Scene around Nara Station during the declaration of a state of emergency, Nara, Japan

SINGAPORE, October 25, 2021 – Japan’s economy should recover moderately after being severely battered by the COVID-19 pandemic. As the economy reopens gradually, higher domestic spending from pent-up demand should lead to a rebound in growth. Nevertheless, any new wave of COVID-19 infections and prolonged global supply disruptions could pose a risk to the country’s growth outlook. These findings are based on the preliminary assessment by the ASEAN+3 Macroeconomic Research Office (AMRO), after its virtual Annual Consultation Visit to Japan from September 27 to October 15, 2021.

The mission was led by AMRO Lead Economist, Dr. Jae Young Lee. AMRO Director, Mr. Toshinori Doi and Chief Economist, Dr. Hoe Ee Khor participated in the policy discussions. The talks focused on the impact of COVID-19 pandemic on the economy; prospects of economic growth and inflation; near-term risks and structural challenges; the fiscal, monetary, and other policies to support growth and financial stability; and post-pandemic policy directions.

Economic developments and outlook

“GDP growth will likely rebound strongly from the fourth quarter of this year, because of the reopening of the economy after the recent wave of infection,” says Dr. Jae Young Lee. “Japan’s economy should grow at 2.6 percent in 2021 and 2.4 percent in 2022, adds Dr. Lee.

“The authorities should provide targeted fiscal measures and maintain its current easy monetary policy to support the recovery, backed by a credible medium-term fiscal consolidation plan. Efforts to address Japan’s structural challenges, including labor shortages and increasing social security spending due to the aging population and low fertility rates, should also be accelerated,” says Dr. Lee.

The Japanese economy experienced a sluggish recovery in the first half of 2021, after being severely battered by the COVID-19 pandemic in 2020. While the economy rebounded sharply in the second half of 2020 on the back of strong external demand, the recent wave of the highly contagious Delta variant weakened the pace of the country’s economic recovery in 2021.

Consumer price inflation remains weak in 2021 on the back of a decline in services prices, after turning negative in Q4 2020. During the first eight months of 2021, services prices declined sharply, mainly due to the reduction in mobile phone charges. Meanwhile, goods prices increased, driven by rising import prices of industrial products.

Japan’s external position remains strong on the back of a large primary income surplus. In the first half of 2021, the current account surplus expanded to 3.8 percent of GDP from 3.3 percent of GDP in 2020, with a strong recovery in goods exports.

Financial conditions have been accommodative on the back of strong liquidity support from the government and the Bank of Japan since the outbreak of the pandemic. The overall financial system remains stable with sufficient liquidity and capital buffers, although financial institutions may face some pressures from rising credit risks.

The fiscal deficit widened sharply in fiscal 2020 as a result of massive economic stimulus packages that were introduced during the pandemic, including three supplementary budgets.

Risks, vulnerabilities, and challenges

Japan’s macro-financial outlook is uncertain, depending on the level of recurrence of COVID infections. Any recurrent waves of the disease will have significant impact on economic activities at home and abroad. Sustained global supply chain disruptions and bottlenecks will adversely affect Japanese manufacturers’ production volumes and exports.

A prolonged pandemic would also have adverse effects on financial institutions, in particular on regional banks, in the form of deteriorating asset quality and profitability. Meanwhile, the premature unwinding of the government’s special lending programs for small and medium-sized enterprises before the COVID-19 pandemic is well under control, could put an upward pressure on the number of bankruptcies.

Structural challenges include weakening fiscal discipline, side effects from prolonged monetary easing, the declining profitability of regional banks, demographic drag from population aging and low fertility rates.

Policy recommendations

Fiscal policy should remain supportive of the economy in the short-term, with targeted measures to the hard-hit sectors, leveraging on unspent fiscal resources. At the same time, the government should commence preparations immediately for a credible fiscal consolidation plan, including financing schemes on extra fiscal burdens from the COVID-19 pandemic to ensure long-term fiscal sustainability. The medium-term fiscal consolidation plan should prioritize containing social security expenditure, while raising tax revenues post-pandemic.

The current easy monetary policy stance should be maintained to support growth and counter deflationary pressures amid the COVID-19 pandemic. If there is another resurgence of the pandemic, the country’s central bank could implement further easing measures to support the weak economy.

Financial supervisory authorities should remain vigilant to ensure that financial institutions can maintain their soundness as the pandemic drags on. In the medium term, the country’s financial policy should also continue supporting financial institutions in adapting to a rapidly changing business environment, against the backdrop of an aging population.

Digitalization should be accelerated, in particular, to address the challenges posed by the COVID-19 pandemic and improve labor productivity. To enhance productivity, the government should strive to create a more conducive environment where Japanese corporates are encouraged to increase their investments in digital transformation and the green economy.

Comprehensive health care reforms should be undertaken by the authorities in a timely fashion to enhance Japan’s social and economic resilience. Meanwhile, the government should continue its strong policy support to address climate change.

To cope with structural labor shortages, embracing female, elderly, and foreign workers should be further encouraged. Strengthening work style reforms, increasing job mobility and teleworking, employing robotics and automation, and using big data, can all contribute to enhancing potential growth.

AMRO would like to express its gratitude to the Japanese authorities and other counterparts for their cooperation and candid exchange of views during the virtual Consultation Visit. AMRO wishes to express its appreciation for the strong support from the authorities and the excellent arrangement that has made this virtual mission possible.