Reload, Reset, or Relaunch?Japan’s Policy Options

Luc EveraertAssistant Director

Asia and Pacific DepartmentInternational Monetary Fund

September 2016

1

Outline

What has Abenomics achieved so far?

Why has Abenomics not made more progress?

What are the policy options?

What are the authorities doing?

2

Abenomics met with some success

Reversed undue appreciation of the yen and boosted corporate profits

Lifted actual and expected inflation

Created modest wage gains and reached full employment

Made progress on fiscal consolidation

Raised labor force participation and improved corporate governance

1. What has Abenomics achieved so far?3

But the targets have not been achieved

1. What has Abenomics achieved so far?4

Current policies will deliver mediocre growth and low inflation

Weak growth will persist due to subdued private demand ….

….and inflation will remain below target

1. What has Abenomics achieved so far?

-6

-5

-4

-3

-2

-1

0

1

2

3

2012Q4 2013Q4 2014Q4 2015Q4 2016Q4 2017Q4

Private inventories Private consumption

Net exports Government spending

Private gross fixed investment Real growth (q/q)

Contributions to QoQ Growth (SA)(In percent)

Source: Haver Analytics.

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2015Q1 2016Q1 2017Q1 2018Q1 2019Q1 2020Q1

Headline (y/y) Core (y/y) Inflation Expectations (y/y) 1/

Baseline Inflation Outlook(YoY; in percent)

Source: IMF staff estimates. 1/ Average of one-year ahead expectations from Consensus, market based measures and Tankan Survey of firms until 2016Q2. Projections assume inflation expectations are based on a weighted average of past and future rates of inflation. Jump in 2016Q1-Q2 reflect the effects of the expected consumption tax rate hike in 2017.

2020Q4

5

Public deficits and debt remain high

Fiscal deficits are large Putting public debt on an unsustainable trajectory

30.7

37.8

32.434.9

21.1 19.8

-15

0

15

30

45

-15

0

15

30

45

1990 1995 2000 2005 2010 2015 2021

Balance Expenditure Total revenue Tax revenue

General Government Fiscal Balance(In percent of GDP)

Sources: IMF WEO database; and IMF staff estimates.

150

200

250

300

-12

-10

-8

-6

-4

-2

0

2

4

2005 2010 2015 2020 2025 2030

Japan: Gross Public Debt1/ and Fiscal Balance(In percent of GDP)

Sources: Cabinet Office; and staff estimates and projections.1/ Gross debt of the general government including the social security fund.Withdrawal of fiscal stimulus and consumption tax increases to 10 percent in October 2019 are assumed.

Fiscal balance (LHS)

Gross debt (RHS)

1. What has Abenomics achieved so far?6

Headwinds, structural obstacles and limits to policy effectiveness

2. Why has Abenomics not made more progress? 7

Global weakness depressed exports and lowered inflation

Global trade slowdown has offset benefits from currency depreciation while….

..falling commodity prices have failed to boost activity and put downward pressure on inflation

2. Why has Abenomics not made more progress?8

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

-60

-50

-40

-30

-20

-10

0

10

20

2012Q1 2013Q2 2014Q3 2015Q4

WEO Oil Price Headline Inflation w/o VAT effect (RHS)

World Oil Price and Japan Inflation (In percent; YoY)

Sources: World Economic Outlook; and IMF Staff Calculations.

2016Q2

60

70

80

90

100

110

120

Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16

Real exports REER

Source: Haver Analytics.

Real Exports and REER(2012 Oct=100)

Developments in financial and external conditions complicate the short-term

Financial conditions have tightened recently…

….and the yen has appreciated strongly since end of 2015

2. Why has Abenomics not made more progress?

-3-2-10123456

1998Q1 2002Q4 2007Q3 2012Q2

Financial condition index 1/

Credit cycle 2/Tighter

Japan: Financial Condition Index and Credit Cycle

2016Q2

Sources: Bank of Japan; Ministry of Finance; Haver Analytics; and IMF staff estimates.1/ Estimated as the first principal component of (standardized) 3-month TIBOR, 10-year JGB yield, stock price, and NEER.2/ Estimated as the average of the HP-filtered real total credit growth (deflated byCPI) and total credit-to-GDP ratio.

