OECD Economic Outlook, Volume 2019 Issue 2

Japan

The economy is estimated to have expanded by 1% in 2019, but growth is projected to ease somewhat in 2020‑21. The temporary effect of the consumption tax increase on GDP growth will be mitigated by fiscal measures and the 2020 Olympic Games in Tokyo. With wage and investment growth sustained by labour and capacity shortages, GDP growth is set to remain close to potential following the rollback of the temporary fiscal measures in 2021. Headline inflation is projected to edge up to 1½ per cent by 2021, sustained by continued wage and economic growth.

Record high gross government debt, at 224% of GDP, poses serious risks and calls for a detailed consolidation programme in the medium to long term with further gradual increases in the consumption tax rate and measures to control spending in the face of rapid population ageing. Structural reforms to boost employment and productivity are also key, both to put the public finances back on a sustainable trajectory and to improve well‑being. The Bank of Japan should maintain its expansionary monetary policy until the 2% inflation target is achieved.

Domestic demand is supporting growth

Despite sluggish exports reflecting weaker world trade growth, economic growth in the first three quarters of 2019 picked up to 1¼ per cent, sustained by a moderate recovery of private consumption and robust business investment. While export volumes have remained flat since mid‑2018, wage income in real terms has been growing at 1.3% per annum since autumn 2018 and firms plan to increase business investment by 2.4% in FY 2019. Domestic demand was also supported by the FY 2018 second supplementary budget and the FY 2019 budget, including via extra public investment.

Capacity and 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 of responding that they had excess capacity minus those with a capacity shortage. A negative number thus indicates an overall shortage of labour and capacity. The numbers for 2019Q4 are based on forecasts by firms.

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 July 2019. Both scenarios incorporate the increase in the consumption tax rate from 8% to 10% in October 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 increase, which added 2 percentage points to inflation in FY 2014 according to a government estimate. It also excludes the impact of the October 2019 consumption tax increase, which adds 1.0 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 106 database; and Bank of Japan.

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Labour shortages have been exacerbated by the rapidly declining working‑age population and are sustaining wage growth and business investment. The unemployment rate has stayed at around 2¼ per cent and the ratio of job openings-to-applicants around 1.6, its highest level since 1974. Repeated minimum wage increases and a tax incentive to raise wages have contributed to overall wage gains. While headline inflation remains well below the Bank of Japan’s 2% target, underlying inflation has gradually risen to close to ½ per cent, as increases in unit labour costs have fed into prices of goods and services.

Meeting the intertwined challenges of population ageing and government debt

To cushion the short-term economic impact of the October 2019 increases in the consumption tax rate, the government introduced several temporary spending and tax measures, alongside some new durable spending programmes funded by half of the 1% of GDP additional revenue. The primary deficit is projected to stay around 2½ per cent of GDP over 2019-20 but to decline to 1.9% in 2021, with temporary fiscal measures to be withdrawn starting in FY 2021 in line with the government’s fiscal consolidation plan to achieve a primary surplus by FY 2025. Restoring fiscal sustainability requires a detailed and concrete consolidation programme beyond the FY 2025 primary surplus target. Revenue measures should rely primarily on less-distortive taxes, notably the consumption tax, which should be gradually raised further, and environmentally-related taxes. On the spending side, containing social spending, notably by making better use of healthcare resources, is a priority.

Under its “yield curve control” policy, and with its large holdings and continued purchases of government bonds, the central bank is currently keeping the yield on 10‑year government bonds at around zero. It is committed to continuing monetary base expansion until CPI inflation (excluding fresh food) exceeds the 2% target and stays above it in a stable manner, and expects interest rates to remain at their present or lower levels as long as it is necessary to maintain the momentum toward achieving the target. The projection assumes an unchanged degree of monetary accommodation through 2021.

Despite the relatively high employment rate of older persons, Japan’s shrinking and ageing population makes it important to remove obstacles to employing them, particularly beyond age 65. Boosting elderly employment could include abolishing the right of firms to set mandatory retirement ages, which are most typically at age 60. This would also help reduce the importance of seniority in wage setting. Breaking down labour market dualism, including by reducing employment protection for regular workers, would promote female employment and reduce Japan’s large gender wage gap. The government launched a plan to accept up to 345 150 foreign workers over 2019-24 in sectors facing severe labour shortages, such as construction, accommodation and food services and long-term care. With the Action Plan of the Growth Strategy launched in June 2019, the government plans a range of measures to realise “Society 5.0”, including rulemaking on transactions in the digital market, regulatory reforms to promote new services such as Fintech, and further corporate governance reforms. Further efforts to boost productivity growth are needed, including to promote trade openness through multilateral arrangements.

Growth is projected to remain just above potential

Growth will be supported in 2020 by the fiscal measures mitigating the impact of the consumption tax increase, and by the Olympic Games, which are expected to buoy private consumption and service exports. Labour and capacity shortages will tend to push up wages and investment. As a result, growth is projected to remain just above its estimated potential through 2021, notwithstanding the unwinding of temporary fiscal stimulus. This should help headline inflation move up to 1½ per cent towards the end of the period.

Japan, particularly the manufacturing sector, is vulnerable to a further slowdown in China’s import demand. Protectionism also remains a risk, though no new trade restrictions on Japanese exports are expected in view of the September 2019 Japan‑US Joint Statement. Fiscal policy could counteract those downside risks, including through additional temporary stimulus measures to be included in the FY 2019 supplementary budget and the FY 2020 budget. Nevertheless, 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.