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The strengthening of the economy has raised hopes that Japan is emerging from a decade of stagnation. Output has been increasing at a more than 2 per cent annual rate since 2002, reflecting strong external demand and the progress made in corporate restructuring and economic reform. However, Japan still faces a number of serious headwinds to sustained growth, notably entrenched deflation and continued declines in bank lending and land prices. Meanwhile, the government’s financial position continues to deteriorate, raising concerns about fiscal sustainability at the same time that population ageing is increasing demands for public spending. Addressing these challenges requires a combination of well-designed macroeconomic policies and structural measures to boost the growth potential and ensure rising living standards in the face of rapid population ageing.
Monetary policy: ending deflation and supporting the expansion
The priority should be to end six years of deflation by maintaining the quantitative easing policy until inflation is sufficiently high so as to make the risk of falling back into deflation negligible. Setting a higher inflation threshold as a condition for changing monetary policy would also help guide private-sector expectations and help limit the reaction in markets. While it is essential to avoid a premature tightening of monetary policy, maintaining the quantitative easing policy for too long after deflation ends could lead to sustained inflation at high rates. Coping with the shocks likely to accompany the end of quantitative easing would be facilitated by further progress in rehabilitating the banking system through continued reductions in non-performing loans and a strengthening of capital, particularly in the regional banks. Moreover, a stronger banking system is essential to reverse the decline in lending and help sustain the expansion.
Fiscal policy: achieving fiscal sustainability through a more ambitious medium-term consolidation plan
Large government budget deficits have boosted gross public debt to over 160 per cent of GDP, the highest in the OECD area, raising concern about the possibility of a rise in the risk premium. The government’s medium-term plan aims at keeping the size of government spending around its FY 2002 level through FY 2006, a goal that requires additional reductions in discretionary outlays and further reform of the social security system. However, spending restraint alone will not be sufficient to achieve fiscal sustainability, which is likely to require a fiscal consolidation of more than 5 per cent of GDP. Increases in government revenue thus seem unavoidable and will require a broadening of tax bases and a hike in the consumption tax rate at some point. Confidence in the fiscal position would be sustained by larger deficit reductions, provided the recovery keeps momentum. This should be accompanied by a credible medium-term plan that is more ambitious and detailed than the 2004 plan.
Reforming the relationship between different levels of government
With the debt of local government rising sharply in recent years, fiscal consolidation also requires a revamping of relations between different levels of government. The “Trinity Reform”, which aims at cutting earmarked grants and reforming block grants provided by the central government while increasing local tax revenues, is a step in the right direction. However, this initiative should include stronger mechanisms to discipline local government fiscal behaviour. To benefit more fully from decentralisation, local authorities should be allowed greater autonomy by reforming the grant system to increase their ability and incentives to provide better services at lower cost. In addition, the tax autonomy of local governments should be increased, while keeping the tax system as simple and neutral as possible.
Accelerating structural reforms to increase potential growth
Faster output growth is a key to meeting the challenges posed by the fiscal situation and population ageing. The top priorities are the privatisation of Japan Post and accelerating regulatory reform, in part by extending the measures in the special zones nation-wide. Competition should be enhanced by strengthening the Japan Fair Trade Commission, improving the regulatory framework in network industries and increasing openness to trade and inflows of FDI.
Addressing problems in the labour market
The share of non-regular workers has risen to more than a quarter of employees, enabling firms to reduce wage payments while enhancing flexibility. However, the increasing dualism of the labour market poses a number of efficiency and equity concerns that should be addressed by a comprehensive approach, including enhancing employment flexibility for regular workers, expanding the social security coverage of non-regular workers and other policies, such as training. Encouraging higher employment rates, particularly among women and youth, is essential to sustain Japan’s growth potential in the face of rapid population ageing.
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