Over the past two decades, Japan's economic growth has been sluggish. Per capita income fell from a level matching the top half of Organization for Economic Cooperation and Development (OECD) countries in the early 1990s to 14 percent below in 2013 (Figure 1). The collapse of the massive asset price bubble of the early 1990s was followed by an extended period of corporate restructuring and a banking crisis. Furthermore, weak growth has contributed to Japan’s serious fiscal problems by limiting the increase in government revenue. Rising spending, driven by an aging population and frequent fiscal stimulus packages, has been financed largely by borrowing, which has driven gross government debt to the highest levels ever recorded in the OECD. Persistent deflation has also been a headwind to growth and contributed to the run-up in the country’s debt to GDP ratio.
Figure 1. Japan’s income and productivity levels lag the leading OECD countries1
Japan relative to the top half of OECD countries. Per capita GDP is calculated using 2005 prices and PPP exchange rates. Labor productivity equals GDP per hour of labor input.
Source: OECD Going for Growth Database.
In early 2013, Japan launched a three-pillar approach, the so-called “three arrows” of Abenomics. These arrows represent three strategies to reverse deflation and revitalize the country. First, a bold monetary policy, next a flexible fiscal policy, and finally a growth strategy based on deep structural reforms. In the fourth year of Abenomics, some progress is visible but many challenges remain.
The first arrow: bold monetary policy
The first arrow was launched in early 2013 with the introduction of “quantitative and qualitative easing” ‒ a clear break from past Bank of Japan (BoJ) quantitative easing in terms of scale, decisiveness, and ambition:
- The BoJ set a 2 percent inflation target for the consumer price index (CPI).
- It launched large-scale purchases of government bonds, initially at an annual pace of 50 trillion yen and then at 80 trillion yen (16 percent of GDP) since October 2015.
- Negative interest rates were introduced in February 2016.
Following implementation of the first arrow, CPI inflation did reach 1½ percent (on a year-on-year basis, excluding the impact of the consumption tax hike) in 2014, but it has since fallen back to around zero in the context of declining oil prices (Figure 2). However, core CPI inflation, which excludes energy and food, has risen from negative territory to nearly one percent, matching levels in the Euro area. Moreover, the fall in oil prices has provided significant real income gains for Japanese consumers, which will support consumption and growth, thereby helping to achieve the 2 percent inflation target. At the same time, monetary policy has ventured into uncharted territory, with the central bank’s holdings of government bonds surpassing one-third of the total bonds available. Some of these results are promising, however, monetary policy alone cannot revitalize Japan. Thus, the next step in Abe’s plan: flexible fiscal policy.
Figure 2. Core consumer price inflation has reached nearly 1%
1. Headline and core consumer price inflation excluding the impact of the April 2014 consumption tax hike from 5% to 8%. The tax hike added 2 percentage points to inflation according to estimates by the Bank of Japan and the Cabinet Office.
2. Excludes food, energy, alcohol and tobacco.
Source: OECD Economic Outlook Database; Bank of Japan.
The second arrow: flexible fiscal policy
Fiscal policy has featured a number of stimulus packages, while trying to reach the medium-term objectives of reaching a primary surplus – in which government revenues exceed spending before interest payments – for central and local governments by Fiscal Year (FY) 2020 and placing the government debt ratio on a downward trend by FY 2021. While the primary deficit fell from 7.8 percent of GDP in 2013 to less than 5 percent in 2015 on a general basis, it is still significantly larger than in the United States or the Euro area.
Large budget deficits continue to drive up government debt, which has reached historic levels at 230 percent of GDP in 2015. Even after taking account of government assets, net debt is also the highest in the OECD area, at 129 percent. The impact of such high debt on government interest payments has been mitigated thus far by exceptionally low interest rates, limiting net interest payments to one percent of GDP. However, low interest rates are unlikely to continue indefinitely, which puts Japan at risk of a loss of confidence in its fiscal sustainability. That loss of confidence could, in turn, destabilize the financial sector and the real economy, with serious spillovers into the world economy.
The third arrow: The Japan Revitalization Strategy
The structural reforms necessary to lock in the effects of the first two arrows are embodied in the Japan Revitalization Strategy, which was launched in June 2013 and is revised each year. This strategy includes some important measures:
- In February 2016, Japan signed the Trans-Pacific Partnership (TPP), which will advance the restructuring of the agricultural sector. Further progress is needed in the negotiations for the Japan-EU Economic Partnership Agreement and the Japan-China-Korea FTA.
- The corporate governance framework is being upgraded by the introduction of the Stewardship Code in 2014 and the Corporate Governance Code in 2015. Such reforms may increase corporate dynamism and encourage firms to increase investment and reducing cash hoarding.
- The government is expanding the capacity of public childcare centres by 0.5 million over FY 2013 to FY 2017, thus supporting the rising employment of women.
Economic growth since 2013 has been modest at 0.5 percent per year on average, far below the 2 percent rate targeted by the Revitalization Strategy. The changes in trade policy and corporate governance will take time to have a major impact. Additional reforms, such as labor market reforms, changes in the tax and benefit system to promote employment, and steps to enhance corporate dynamism, are also essential to boost output growth.
Conclusion
Abenomics has boosted core inflation to positive territory and has reduced the government budget deficit. However, the third arrow of Abenomics is its most crucial component, without which the unprecedented monetary expansion and the fiscal measures will not succeed in putting Japan on a path to faster growth and fiscal sustainability. Here, more ambitious and bold reforms are needed to support faster output growth in the face of rapid population aging. However, with labor productivity a quarter below the top half of OECD countries, Japan has considerable scope to narrow the gap and sustain economic growth.
