Japan: Solid Recovery, But Europe Dampens Outlook

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

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...