OECD Economic Outlook, Volume 2019 Issue 1

Japan

Economic growth is projected to remain close to only 0.7% in 2019-20, with wage and investment growth sustained by labour and capacity shortages. The temporary effect of the October 2019 consumption tax increase will be mitigated by fiscal measures. Sustained growth is projected to gradually push up headline inflation to 1% (excluding the impact of the tax increase) by 2020.

Government debt relative to GDP is the highest ever recorded in the OECD area, posing serious risks. Achieving fiscal sustainability requires a detailed consolidation programme that includes gradual increases in the consumption tax rate beyond the 2019 increase, and measures to control spending in the face of rapid population ageing. With a declining working-age population, structural reforms to boost productivity and employment are key to achieve fiscal sustainability and improve well-being. The Bank of Japan should maintain its expansionary monetary policy until the 2% inflation target is achieved.

Labour and capacity shortages sustain wages and business investment

After peaking at 1.9% in 2017, economic growth slowed to 0.8% in 2018, reflecting weaker export momentum as world trade decelerated. Nevertheless, the current expansion, which began in late 2012, is now the longest in Japan’s post-war history, supported by a moderate recovery of consumption and robust business investment. The expansion faltered in early 2019, with declines in industrial production and exports, though labour market conditions remain tight.

Labour shortages and exports: Japan

1. The diffusion indices show the number of firms responding they had an excess number of workers minus those reporting a shortage and the number responding that they had excess capacity minus those with a capacity shortage. A negative number thus indicates an overall shortage of labour and capacity.

2. Seasonally-adjusted data (three-month moving average).

Source: Bank of Japan.

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Japan: Demand, output and prices

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Budget deficit and inflation: Japan

1. Government projections in January 2019. It assumes that the rise in the consumption tax rate from 8% to 10% is implemented as planned in 2019. The primary balance is central and local governments, as a percentage of GDP on a fiscal year basis.

2. Excluding the effects of the April 2014 consumption tax rise, which added 2 percentage points to inflation in FY 2014 according to a government estimate. It also excludes the scheduled October 2019 consumption tax increase, which would add 1 percentage point to inflation in the fourth quarter of 2019, and the impact of free childcare for children aged three to five, which would reduce it by 0.5 percentage points, according to an OECD estimate.

3. OECD measure, which excludes food and energy.

Source: Cabinet Office; OECD Economic Outlook 105 database; and Bank of Japan.

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The accelerating decline in the working-age population has exacerbated labour shortages. The unemployment rate hovers around 2½ per cent, while the ratio of job openings-to-applicants has risen to around 1.6, its highest level since 1974. Real wages were supported in 2018 by large bonus payments underpinned by record high corporate profits. This year’s spring wage negotiations imply a 2.1% annual wage rise, in line with 2018. Combined with capacity shortages and high profits, labour shortages are also sustaining business investment. While consumer price inflation remains well below the Bank of Japan’s 2% target, the 2.2% increase in unit labour costs in 2018, the highest since the early 1990s, is expected to feed into the prices of goods and services.

Meeting the intertwined challenges of population ageing and government debt

Japan’s gross government debt has risen to 226% of GDP. The planned rise in the consumption tax rate will generate revenue of about 1% of GDP. To mitigate the short-term economic impact, the FY 2018 second supplementary budget and the FY 2019 budget jointly added public investment of 0.4% of GDP. The government is also planning exceptional measures over FY 2019-20, such as a cut in taxes on cars and housing. In addition, the government’s decision to use half of the additional revenue for new spending programmes will offset the impact of the tax rise. Ensuring confidence in fiscal sustainability requires a detailed and concrete consolidation plan beyond the FY 2025 primary surplus target to put the government debt ratio on a downward path. Measures to raise revenues should rely primarily on less‑distortive taxes, notably the consumption tax. The 2019 consumption tax increase should be followed by gradual further increases that raise it towards the 19% OECD average. On the spending side, containing social spending, notably by making better use of healthcare resources, is a priority.

Large-scale government bond purchases by the Bank of Japan, which now amount to 85% of GDP, have mitigated the impact of high government debt. Under its “yield curve control” policy, the central bank is currently keeping the yield on 10-year government bonds close to zero. The Bank of Japan is committed to continue expanding the monetary base until CPI inflation (excluding fresh food) exceeds the 2% target and stays above it in a stable manner. The projection assumes that the supportive monetary stance continues through 2020.

Japan’s shrinking and ageing population makes it important to remove obstacles to employment for older persons through labour market reform, including abolishing the right of firms to set mandatory retirement, which is at age 60 at most firms. This would also help reduce the importance of seniority in setting wages. Breaking down labour market dualism would promote female employment and reduce Japan’s large gender wage gap. The government plans to accept 345 000 foreign workers over 2019‑24 under a new law that allows those who have completed training programmes in Japan to remain for up to five additional years to work in sectors facing severe labour shortages. The New Economic Policy Package sets an ambitious target of doubling labour productivity growth to 2% by 2020 through a range of measures, including corporate governance reforms, financial support for investment in ICT by SMEs and tax incentives for wage and investment increases. Increased openness to trade will also help. With Japan’s leadership, the Comprehensive and Progressive Agreement for Trans-Pacific Partnership entered into force in December 2018, followed by the Japan-EU Economic Partnership Agreement in February 2019.

Growth is projected to continue in line with potential

With the measures mitigating the impact of the consumption tax increase, output growth over 2019‑20 is projected to remain around 0.7%, in line with Japan’s estimated potential growth rate. The 2019 wage agreements imply moderate wage gains that will support private consumption. Continued wage increases are needed to sustain the expansion in 2020. While the new free trade agreements and the 2020 Olympic Games in Tokyo are expected to boost exports of goods and services, Japan is vulnerable to a further slowdown in China’s domestic demand. Protectionism also remains a risk, though no new trade restrictions against Japan are to be introduced during the consultations based on the September 2018 Japan‑US Joint Statement. Japan’s unprecedentedly high level of public debt is a key risk. A loss of confidence in Japan’s fiscal sustainability could destabilise the financial sector and the real economy, with large negative spillovers to the world economy.