-10

0

10

20

30

40

50

95

100

105

110

115

120

125

130

8/17/2015 11/5/2015 1/24/2016 4/13/2016 7/2/2016

Yen noncommercial traders' net long-positions (USD bn; RHS)Exchange rate (Yen/Dollar)VIX (1941-43=10; RHS)

Sources: Bloomberg, L.P.; and IMF staff calculations.

9/14/2016

Japan Exchange Rate Movements

9

Structural impediments are weighing on growth and wages

Demographic headwinds are lowering potential growth…

…and labor market duality is preventing wage growth

-1

-0.5

0

0.5

1

1.5

2

2000 2003 2006 2009 2012 2015 2018 2021 2024 2027 2030

Capital Employment Hours TFP Potential Growth Rate

Potential Growth(percent)

2. Why has Abenomics not made more progress? 10

27

29

31

33

35

37

-3

-2

-1

0

1

2

3

2002Q2 2004Q2 2006Q2 2008Q2 2010Q2 2012Q2 2014Q2 2016Q2

Change in full-time wagesComposition effectChanges in part-time wagesShare of nonregular workers (right side) 1/

Sources: Haver Analytics; and IMF staff estimates.1/ Yearly Average.

Nonregular Workers and Wage Growth (YoY; in percent) (In percent of staff)

Profits are accumulating and the labor market is increasingly tight

2. Why has Abenomics not made more progress?

And there are more vacancies than job applicants

Profits are accumulating in corporate cash holdings

11

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

0

0.5

1

1.5

2

2.5

3

3.5

4

1970Q1 1977Q1 1984Q1 1991Q1 1998Q1 2005Q1 2012Q1

Vacancy Rate

Ratio of Job Job Openings to Applicants (RHS)

Vacancy Rate and Ratio of Job Openings to Applicants(In percent, ratio)

Source: Haver Analytics.

2016Q2

Aging is dampening inflation and growth

2. Why has Abenomics not made more progress?

Aging reduces productivity growth

Declining neutral rate reduces monetary policy effectiveness

Labor Total factor productivity productivity

____________________________________________________Old age -0.851** -1.157**Dependency (0.338) (0.664)

Net migration 0.724* 2.491***(0.361) (0.691)

Lagged -0.00632 0.0883**Population growth (0.0199) (0.0407)

Control variables Yes YesLagged dependent Yes YesTime dummy Yes Yes

Observations 1380 1380R squared 0.643 0.585____________________________________________________Robust standard errors in parenthesis*** p<0.01; ** p<0.05; * p<0.10

-1.5-1

-0.50

0.51

1.52

2.53

3.54

1986Q2 1991Q2 1996Q2 2001Q2 2006Q2 2011Q2 2016Q2

Japan: Natural Rate of Interest(In percent)

Actual

Natural rate of interest

Sources: Bank of Japan; Haver Analytics; and Fund staff estimates. Note: The blue line is the actual real discount rate deflated by the inflation expectations estimated from an MA(4) model,and the red line marks the mean posterior estimates of the natural rate of interest from a Bayesian time-varying parameter vector autoregression (TVP-VAR) model following Lubik and Matthes (2015). The shadow areas highlight the recession periods (defined as when the SAAR real GDP growth falls below zero for at least two consecutive quarters).

12

Monetary policy has been losing traction

Loan growth has stalled, getting little help from NIRP

…and markets are no longer impressed

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

January 29 March 15 April 28 June 15 July 28

FX market reaction on the day of BoJ meetings(Yen/U.S. Dollar exchange rate, percent change)

Source: Haver

Appreciation

2. Why has Abenomics not made more progress?13

Fiscal policy is contributing to uncertainty

Stop-go nature of fiscal policy contributes to policy uncertainty

With adverse effects on investment and consumption

2. Why has Abenomics not made more progress?14

Japan is at a Fork in the Road

3. What are the policy options?15

Three alternative policy packages

Comprehensive policy reload to reach targets under current time-frames

Reset of targets and policies to prepare for the long haul

Relaunch policies with further unorthodox measures?

