(EnergyAsia, July 20 2011, Wednesday) — While showing signs of economic recovery, post-quake Japan must consolidate its fiscal position by lowering public debt and implementing reforms, said the International Monetary Fund (IMF).

Following the massive earthquake that struck northeastern Japan on March 11, Tokyo has increased spending and pushed the country’s public debt to higher levels. The world’s third largest economy must consolidate its fiscal position over the medium term if it is to continue being a positive force in the region, said the IMF in its latest assessment of the Japanese economy.

“Japan needs to implement fiscal and structural reforms to strengthen the resilience and growth prospects of its own economy if it is to continue with its existing important, positive role,” said Mahmood Pradhan, the IMF mission chief for the northeast Asian country.

Japan’s public debt now stands at over 220% of its GDP in gross terms, the highest level among advanced economies. In their “Article IV” report on the state of the Japanese economy, IMF economists proposed reforms to bolster confidence in public finances, including reining in social security spending, increasing the country’s tax revenue, and boosting growth through structural reforms.

Uncertainty ahead, need for stable electricity supply and tax reform

While detecting a recovery in economic activity, the IMF report also expressed a high degree of uncertainty remains with the recovery dependent on the easing of supply bottlenecks, a stable long-term supply of electricity, and the recovery of sentiment.

Reconstruction spending is likely to further increase Japan’s sizable public debt, and the report predicts GDP growth is likely to slow to -0.7% this year before rising to 2.9% in 2012.

The report suggests reconstruction spending could be financed by a modest increase in the consumption tax from 5% to as high as 8% in 2012, with a greater and continued increase up to 15% thereafter. This is also needed to bring down Japan’s high level of public debt.

“Bringing down public debt over the medium term will require a sustained and significant adjustment of the primary balance,” said the report.

Given the limited scope for spending cuts, the IMF said fiscal adjustment depends on limiting existing spending and finding new sources of revenue, which include raising and imposing new taxes.

At 17% of GDP, one of the lowest tax revenue levels in the world, Japan has “ample space” to use taxes as a way of improving its fiscal position, said the IMF.

The government has already outlined plans to double the sales tax to 10% by the middle of the decade to help meet its target of halving the primary deficit (in percent of GDP). This forms part of a package of measures unveiled in June which included reforms to social security spending, a proposal to raise the retirement age, and adjustments to pension benefits.

An opportunity in the face of disaster

The IMF said it welcomed Tokyo’s plan for fiscal consolidation, but called for more vigorous action to reduce public debt levels at a faster rate within the next five years. They believe the economic slowdown prompted by the Great East Japan earthquake provides an opportunity to kick-start much-needed structural reforms.

While fiscal adjustment could reduce domestic demand in the short term, lowering the level of public savings would help boost confidence, investment and household incomes over the longer term.

“Fiscal consolidation would also benefit Japan’s partners by releasing a pool of savings for other countries to borrow and reducing risks from a disruption in the Japanese government bond market,” said the report.

The Japanese economy is battling a shrinking labor force, and the priorities identified by the economists include boosting employment by raising labor participation among the elderly, young, and women, pursuing trade liberalisation, and promoting SME restructuring.

Quake to cost up to four percent of GDP

The IMF expects the Japanese economy to expand later this year into 2012. After a sharp contraction in the first half, it expects supply conditions to normalise around now with reconstruction spending to pick up steadily, and exports to to lift domestic demand.

The IMF is forecasting Japan’s GDP to decline by 0.7% in 2011 before rising to 2.9% in 2012. Headline inflation is projected to be around zero percent in 2011 and 2012, while underlying inflation—excluding food and energy—will likely remain negative as a result of the still wide output gap.

Uncertainty surrounding this outlook is large with the risks mainly on the downside. The key risks facing the recovery are from delays in restoring electricity capacity and a slow pick-up in private demand.

The fiscal costs of the earthquake could range between two and four percent of GDP spread over several years.

Reconstruction is projected to increase the fiscal deficit in 2011 to 10.5% of GDP and the net debt-to-GDP ratio to above 130% of GDP. In May, the government passed its first supplementary budget (0.8% of GDP) to repair damaged infrastructure, and the cabinet endorsed a second one in early July (0.4% of GDP) to continue reconstruction. An additional supplementary budget focused on revitalizing the region is expected later this year.

To support reconstruction and contain risks of deflation re-emerging, the Bank of Japan (BoJ) has further eased its accommodative policy stance by expanding the size of its asset purchase program to 10 trillion yen and through a new one-trillion-yen loan programme to support lending activity of financial institutions in the affected regions. (US$1=78 yen).

The BoJ also expanded its lending facility to “strengthen the foundations of economic growth” by 500 billion yen to encourage asset-based lending by financial institutions. Financial sector policies helped maintain financial stability and ensured a smooth functioning of financial transactions in the affected regions.