New OECD Study on Japan

The Organisation for Economic Cooperation and Development (OECD) has published a new economic survey for Japan. The OECD urges the Bank of Japan to ease monetary policy significantly, arguing that its existing actions have not worked and that the time has come to adopt a 'more adventurous' strategy. In the report the OECD argues that the central bank of the world's second largest economy should "move further into unchartered territory" if it is to stand any chance of bringing an end to deflation.It said the bank should raise the target range for current accounts of the banking system by considering purchasing more government bonds, expanding the range of assets it is prepared to acquire, and possibly setting an inflation target. These are measures the bank has itself described as "unorthodox", but with the reform of Japan's banking sector gathering pace consideration of such policy options is, it seems, becoming more likely.

Regarding government debt the OECD projects that a primary surplus of 1.75 per cent of GDP is likely to be necessary to stabilise the debt/GDP ratio at 180 per cent by 2010. With a primary deficit currently around 6.5 per cent of GDP, significant consolidation is therefore required. The OECD projects the primary deficit being reduced to 2.2 per cent of GDP by 2006. This of course, is a 'best case' scenario. I don't even want to contemplate what the 'worst case' one might look like.

The Japanese economy remains in a serious deflationary situation even while experiencing a cyclical recovery phase in mid 2002 underpinned by inventory correction and a sharp pick-up in exports. But the recovery is too narrowly based to represent a break with the pattern of generally low growth experienced through the 1990s. The still high capital/output ratio is likely to limit any pick-up in investment to a short term adjustment, while continuing weakness in the labour market is expected to restrain consumption growth to around one per cent per annum. More recently, a combination of factors – particularly low share prices in Japan and elsewhere, a marked appreciation of the yen and a moderating export expansion – has dampened growth prospects going into 2003.

All in all, the economy may grow by only around 1 per cent per annum to the end of 2004 with deflation continuing. But the balance of risks is now on the downside given signs of slower growth in the world economy and the possibility of a further deterioration in financial conditions, which might lead to a worsening of deflation. Thus Japan continues to be faced with the daunting challenge of radically and quickly improving the functioning of itseconomic system and halting deflation.

What needs to be done to control
public debt?

Beyond FY 2003, the central issue is whether or not Japan succeeds in placing its public finances on a credible consolidation path which would minimise the danger of a sharp increase in interest rates and increased household savings via a Ricardian effect. The OECD projects that, on a general government basis, a primary surplus of 1¾ per cent of GDP is likely to be necessary to stabilise the debt/GDP ratio at some 180 per cent by 2010. With the primary deficit currently around 6½ per cent of GDP, significant consolidation is therefore required. In this light, the extent of fiscal consolidation envisaged in the government’s Medium-term Economic and Fiscal Perspective, agreed in January, is far from sufficient. The Perspective projects the primary deficit of the central and local governments to be reduced to 2.2 per cent of GDP by FY 2006, the end of their projection period, with a view to eliminating it as soon as possible after FY 2010. However, this involves an optimistic assumption about an end to deflation, which is unlikely to be realised in the near future. The Perspective is a small first step towards defining a medium-term fiscal policy framework. It needs to be made both more ambitious in its objectives and more concrete, and make use of shorter run real spending targets to improve credibility.

It should also spell out specific policy requirements that should guide current and future policy decisions. It needs to consider how the required revenues can be secured and spending cuts achieved against the mounting pressure for expenditure to rise, not least due to population ageing. In this respect, the heavy dependence of prefectural and local governments on the central government via public works and tax transfers, which has been a marked feature of public governance, also needs to be addressed. The government’s sense that deep changes are required in order to develop regional dynamism is appropriate. Reforms in this area will take time and should be linked with fundamental tax and expenditure reform.