Journal Issue

Deep-seated weaknesses: Decisive structural reforms offer key to restoring healthy growth in Japan

International Monetary Fund. External Relations Dept.
Published Date:
January 2001
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Japan’s reform agenda

The modest economic recovery that appeared to be under way in Japan in early 2000 in the context of the buoyant global economy has now given way to renewed weakness. While real GDP grew by 1½ percent in 2000, the economy has slowed sharply this year as the high-tech-driven expansion succumbed to the U.S. and global electronics slowdown. Industrial production and exports have fallen by 9½ percent and 12½ percent, respectively, over the past year (see chart, this page); equity prices have declined by 32 percent to 17-year lows; the unemployment rate has risen to 5 percent; and deflationary pressures have continued, with underlying consumer prices currently declining by around ¾ of 1 percent (12-month basis) (see chart, page 292).

In the face of the weakening economy, the Bank of Japan (BoJ) introduced a new monetary policy framework in mid-March. Under this framework, a quantitative target is set for current account balances (broadly equivalent to bank reserves) at the central bank. The target was initially set at ¥5 trillion, which was sufficient to bring overnight interest rates down to zero, and was increased to ¥6 trillion in mid-August as deflationary trends intensified. The BoJ also announced that it would step up its purchases of long-dated government bonds (so-called rinban operations) to support this higher target. The central bank has indicated that this policy framework will remain in place until year-on-year changes in the consumer price index, excluding perishables, have risen to zero or above.

Despite this easing, short-term prospects are bleak. The staff’s current forecast sees the economy contracting by 0.2 percent in 2001, before returning to modest growth of 0.5 percent in 2002. But the downside risks are considerable. A slower than expected recovery in the U.S. economy and global electronics market, a further decline in equity prices, or a deterioration in consumer confidence could result in a deeper recession. Indeed, concerns are mounting that Japan may re-enter a cycle of slowing activity, rising bankruptcies, and a deteriorating banking system.

Export volume and industrial production

Data: WEFA, Nomura Database; and IMF staff estimates

Government’s reform agenda

Against this background, the new government of Prime Minister Junichiro Koizumi took office in April. Believing that “without structural reform, there can be no rebirth for Japan,” the government has committed itself to addressing Japan’s deep-seated economic problems. While the details are still being fleshed out, the reform program has three central pillars:

•Dealing with the long-standing weaknesses in the bank and corporate sectors. The centerpiece of the bank and corporate restructuring package is the removal of nonperforming loans to bankrupt and near-bankrupt borrowers from major banks’ balance sheets within two years, and the removal of newly emerging nonperforming loans within three years of such classification. Bad loan disposal will involve assets being restructured or sold, through either out-of-court workouts or bankruptcy proceedings. A working group of bank and business representatives has recently issued draft guidelines, which will be finalized later this month, to guide the out-of-court workouts. Difficult loans that remain on banks’ balance sheets at the end of the stipulated two- or three-year period will be sold to the Resolution and Collection Corporation for final disposal. The plans also call for a reduction in banks’ significant exposure to equity price risk. To facilitate this process, the Banks’ Shareholding Acquisition Corporation will be established to purchase equity from the banks. It will then repackage the equity into mutual or exchange-traded funds for sale to investors.

•Implementing structural reforms to create new employment and investment opportunities and raise productivity. In its “seven-point plan,” released in June, the government highlighted a number of high-priority areas. These included regulatory reforms, tax reforms, and reforms of state-run corporations to improve competition and economic efficiency, promote business start-ups and the expansion of the information technology sector, and expand employment opportunities; social security reforms to restore confidence in the system and put its finances on a sound footing; and fiscal reforms (see below). The government’s Council for Regulatory Reform has also called for deregulation to encourage greater private sector involvement in social service provision and measures to revitalize the real estate market.

• Undertaking fiscal reforms to rein in the large budget deficit and return the government’s finances to a sustainable footing. The government has indicated that it believes that balancing the primary budget is a reasonable medium-term objective but has set no time frame for doing this. It has, however, committed itself to limiting the issuance of new government bonds to ¥30 trillion in fiscal year 2002 (which runs from April 1, 2002, to March 31, 2003), and spending guidelines have been issued that represent an initial attempt to secure the cuts needed. If achieved, this target could result in a substantial fiscal contraction next fiscal year. The government has also announced its intention to end the practice of earmarking revenues for specific purposes (like road construction) and to shift greater responsibility to the local governments for their own financing.