Under current policies all targets remain out of reach within the timeframe set by the authorities

3. What are the policy options?16

Option 1: Reload package

Higher incomes and wages with labor contract reform

Fiscal and monetary policies for demand support

Improved medium-term fiscal and monetary policy frameworks

Accelerated structural reforms

3. What are the policy options?17

Income policies to spur and coordinate wage-price dynamics

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

0.0 0.5 1.0 1.5 2.0

Real w

ag

e

gro

wth

Labor productivity growth

Sources: OECD, and IMF staff calculations.

Real wage and productivity growth (In percent, 1992-2014)

Wage growth has lagged productivity growth

“Comply or explain” mechanism would help spur private wage growth

3. What are the policy options?18

86

88

90

92

94

96

98

100

102

104

2007Q1 2009Q1 2011Q1 2013Q1 2015Q1

Total Earnings (per full-time employee)Total Earnings (per half-time employee)Contractual Earnings (per employee)

Different Measures of Earnings(4 quarter MA of total earnings, 2007=100)

Sources: Haver and IMF staff calculations

2016Q2

Fiscal expansion to close output gap but with preannounced consolidationSteady and gradual on the consumption tax

Mind the rising gap in social security

3. What are the policy options?

0

5

10

15

20

25

0

5

10

15

20

25

FY1990 FY1995 FY2000 FY2005 FY2010

OtherElderly careHealth carePensionsTotal social security contributions Total social security benefits

Sources: National Institute of Population and Social Security Research.

Social Security Benefits and Contributions(In percent of GDP)

FY2013

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

year 1 2 3 4 5 6 7 8

(i) 5-stage: 0.5 percent of GDP increase each in year 1-5 (announced in year 1)

(ii) 2-stage (pre-announced): 1 percent of GDP increase in year 1 and 1.5 percent of GDP in year 4 (both announced in year 1)(iii) 2-stage (ad hoc): same as in (ii) except that the second tax increase is announced in year 4

Source: IMF staff estimates.

Consumption Tax Hike: Deviation in Growth from Baseline (In percentage point)

19

Continued monetary accommodation with improvements to the frameworkReverse downward drift of inflation expectations

Strengthen communication and clarify guidance:

Move away from a pre-specified time horizon for meeting targets

Clarify which inflation measures drive policy

Publish a staff baseline forecast together with underlying policy assumptions

Discuss alternative scenarios

3. What are the policy options?20

0

10

20

30

40

50

60

70

80

90

100

Aug-14 Feb-15 Aug-15 Feb-16 Aug-16

5% ~ 2% ~ 5% 0% ~ 2% 0% -2% ~ 0% -5% ~ -2% ~ -5%

Share of households with one year ahead inflation expectation

Source: Cabinet Office.

More structural reforms to boost wage pressure and potential growth

Boost labor supply (female, older, foreign) and deregulate

0

2

4

6

8

10 Corporate governance reform (See IMF WPs by Aoyagi and Ganelli, 2014; Galen, 2014)Financial sector reforms that raise risk capital as well as SMEs restructuring (Peterson Institute, 2012) TPP (Peterson Institute, 2012)

Product market reform (SEZs, Agricultural, Electricity)

Gains from ending deflation

Reducing labor duality (See Aoyagi and Ganelli, IMF WP, 2013)Foreign labor (See IMF 2013 Art IV)

Female labor participation (See OECD, 2015 forthcoming)

Potential Impact of Path-Breaking Structural Reforms (Potential growth; Illustrative)

1.5

0.6

0.4

Potential Impacts (cumulative)

3. What are the policy options?

Restore wage bargaining power

21

Option 2: Resetting targets and policies

3. What are the policy options?22

Monetary policy: easy for longer while minding stability risks

0

10

20

30

40

50

60

70

80

600 650 700 750 800 850 900 950 1000 1050

Oct. 2011 Oct. 2012

Oct. 2014 Dec. 2019-QQE

Dec. 2019-QQE2

Outstanding JGBs

22.3%

12.1%

Share of JGB holdings by the Bank of Japan 1/

(In percent)

Note: 1/ Uses deficit projections to forecast outstanding amount of JGBs (size of the bubble).Source: IMF staff calculations.

QQE-2

QQE

61.1%

45.6%

9.0%

Limited monetary policy room ...

