In their Article IV report (pdf)- - a regular assessment - - of the world’s second largest economy, the economists said Japan’s key challenge is to bring down its high public debt-to-GDP ratio, one of the highest among advanced countries. Tokyo recently announced a fiscal strategy to curb debt and limit deficits.

“Bringing down the debt ratio will require a large and protracted adjustment and, with global scrutiny of public finances on the rise, the need for early and credible fiscal adjustment has increased,” said James Gordon, IMF mission chief for Japan. “We welcome the government’s proposed fiscal strategy and look forward to further details,” Gordon added.

The IMF believes Tokyo’s new fiscal strategy would be boosted by a gradual increase in the consumption tax, and that adjustment should begin next year, with authorities aiming for a 1 per cent of GDP annual reduction in the primary deficit over the next decade.

Strengthening recovery

The economy is rebounding from one of its deepest recessions in postwar history. The recovery gained strength in recent months, fueled by robust exports and policy stimulus. The IMF expects Japan’s GDP growth to rise to 2.4 per cent in 2010 and forecasts an easing of deflation.

The pace of the recovery meanwhile is likely to moderate in the second half of the year as stimulus measures expire and export growth levels off, with projected growth of 1.8 per cent in 2011. But “uncertainty surrounding the outlook remains large including from renewed financial market volatility,” says the IMF report.

Credible reforms

Despite the projected upturn, the recent turmoil in Europe has highlighted Japan’s vulnerability to sovereign risk. At a meeting of the IMF’s Executive Board last week to discuss the findings of the report, the Board’s directors voiced support for comprehensive tax reform, limits on non-social security spending growth, and reforms to entitlement programs. They also encouraged authorities to strengthen the credibility of their fiscal plans by introducing a cap on public debt.

“A fiscal rule capping the level of public debt and targeting a primary surplus would strengthen credibility and help lock-in fiscal gains,” said the report, which followed consultations carried out in May between IMF economists and authorities in the country.

Tokyo has acknowledged the need to curb its unprecedented levels of debt and has committed itself to halving the government primary deficit by 2015 and achieving a primary surplus by FY2020 at the latest.

The IMF says the Prime Minister, Naoto Kan, gave his personal backing for greater fiscal discipline. Last month, in his first major speech since taking over as premier, he warned that the country was at "risk of collapse" under its huge debt mountain without fiscal reforms.

Growth strategy

As part of its drive to reform the economy, last month Kan’s cabinet published a “New Growth Strategy”. The plan aims to raise growth above 2 per cent on average over the next decade and targets an unemployment rate below 4 per cent, from the current 5 per cent range. It identifies seven key areas for development, ranging from the promotion of new “green” markets, encouraging more tourism, and strengthening health care to raising women’s participation in the labour force.

The IMF report supports structural reforms to raise the country’s potential growth rate and notes that higher growth would aid fiscal consolidation.

“Such reforms would cover important new growth areas, such as health care and the environment. If complemented with measures to boost start-ups, employment, and competition, the strategy could raise productivity, increase labor participation, and make Japan a more attractive destination for foreign investment,” said Gordon.