Implementing the reforms

Over the past decade, expansionary macroeconomic policies and piecemeal structural reforms have not succeeded in reinvigorating the Japanese economy. These policies failed because they did not address the deep-seated weaknesses that are at the heart of Japan’s economic problems—particularly the slow adjustment of the economy to the forces of globalization and technical change, which has impeded innovation and productivity growth, and the failure of the bank and corporate sectors to unwind the excess debt and capital built up during the bubble years. A sustained rebound in activity will remain elusive until these structural factors are decisively dealt with.

It is therefore important that the Koizumi government press ahead with its broad-based reform agenda. Delaying or watering down the reforms will simply prolong economic weakness and increase the risk of crisis, as the deep imbalances in the economy are not sustainable. However, in a number of important areas, the reform program will need further strengthening to fully deal with the outstanding issues. An appropriate handling of macroeconomic policy will also be essential given the current weak economy and the likelihood that the disposal of bad loans and corporate restructuring will negatively affect growth and employment in the short run.

The banking sector has appropriately been identified as a top priority, and the vigorous implementation of the announced policy package is essential. Additional measures, however, will be needed to ensure that the bad loan problem is fully recognized and dealt with, and that all deposit-taking institutions, not just the major banks, are covered by the reforms. Targeted public capital injections may be needed to offset the impact on bank capital from the more aggressive provisioning and loan disposal.

The program to accelerate banks’ disposal of bad loans will be a success, however, only if it achieves deep restructuring in distressed firms and the prompt exit of nonviable companies. The final guidelines for debt workouts will therefore need to be strong enough to achieve a durable turnaround in corporate performance. Measures to strengthen the regulatory structure, reduce the role of public enterprises in the economy, improve corporate governance, increase labor market flexibility, and revitalize the real estate market will also be important to generate new investment and employment opportunities, and raise productivity growth over the medium term.

Output gap and core CPI

Data: WEFA, Nomura Database; and IMF staff estimates


In the table on IMF Quotas that appears on page 5 of the IMF Survey Supplement, dated September 2001, Oman’s quota as of August 15,2000, should be SDR 194.0 million.

The government’s focus on developing a credible medium-term fiscal consolidation strategy is essential to put its finances on a solid footing. Such a strategy should aim to establish a medium-term debt target, and the broad objectives and directions of tax, expenditure, and social security policies to back up this target. Detailed short-term fiscal targets could then be affirmed in annual budgets. When to start this process of fiscal reform, and how quickly to pursue it, are key issues, however. While establishing a credible framework for medium-term consolidation is important, the government should avoid an abrupt withdrawal of fiscal stimulus during the period of restructuring and weak economic activity. In this regard, there are welcome recent indications that the government will introduce a supplementary budget later this year to expand the social safety net to support workers who lose their jobs.

With regard to monetary policy, the BoJ has taken an important step with its recent decision to raise its quantitative target and increase its purchases of government bonds. Further measures are still likely to be needed, however, and the effectiveness of policy would be enhanced if the BoJ clearly specified a reasonable time frame for eliminating deflation. The channels through which monetary policy operates in the current environment are likely to include the exchange rate, asset prices, and private sector expectations about the future course of prices. While easier monetary policy may cause some weakening of the yen, regional concerns about a weaker Japanese currency are likely to be markedly less than during the Asian crisis, given the adoption of flexible exchange rates by many countries and healthier external debt profiles throughout the region.

This story is based on the IMF’s recently concluded annual (Article IV) consultation with the Japanese authorities. For more details, please see the Public Information Notice (issued at the conclusion of the IMF Executive Board discussion of the Article IV consultation) and the staff report. Both are available on the IMF website (

Photo credits: Denio Zara, Padraic Hughes, Pedro Marquez, and Michael Spilotro for the IMF.

Ian S. McDonald


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