… with lurking risks to financial stability

0 2 4 6 8 10 12 14 16 18 20

0 10 20 30 40 50 60 70 80 90

100

Mar-05 Nov-06 Jul-08 Mar-10 Nov-11 Jul-13 Mar-15

Monthly transaction volume (In trillion yen, LHS)

Turnover ratio (In percent, RHS)

Inter-dealer Monthly Transaction Volume 1/2/

Sources: Japan Securities Dealers Association; Ministry of Finance.1/ Treasury Discount Bills, etc. are excluded from transaction volume.2/"Turnover ratio" is calculated by dividing the transaction volume by the outstanding amount.

Mar-16

3. What are the policy options?23

Fiscal: steady and gradual consolidation for longer

Moving the Philips curve may exhaust fiscal space

…and risk fiscal confidence shocks

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

0

200

400

600

800

1000

1200

1400

1600

1800

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

BOJ-long BOJ-shortdepository institutions insurance/pension fundsGG othersoverseas excess reserves at BoJ's CAfinancing needs

Sources: Flow of Funds (BoJ); and IMF staff estimates.Note: Includes both central and local governments' debt (including FLIP bonds).

The BoJ is assumed to stop increasing its JGB holdings under QQE2 at end-2017.

Public Debt Financing in the Baseline(In trillion yen; end of period)

3. What are the policy options?24

-2

-1

0

1

2

3

4

-10 -5 0 5

CPI all ite

ms less f

oo

d a

nd

en

erg

y w

/o V

AT

eff

ect (

Yo

Y)

Output Gap

Phillips Curve

Sources: Cabinet Office; Bank of Japan; and IMF staff estimates.

A: 83Q1-95Q4 B: 96Q1-12Q3y= 0.3x+2 y=0.1x-0.2

C: 12Q4-16Q2y=0.2x+0.5

Option 3: Re-launch unorthodox policies

3. What are the policy options? 25

Risky business: net government debt in different scenarios (percent of GDP)

3. What are the policy options?

Krugman fiscal expansionReload package

Svensson exchange rate target Turner monetization

26

Risk-return trade-off remains so far in favor of a comprehensive, balanced package

3. What are the policy options?27

Where do policies stand?

-Private sector wage hikesthrough comply/explain-Larger tax incentives (andpenalties if needed)-Public sector wage increases-Contract reform

-Credible medium-term framework with gradual consumption tax hikes-Independent macroeconomicand budget projections

Strengthen communicationframework and clarify guidance

-Labor supply measures for women, older, and foreigners-Productivity enhancing deregulation-Capital deepening

-Minimum wage increases-Tax incentives for private wage increases

Near term stimulus

-Accommodative stance-More sustainable frame-work-Child and nursing care reform-Corporate governance reform

4. What are the authorities doing?28

Incomes policy and contract reform

Fiscal Policy

Monetary Policy

Structuralreforms

Done To do

Thank You!

29

References IMF Staff Report for the 2016 Article IV Consultation with Japan:

http://www.imf.org/external/pubs/ft/scr/2016/cr16267.pdf Selected Issues (analytical work by the IMF Japan team):

http://www.imf.org/external/pubs/cat/longres.aspx?sk=44159.0 “How to Reload Abenomics”, IMF News Article:

http://www.imf.org/en/News/Articles/2016/08/02/13/00/NA080216-How-to-Reload-Abenomics

IMF blog on “Japan: Time to Load a Fourth Arrow-Wage Increases”: https://blog-imfdirect.imf.org/2016/03/13/japan-time-to-load-a-fourth-arrow-wage-increases/

Davide Porcellachia ”Wage-price dynamics and structural reforms in Japan” WP16/20 http://www.imf.org/external/pubs/cat/longres.aspx?sk=43693.0

George Kopits “The Case for an Independent Fiscal Institution in Japan” WP16/156 http://www.imf.org/external/pubs/cat/longres.aspx?sk=44161.0

Arbatli, Botman et. al. “Reflating Japan: Time to Get Unconventional?” WP16/157 http://www.imf.org/external/pubs/cat/longres.aspx?sk=44162.0

Ikuo Saito “Fading Ricardian Equivalence in Ageing Japan” WP forthcoming

30