Policy After Deflation


7. A Post-Deflation Monetary Framework

This chapter is about how to adjust Japan’s monetary policy framework to meet the resumption of inflation. At the time of this writing (fall 2005), Japan’s monetary policy framework is tailored to ending deflation and maintaining financial stability. The Bank of Japan (BoJ) has committed to maintaining a highly accommodative stance under its “quantitative easing” policy at least until actual and expected deflation end. Operationally, it relies on a quantitative operating target, namely bank and nonbank reserves (or “current balances” held at the BoJ), supplying ample liquidity and thereby keeping the policy interest rate at virtually zero. This has the additional benefit of bolstering financial stability.
Charles Kramer, Mark Stone

8. Practical Issues Surrounding the New Understanding of Price Stability

This chapter examines the issues facing the Bank of Japan’s (BoJ’s) Policy Board in implementing a new post-deflationary framework for monetary policy. The chapter provides an overview of the new framework and the ramifications of the Policy Board’s “understanding of price stability” as a range of inflation (over the medium term) from zero to 2 percent. While lower than the benchmarks used at other central banks, this chapter shows that the range may be appropriate because inflation has indeed been more subdued in Japan than in most industrial countries. This said, inflation expectations could be better anchored in positive territory if BoJ communications emphasized that most Policy Board members assess price stability as ranges for CPI inflation with medians close to 1 percent. Finally, while the Policy Board’s range focuses on headline CPI inflation, other price indicators could also be useful in assessing—and communicating—incipient inflationary pressures.1 In particular, the traditional measure of core inflation performs well in describing the medium-term inflation outlook. However, there is also a broader class of price indices, derived to correct some of the shortcomings of core inflation, that also perform well.
Christopher Faulkner-MacDonagh

The Rise in Cross-Border Capital Flows


9. Home Bias in Japan

An apparent preference for domestic over foreign assets, or “home bias,” has been a conspicuous feature of the behavior of many investors in Japan, both individual and institutional. This home bias has declined markedly in the past decade by some measures, but remains higher than average for mature market countries. To the extent that a strong revealed preference for domestic assets in Japan results in a suboptimal allocation of financial assets, it would represent an unexploited opportunity for higher returns on investment in a country that has recently suffered from low rates of return, and that faces the prospect of having to cover a large funding gap in social security programs. From a global perspective, an inefficient portfolio held by Japanese investors could have consequences for the prices of foreign and domestic assets.
W. Christopher Walker

10. Recent Developments and Outlook for Japan’s Capital Flows

In recent years, capital flows have picked up sharply, reflecting a more outward-oriented attitude by private Japanese investors (Figure 10.1). Private holdings have been largely concentrated in debt securities, consistent with a widening of interest rate differentials, low market volatilities, and a generally conservative approach to investing. Households are also purchasing an increasing amount of equities in search of higher yield. Meanwhile, Japanese corporations are seeing a sharp increase in income from foreign assets, reflecting past projects that are now turning profitable.
Shinobu Nakagawa, Christopher Faulkner-MacDonagh

Challenges for the Banking Sector


11. Why is Japanese Banking Sector Profitability so Low?

Significant progress has been made in stabilizing the Japanese banking system in recent years. Efforts to address the bad debt problem in the banking system, including public capital injections and heightened supervision by the Financial Services Agency (FSA), have borne fruit. Major banks have lowered their nonperforming loan (NPL) ratios dramatically and key indicators such as capitalization and bank ratings have also improved, although progress has lagged among the regional banks (Table 11.1 and Figure 11.1. Fears of a financial meltdown have eased, and the near-term stability of the banking system is not in doubt.
Alexander Wolfson

12. The Re-emergence of Japanese Banks in Asia

In an effort to diversify their lending and raise profits, Japanese banks are expanding overseas, particularly in other countries in Asia.1 As they move toward less defensive financial positions—including by reducing government bond investment and expanding uncollateralized small and medium-size enterprise (SME) lending—banks are also re-establishing operations in Asia that were scaled back in the wake of the collapse of the bubble as well as the 1997–98 Asian crisis. These operations mainly comprise providing lending, derivatives, and cash management services to Japanese companies as they shift production and distribution into Asia, but they also increasingly include transactions with non-Japanese clients. Japanese banks’ strategies in Asia differ from those in Europe and the United States, where they focus more on investment banking services such as mergers and acquisitions and securities lending.
Shinobu Nakagawa

Structural Reforms


13. Priorities for Structural Reforms

Unresolved structural rigidities explain much of Japan’s low potential growth. Sector specific issues and economy-wide factors that inhibit competition, innovation, and entrepreneurship have combined to depress productivity (Chapter 2). After a decade of weak performance, a program of structural reforms was launched in 2001. It aimed at rationalizing public enterprises, reducing regulation, facilitating corporate restructuring and startups, and enhancing labor market flexibility. However, the gains so far have been limited as much remains to be done. This chapter examines the state of play with the reform agenda and policy options for enhancing productivity further, particularly in the service sector.
Yougesh Khatri

14. Agricultural Policies in Japan: Domestic and International Repercussions

Government support of agriculture remains among Japan’s main structural issues. Present policies slow the reallocation of resources out of agriculture into sectors where they could be used more productively. Reducing support levels and better targeting support toward clear policy objectives would help to improve productivity and generate economic welfare benefits. In this context, agricultural policy reform can contribute to revitalizing Japan’s economic growth.
Bradley McDonald

International Spillovers


15. The Domestic and Global Impact of Japan’s Policies for Growth

The analysis presented in this chapter illustrates the impact of fiscal and structural reforms on the Japanese and world economies. Japan faces a sizable fiscal deficit, against a backdrop of weak trend growth and growing imbalances in the world economy. Moreover, upward pressure on healthcare and social security spending owing to an aging population will add significantly to strains on public resources in the years ahead. In light of these issues, the Japanese authorities have undertaken a range of reforms aimed at raising productivity growth and stabilizing the public debt in relation to GDP over the medium term.
Nicoletta Batini, Papa N’Diaye, Alessandro Rebucci

16. Capital Flows and the Yen-U.S. Dollar Exchange Rate

A weak yen has fueled the perception that its evolution is disconnected from the economic fundamentals that determine its long-term value. The yen has continued to depreciate against major currencies since 2006. In 2006 the yen lost 5 1/2 percent of its value against the U.S. dollar and 9 1/4 percent in real effective terms. This trend has continued through the first half of 2007. Yet, Japan’s fundamentals have strengthened markedly in recent years.1
Papa N’Diaye


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